Open Economy

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Chapter 5: The Open Economy
1. In a small open economy, if exports equal $20 billion, imports equal $30 billion, and domestic national saving equals $25 billion, how much are net capital outflows?

Answer:–$10 billion NX = capital flows = 20-30 = -$10b 2. In Micronesia, which is a small open economy, if exports equal $5 billion and imports equal $7 billion, what is Micronesia’s trade balance?

Answer: Micronesia has a deficit trade balance of -2 billion. Trade balance = EX – IM =
5-7 = -$2b 3. In a small open economy, if exports equal $15 billion and imports equal $8 billion, find net capital outflow.

Answer: $7 billion Trade balance = EX- IM = 15-8 = $7b

4. If 5 Swiss francs trade for $1, the U.S. price level equals $1 per good, and the Swiss price level equals 2 francs per good, calculate the real exchange rate.

Answer:2.5 = 5 × (1/2) = 2.5

5. If the nominal exchange rate falls 10 percent, the domestic price level rises 4 percent, and the foreign price level rises 6 percent, find the change in the real exchange rate.

Answer: -12 percent. %Δe = %Δε + (* - )
-10 = x + (6-4) %Δε = -12

6. If purchasing-power parity held, if a Big Mac costs $2 in the United States, and if 10 Mexican pesos trade for $1, how much would a Big Mac in Cancun, Mexico cost?

Answer: 20 pesos. P* = 20 pesos

7. Answer the following
a. In September 1995, Patrick Buchanan, a Republican candidate for president, proposed a 10 percent tariff on Japanese imports to the United States, a 20 percent tariff on Chinese imports to the United States, and an unspecified “social” tariff on imports from third-world countries. Use the long-run model of a small open economy to illustrate graphically the impact of these trade policies on the U.S. exchange rate and the trade balance. Assume that the country starts from a position of trade balance, i.e., exports equal imports. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the new long-run equilibrium values. Answer:

NX2
NX1
NX, S-I
+
-
0
ε
ε2
ε1
S1-I1

b. Based on your graphical analysis, explain the predicted impact of Mr. Buchanan's proposed policies. Specifically state what happens to the exchange rate, the trade balance, the volume of imports, and the volume of exports. Answer:

b. Under Mr. Buchanan’s policy, the dollar exchange rate would appreciate but the trade balance would remain unchanged. However, the volume of imports will decrease (because of the tariffs) and the volume of exports will decrease by the same amount (because of the appreciation of the exchange rate).

8. Answer the following:
a. In April 1995, Michel Camdessus, managing director of the International Monetary Fund (IMF), criticized U.S. economic policy for allowing the dollar exchange rate to fall too low. He recommended that the United States reduce its budget deficit in order to raise the exchange rate. Use the long-run model of a small open economy to illustrate graphically the impact of reducing the government's budget deficit on the exchange rate and the trade balance. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the new long-run equilibrium values. Answer: (a)

0
+
-
NX1
NX2
NX, S-I
NX
ε1
ε2
ε
S1- I1
S2- I2

b. Based on your graphical analysis, explain whether Mr. Camdessus's policy recommendation will work. Specifically state what happens to the exchange rate and the trade balance as a result of the government...
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