Gordon Chapter 6 International Trade, Exchange Rates, and Macroeconomic Policy

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Gordon Chapter 6 International Trade, Exchange
Rates, and Macroeconomic Policy
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The link between domestic savings, foreign
savings, and domestic investment

• What are the components of domestic savings?
• How does the trade deficit relate to borrowing of
  foreign savings?
• What is the link between domestic (public and
  private) and foreign savings and domestic
  investment?

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Already learned from chapter 5

• How may a fiscal surplus (higher domestic public
  savings) be offset by lower private domestic
  savings with no effect on domestic investment or
  foreign borrowings?
• How can foreign borrowings be used to support
  domestic investment?
• Why would the long-run effect of lower domestic
  savings result in lower domestic investment and
  economic growth unless the country is able to
  attract more foreign capital?

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The balance of payments in an open economy

• What is measured in the current account of the
  balance of payments?
• What is the difference between the balance of
  trade and the balance in the current account?
  (Note the role of net income from foreign
  investment and unilateral transfer payments.)
• What determines whether or not a transaction is a
  credit or a debit in the current account?
• How does a credit affect the demand for dollars
  and a debit add to the supply of dollars in the
  international exchange market?

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Balance of Payment (cont.)

• What is meant by the capital account in the
  balance of payments?
• How could a credit be generated in the capital
  account? A deficit?
• Why with flexible exchange rates does the current
  account balance plus the capital account balance
  equal zero?
• Why under fixed exchange rates could some of a
  trade deficit require financing by borrowing
  official reserve assets from foreign central
  banks?

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Foreign Borrowing and International Indebtedness

• Why does any increase in borrowing from foreign
  investors or foreign central banks add to the
  countrys indebtedness?
• Why is greater international indebtedness the
  consequence of a deficit in a countrys current
  account?
• Why does a persistent current account deficit
  results in domestic citizens paying interest and
  dividend income to foreigners that lowers
  domestic income?

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Exchange Rates

• What is meant by the exchange rate between
  currencies?
• What does it mean when we say that there is an
  increase in the value of the dollar
  (appreciation)?
• What does it mean when we say the value of the
  dollar is depreciating?
• What is the difference between a nominal exchange
  rate and the real exchange rate?
• Why is domestic demand affected by the real
  exchange rate and not by the nominal exchange
  rate?

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Purchasing Power Parity

• What is meant by purchasing power parity? How
  can this be used to determine if a currency is
  overvalued or undervalued relative to other
  currencies?
• What is the Big Mac Index? http//www.economist.co
  m/markets/bigmac/displayStory.cfm?story_id3503641
  
• What factors interfere with purchasing power
  parity theory?

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Exchange Rate Systems

• What does it mean when we say that the problem of
  financing balance of payment deficits could be
  (1) by allowing flexible exchange rates or (2) by
  the use of official reserves?
• How would flexible exchange rates eliminate a
  balance of payment deficit or surplus?
• How could fixed exchange rates be managed by
  central banks who use official reserves to keep
  the exchange rate constant despite change in the
  demand or supply of currencies?

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Central Bank Reserves

• Why does a trade surplus add to the supply of the
  central banks reserve currencies under fixed
  exchange rates but a trade deficit reduces the
  supply of reserve currencies?
• Why is the support of a currency increasingly
  difficult when a balance of payment deficit
  occurs and the central bank lacks sufficient
  reserve currencies?
• How may the threat of domestic inflation limit
  the use of reserve currencies by a central bank
  to maintain a fixed exchange rate when a balance
  of payments surplus exists?

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The Trilemma

• What is the trilemma?
• How was the reality of trilemma underscored in
  international crisis in Mexico (1994), Southeast
  Asia (1997), Russia and Brazil (1998), and
  Argentina?
• How can freedom of capital flows initially lead
  to large inflows of capital with fixed exchange
  rates, shifting up the demand for domestic
  currency and accumulation of extra reserves by
  central bank?

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• How can a higher demand for a countrys assets
  that leads to an asset bubble eventually cause
  foreigners to run for the exits by withdrawing
  their funds and converting capital inflows to
  capital outflows?
• Why cant central banks reverse the capital
  outflow through the use of reserves?
• Why would central banks eventually be forced to
  allow their currencies to float, leading to
  devaluation and further panic outflows by
  foreigners?
• What conditions are necessary to support a more
  orderly foreign exchange rate?

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Limitations of Monetary and Fiscal Policy

• Why does monetary policy have no control over an
  economy with fixed exchange rates and perfect
  capital mobility? (Perfect capital mobility
  never exists but has a greater relative impact on
  smaller countries)
• If monetary policy is ineffective with fixed
  exchange rates and perfect capital mobility, what
  is the appropriate fiscal policy to reverse a
  capital outflow?
• What would be the repercussions of this fiscal
  policy on the domestic economy?
• Is the problem, fixed or flexible exchange rates,
  or is it a problem of lack of control of on the
  free flow of capital?

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Determinants of Net Exports

• What are the influences of the following
  principal factors on net exports?
• Higher real income
• A higher real exchange rate
• What is the link between the real exchange rate
  and real interest rate differential among
  countries?
• How do fiscal policy and monetary policy impact
  on the balance of payments as they influence the
  goods market and the money market of an economy?
• Why did the positive link between real interest
  rates and the real exchange rate in the U.S.
  break down in 1995?

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International Perspective Exchange Rates and
Monetary Policy in U.S., Europe, and Japan

• The effectiveness of expansionary monetary policy
  and lower interest rates to combat the U.S. 2001
  recession was limited to the consumer and housing
  sectors of the economy. Why didnt the dollar
  depreciate to encourage net exports?
• The ECB responded less aggressively to the
  downturn compared with the Fed. Why?
• What has happened to the value of the dollar
  versus the euro recently? Why?

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Interest Rates and Capital Mobility

• Why would complete capital mobility cause the
  flow of funds to removing the differential in
  real interest rates (adjusted for risk)?
• Why would monetary expansion that temporarily
  lowers domestic interest rates have no permanent
  impact on the interest rate?
• Why would fiscal policy that raises the domestic
  interest rate result in a huge capital inflow
  that would bring the interest rate back to its
  original level?

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The ISLM Model in a Small Open Economy

• Why is the BP schedule horizontal where the
  domestic interest rate equals the foreign
  interest rate?
• Why is monetary under fixed exchange rates
  completely ineffective and fiscal policy even
  more effective in a small open economy?
• Why are domestic monetary policy and fiscal
  policy effective under flexible exchange rates?
• Why is the BP line in a large, open economy
  upward sloping, allowing for some change in
  domestic interest rates from foreign interest
  rates without complete capital mobility?