Chapter 19, The Goods Market in an Open Economy Video Solutions, Macroeconomics Australasian Edition

Problem 1

Using the information in this chapter, label each of the following statements true, false or uncertain. Explain briefly.
a. Trade deficits generally reflect high investment, not low national saving.
b. The national income identity implies that budget deficits cause trade deficits.
c. Opening the economy to trade tends to increase the multiplier because an increase in expenditure leads to more exports.
d. The only way a country can eliminate a trade surplus is through a real appreciation.
e. A small open economy can reduce its trade deficit through fiscal contraction at a smaller cost in output than a large economy can.
f. If the trade deficit is equal to zero, the domestic demand for goods and the demand for domestic goods are equal.
g. The current high US trade deficit is the result of higher growth in the United States than in the rest of the world since the mid-1990s.

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Problem 2

Real and nominal exchange rate and inflation
Using the definition of the real exchange rate (and propositions 7 and 8 in Appendix 2 at the end of the book), you can show that the following is true:
$$
\frac{\Delta \epsilon}{\epsilon}=\frac{\Delta E}{E}+\frac{\Delta P}{P}-\frac{\Delta P^*}{P^*}
$$
where $\frac{\Delta x}{x}=\frac{x_1-x_{t-1}}{x_{t-1}}$. In words, the percentage real appreciation equals the percentage nominal appreciation plus the difference between domestic and foreign inflation.
a. If domestic inflation is higher than foreign inflation, but the domestic country has a fixed exchange rate, what happens to the real exchange rate over time? Assume that the MarshallLerner condition holds. What happens to the trade balance over time? Explain in words.
b. Suppose the real exchange rate is constant, say at the level required for net exports (or the current account) to equal zero. In this case, if domestic inflation is higher than foreign inflation, what must happen to the nominal exchange rate over time?

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Problem 3

The potential effects of a recession in Japan on the Australian economy
a. The share of Japanese spending on Australian goods is 19 per cent of Australian exports, which are themselves equal to about 21 per cent of Australian GDP. What is the share of Japanese spending on Australian goods relative to Australian GDP7
b. Assume that the multiplier in Australia is 2, and that a recession in Japan has reduced output by 5 per cent (relative to its natural level). What is the impact on Australian GDP of the Japanese slowdown?
c. If the Japanese recession also leads to a slowdown of the other economies that import goods from Australia, the effect could be larger. Assume that Australian exports fall by 5 per cent (of themselves). What is the impact of this on Australian GDP?
d. Comment on the following statement from an economist on television: 'Unless Japan recovers from recession quickly, growth will grind to a halt in the rest of the world.'

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Problem 4

Briefly explain in words the results in Table 19.1.

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09:46

Problem 5

Net exports and foreign demand
a. Suppose that there is an increase in foreign output. Show the effect on the domestic economy (that is, replicate Figure 19.4). What is the effect on domestic output? On domestic net exports?
b. If the interest rate remains constant, what will happen to domestic investment? If taxes are fixed, what will happen to the domestic budget deficit?
c. Using equation (19.5), what must happen to private saving? Explain.
d. Foreign output does not appear in equation (19.5), yet it evidently affects net exports. Explain how this is possible.

Md.Daniyal Arshad

Numerade Educator

Problem 6

Eliminating a trade deficit
a. Consider an economy with a trade deficit $(N X<0)$ and with output equal to its natural level. Suppose that, even though output may deviate from its natural level in the short run, it returns to its natural level in the medium run. Assume that the natural level is unaffected by the real exchange rate. What must happen to the real exchange rate over the medium run to eliminate the trade deficit (that is, to increase $N X$ to 0 )?
b. Now write down the national income identity. Assume again that output returns to its natural level in the medium run. If $N X$ increases to 0 , what must happen to domestic demand in the medium run? What government policies are available to reduce domestic demand in the medium run? Identify which components of domestic demand each of these policies affect.

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Problem 7

Multipliers, openness and fiscal policy
Consider an open economy characterised by the equations below:
$$
\begin{aligned}
C & =c_0+c_1(Y-T) \\
I & =d_0+d_1 Y \\
I M & =m_1 Y \\
X & =x_1 Y
\end{aligned}
$$

The parameters $\mathrm{m}_1$ and $\mathrm{x}_1$ are the propensities to import and export. Assume that the real exchange rate is fixed at a value of 1 and treat foreign income, $Y^*$, as fixed. Also assume that taxes are fixed and that government purchases are exogenous (that is, decided by the govermment). We explore the effectiveness of changes in $\mathrm{G}$ under alternative assumptions about the propensity to import.
a. Write the equilibrium condition in the market for domestic goods and solve for $Y$.
b. Suppose that government purchases increase by one unit. What is the effect on output) (Assume that $0<m_1<c_1+d_1<1$. Explain why.)
c. How do net exports change when government purchases increase by one unit?

Now consider two economies, one with $\mathrm{m}_1=0.5$ and the other with $\mathrm{m}_1=0.1$. Each economy is characterised by $\left(\mathrm{c}_1+\mathrm{d}_1\right)=0.6$.
d. Suppose that one of the economies is much larger than the other. Which economy do you expect to have the larger value of $m$ ? Explain.
c. Calculate your answers to parts (b) and (c) for each economy by substituting the appropriate parameter values.
f. In which economy will fiscal policy have a larger effect on output? In which economy will fiscal policy have a larger effect on net exports?

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07:18

Problem 8

Policy coordination and the world economy
Consider the following open economy. The real exchange rate is fixed and equal to one. Consumption, investment, government spending and taxes are given by:
$$
C=10+0.8(Y-T)_i I=10_i G=10_i T=10
$$

Imports and exports are given by
$$
I M=0.3 Y_i X=0.3 Y^*
$$
where an asterisk denotes a foreign variable.

Alex Loukas

Numerade Educator

09:11

Problem 9

Get from your library a recent issue of the International Financial Statistics, published monthly by the IMF (also available on CD-ROM or online from the IMF, <wwwimf.org $>$ ). Look at the list of countries in the table of contents. Make a list of five countries you would expect to have high ratios of exports to GDP. Then, go to the page corresponding to each country, and look up the numbers for exports and GDP, for the most recent available year. (Make sure that you are comparing exports and GDP measured in the same units-either domestic currency or dollars. If one variable is in domestic currency and the other variable is in US dollars, use the exchange rate to convert the two to the same currency.) Calculate the export ratios. How good were your guesses?

Xiaomin Bian

Numerade Educator

Problem 10

The Australian trade deficit and investment
a. Look at equation (19.5). Define national saving as private saving plus the government surplusthat is, as $S-T-G$.
With this definition in mind, by accounting, how is an increase in the trade deficit related to the difference between national saving and domestic investment?
Go the statistical tables on the RBA website (www.rba.gov.au) and download Table G11. Construct annual data for GDP, domestic investment (all types) and net exports from 1980 to the most recent year available. (Net exports are obtained by subtracting imports from exports for each year.) Divide domestic investment and net exports by GDP for each year to express their values as a percentage of GDP.
b. When did Australia last have a trade surplus?
Subtract the value of net exports (as a percentage of GDP) in that year from the value of net exports (as a percentage of GDP) in the most recent year available. Do the same for domestic investment. Has the decline in net exports been matched by an equivalent increase in investment? What do your calculations imply about the change in national saving between then and the present?
c. Is a trade deficit more worrisome when not accompanied by a corresponding increase in investment? Explain your answer.

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