← 7. The Open Economy and Trade

Exercises

Problems to check your understanding of this chapter. The solutions are folded away — try them yourself first.

Medium

1Medium

The world interest rate falls from r∗=5%r^* = 5\% to r∗=2%r^* = 2\%.

In a small open economy with no saving or investment shifts, find SS, II, and NXNX, and say whether the country is a lender or a borrower. (Saving is S=60+8r∗S = 60 + 8r^* and investment is I=140−8r∗I = 140 - 8r^*.)

World rate 2%2\% — a borrower with NX=−48NX = -48.
Show solution

  1. Cheap world money pays less for saving: S=60+8⋅2=76S = 60 + 8 \cdot 2 = 76. Borrowing is cheaper, so investment rises: I=140−8⋅2=124I = 140 - 8 \cdot 2 = 124.

  2. Net exports are NX=S−I=76−124=−48NX = S - I = 76 - 124 = -48. Domestic saving falls 4848 short of funding investment, so that 4848 is borrowed from abroad — the country is a borrower, and its trade deficit of 4848 is exactly that borrowing.

Hard

2Hard

A surplus country with net saving S−I=20S - I = 20 slides to S−I=−20S - I = -20 on government deficits.

With the net-export schedule NX(ε)=90−5εNX(\varepsilon) = 90 - 5\varepsilon: (1) how much does the exchange rate appreciate?

(2) how much do net exports change?

(3) would either answer change if a tariff had been imposed along the way?

After the deficits — S−I=−20S - I = -20, ε∗=22\varepsilon^* = 22.
Show solution

  1. (1) In surplus, ε∗=(90−20)/5=14\varepsilon^* = (90 - 20) / 5 = 14; in deficit, ε∗=(90+20)/5=22\varepsilon^* = (90 + 20) / 5 = 22. The exchange rate appreciates by 22−14=822 - 14 = 8.

  2. (2) Net exports track net saving exactly, by the identity: from +20+20 to −20-20, a worsening of exactly 4040. The 88 points of appreciation cost 5⋅8=405 \cdot 8 = 40 of net exports — the two answers are the same fact seen from two sides.

  3. (3) No.

    A tariff moves neither saving nor investment, so S−IS - I is unchanged, and the exchange rate readjusts to pin net exports to S−IS - I again.

    To fix a deficit you fix saving — the budget — not trade.