Prepared and Collected by Trần Đức Thành - TA Macroeconomics

CHAPTER 31. OPEN ECONOMY - THE BASIC CONCEPT

1. How would the following transactions affect U.S. exports, imports, and net exports?

a. An American art professor spends the summer touring museums in Europe.

b. Students in Paris flock to see the latest movie from Hollywood.

c. Your uncle buys a new Volvo

d. The student bookstore at Oxford University sells a pair of Levi's 501 jeans

e. A Canadian citizen shops at a store in northern Vermont to avoid Canadian sales taxes.

2. How would the following transactions affect U.S. net capital outflow? Also state whether each
involves direct investment or portfolio investment.

a. An American cellular phone company establishes office in the Czech Republic.

b. Garrod's of Dondon (belonging to UK) sells stock to Heneral Llectric in the US pension fund.

c. The Sony pension fund buys a bond from the U.S. Treasury.

3. A can of soda costs $0.75 in the U.S and 12 pesos in Mexico. What would the peso ‐ dollar
exchange rate be if the purchasing-power parity holds? If a monetary expansion causes all prices
in Mexico to double, so that soda rose to 24 pesos, what will happen to the peso-dollar exchange
rate?

4. If a Japanese car cost 500,000 yen, a similar American car cost $10,000, and a dollar can buy
100 yen, what are the nominal exchange rate and real exchange rate?

5. Suppose that the price of a Big Mac is a good approximation of the price level in the country. A
Big Mac costs £2 in London and $3 in New York.

a. If purchasing power parity holds, what is the exchange rate between the U.S. dollar and the
British pound?

b. If the current exchange rate is $1.6 per pound, what is the dollar price of a Big Mac in London?
What do you predict will happen to the exchange rate? Explain.

6. Suppose that money supply growth continues to be higher in Turkey than it is in the United
States. What does purchasing-power parity imply will happen to the real and to the nominal
exchange rate?

7. Suppose that two countries, Vietnam and Côte d’Ivoire, produce coffee. The currency unit used
in Vietnam is the dong (VND). Côte d’Ivoire is a member of Communauté Financière Africaine
 Prepared and Collected by Trần Đức Thành - TA Macroeconomics

(CFA), a currency union of West African countries that use the CFA franc (XOF). In Vietnam,
coffee sells for 5,000 dong (VND) per pound. The exchange rate is 30 VND per 1 CFA franc,
E(VND/XOF)= 30.

a. If the law of one price holds, what is the price of coffee in Côte d’Ivoire, measured in CFA
francs?

b. Assume the price of coffee in Côte d’Ivoire is actually 160 CFA francs per pound of coffee.
Compute the real exchange rate of Côte d’Ivoire versus Vietnam. Where will coffee traders buy
coffee? Where will they sell coffee in this case? How will these transactions affect the price of
coffee in Vietnam? In Côte d’Ivoire?

8. A case study in the chapter analyzed purchasing- power parity for several countries using the
price of Big Macs. Here are data for a few more countries:

Country Price of a Big Mac Predicted Exchange Actual Exchange Rate

Rate
Chile 2,100 pesos ? pesos/$ 715 pesos/$
Hungary 900 forints ? forints/$ 293 forints/$
Czech Republic 75 korunas ? korunas/$ 25.1 korunas/$
Brazil 13.5 real ? real/$ 4.02 real/$
Canada 5.84 C$ ? C$/$ 1.41 C$/$

a. For each country, compute the predicted exchange rate of the local currency per U.S. dollar.
(Recall that the U.S. price of a Big Mac was $4.93.)

b. According to purchasing-power parity, what is the predicted exchange rate between the
Hungarian forint and the Canadian dollar? What is the actual exchange rate?

c. How well does the theory of purchasing-power parity explain exchange rates?

9. Use the table that follows to answer this question. Treat the country listed as the home country
and treat the United States as the foreign country. Suppose the cost of the market basket in the
United States is PUS = $190. Check to see whether PPP holds for each of the countries listed, and
determine whether we should expect a real appreciation or real depreciation for each country
(relative to the United States) in the long run. For the answer, create a table similar to the one
shown and fill in the blank cells.

FX: Foreign exchange

 Prepared and Collected by Trần Đức Thành - TA Macroeconomics

10. Use the table below to answer the following questions

Actual exchange rate US index FX index

Brazil (real) 2.189 real/USD 400 840
India (rupee) 46.665 rupee/USD 400 18,666
Mexico (peso) 11.013 peso/USD 400 4405
South Africa (rand) 6.929 rand/USD 400 2900

a. What is the purchasing power of each currency? Which currency follow Laws of One Price
that Purchasing Power Parity holds?

b. Which currency is more valuable than predicted exchange rate?

c. What is the real exchange rate of each country compared to the US?

d. Which countries have goods and services more expensive than those in the US? Which
countries do not?

CHAPTER 32. A MACROECONOMIC THEORY OF THE OPEN ECONOMY

11. The rise in the U.S. trade deficit during the 1980s was due largely to the rise in the U.S. budget
deficit. On the other hand, the popular press sometimes claims that the increased trade deficit
resulted from a decline in the quality of U.S. products relative to foreign products.

a. Assume that U.S. products did decline in relative quality during the 1980s. How did this
affect net exports at any given exchange rate?

b. Draw a three-panel diagram to show the effect of this shift in net exports on the U.S. real
exchange rate and trade balance.

c. Is the claim in the popular press consistent with the model in this chapter? Does a decline
in the quality of U.S. products have any effect on our standard of living? (Hint: When we sell our
goods to foreigners, what do we receive in return?)
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12. Suppose the French suddenly develop a strong taste for California wines. Answer the following
questions in words and with a diagram.

a. What happens to the demand for dollars in the market for foreign-currency exchange?

b. What happens to the value of the dollar in the market for foreign-currency exchange?

c. What happens to U.S. net exports?

13. Suppose the United States decides to subsidize the export of U.S. agricultural products, but it
does not increase taxes or decrease any other government spending to offset this expenditure.
Using a three- panel diagram, show what happens to national saving, domestic investment, net
capital outflow, the interest rate, the exchange rate, and the trade balance. Also explain in words
how this U.S. policy affects the amount of imports, exports, and net exports.

14. The president is considering placing a tariff on the import of Japanese luxury cars. Discuss the
economics and politics of such a policy. In particular, how would the policy affect the U.S. trade
deficit? How would it affect the exchange rate? Who would be hurt by such a policy? Who would
benefit?

a. If the Japanese decided they no longer wanted to buy U.S. assets, U.S. net capital outflow would
increase, increasing the demand for loanable funds. The result is a rise in U.S. interest rates, an
increase in the quantity of U.S. saving (because of the higher interest rate), and lower U.S.
domestic investment.

b. In the market for foreign exchange, the real exchange rate declines and the balance of trade
moves toward surplus.

15. Use the market for loanable funds and foreign exchange currency approach to analyze the
impact of these events. Illustrate on the diagram

a. New investors will have a priority to delay corporate income tax payment for about 3 years.
b. Interest rate for saving accounts is lower due to new policies from the central bank
c. Tax revenue was improved so that budget balance of the government was also improved.
d. Political instability and capital flight
e. A tax cut and increase government spending

16. Use the model of the small open economy to predict what would happen to the trade balance,
the real exchange rate in response to each of the following events.
a. A fall in consumer confidence about the future induces consumers to spend less and save more.
b. The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over
domestic cars.
c. The introduction of automatic teller machines reduces the demand for money.
 Prepared and Collected by Trần Đức Thành - TA Macroeconomics

17. Suppose that Congress is considering an investment tax credit, which subsidizes domestic
investment.

a. How does this policy affect national saving, domestic investment, net capital outflow, the
interest rate, the exchange rate, and the trade balance?
b. Representatives of several large exporters oppose the policy. Why might that be the case?

18. Suppose that U.S. mutual funds suddenly decide to invest more in Canada.

a. What happens to Canadian net foreign investment, Canadian saving, and Canadian domestic
investment?
b. What is the long-run effect on the Canadian capital stock?
c. How will this change in the capital stock affect the Canadian labor market? Does this U.S.
investment in Canada make Canadian workers better off or worse off?
d. Do you think this will make U.S. workers better off or worse off? Can you think of any reason
why the impact on U.S. citizens generally may be different from the impact on U.S. workers?

19. Suppose China exports TVs and uses the yuan as its currency, whereas Russia exports vodka
and uses the ruble. China has a stable money supply and slow, steady technological progress in
TV production, while Russia has very rapid growth in the money supply and no technological
progress in vodka production. On the basis of this information, what would you predict for the
real exchange rate (measured as bottles of vodka per TV) and the nominal exchange rate
(measured as rubles per yuan)? Explain your reasoning. (Hint: For the real exchange rate, think
about the link between scarcity and relative prices.)

20. The country of Myersovia is a small open economy. Suddenly, a change in world fashions
makes the exports of Myersovia unpopular.
a. . What happens in Myersovia to saving, investment, net exports, the interest rate, and the
exchange rate?
b. The citizens of Myersovia like to travel abroad. How will this change in the real exchange rate
affect them?
c. The fiscal policymakers of Myersovia want to adjust taxes to maintain the exchange rate at the
previous level. What should they do? If they do this, what are the overall effects on saving,
investment, net exports and the interest rate?
d. Suppose that Malta, a small open economy, bans the import of Japanese DVD players in order
to reduce their trade deficit. Will this policy measure achieve its goal?