T. 9 - Problem SET - Ejercicio obligatorio del tema 9. PDF

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Ejercicio obligatorio del tema 9....

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2. If the UK prime minister announces that the government are solidly on a course of deficit reduction, which should make the pound more attractive to investors, would such a deficit reduction in fact raise the value of the pound? Explain. If there is deficit reduction, it means that the budget deficit is decreasing, and so, the national savings are increasing. Firstly, we’ve got a r-LF graph: As budget deficit is reducing, it means that savings are increasing and so, the supply curve of loanable funs, increases (shifts to the right). This causes a decrease in interest rate (r). Secondly, we’ve got a r-NCO graph: As interest rates decreases, NCO increases (they are contrary). To end up, we’ve got an E-Dollars graph: As NCO increases, it means the supply curve of dollars (NCO) shifts to the right. This shift would cause a decrease also in the real exchange rate. THUS, THE REAL VALUE OF THE POUND WOULD DECLINE, NOT INCREASE AS THE PRESIDENT SUGGESTED. (If E depreciates it means the value of money depreciates too). A reduction in the UK government budget deficit would increase national saving, shifting the supply curve of loanable funds to the right in Figure 3. This would reduce the real interest rate in the UK, thus increasing net capital outflow, and reducing the real exchange rate. Thus, the real value of the pound would decline, not increase as the president suggested

3. Suppose that the government passes an investment tax credit, which subsidizes domestic investment. How does this policy affect national saving, domestic investment, net capital outflow, the interest rate, the exchange rate and the trade balance? First graph interest rate-loanable funds: If this tax credit subsidizes domestic investment, it means that the investment would increase, and so the demand supply for loanable funds would shift to the right. As a result, the interest rate would increase. Second graph interest rate-net capital outflow: As the interest rate increases, it means a downward sloping curve of NCO. Third graph real exchange rate-dollars: As the interest increases, it means the NCO decreases, so the supply curve of dollars in the market for foreign exchange shifts to the left. As a result, the quantity of dollars would decrease, the NCO would decrease, and so, the real exchange rate would increase, the value of the pounds, appreciate. The trade also decreases, since the NCO and NX are lower. The higher real interest rate also increases the quantity of national saving. In summary: Saving increases, domestic investment increases, NCO decreases, real interest rate increases, the real exchange rate increases, and the trade balance decreases. If the government passes an investment tax credit, it subsidizes domestic investment. The desire to increase domestic investment leads firms to borrow more, increasing the demand for loanable funds, as shown in Figure 4. This raises the real interest rate, thus reducing net capital outflow. The decline in net capital outflow reduces the supply of domestic currency in the market for foreign exchange, raising the real exchange rate. The trade balance also declines, since net capital outflow and hence net exports are lower. The higher real interest rate also increases the quantity of national saving. In summary, saving increases, domestic investment increases, net capital outflow declines, the real interest rate increases, the real exchange rate increases, and the trade balance decreases.

4. Assume that there is a rise in the trade deficit of a country due largely to the rise in a government budget deficit. Assume also that some commentators in the popular press claim that the increased trade deficit resulted from a decline in the quality of the country’s products relative to foreign products. A rise in the trade deficit it means that, the net exports are still negative but, in addition, the imports are still increasing. Some people say that this increase in trade deficit is because of a decline in the quality of the country’s products comparing them into the foreign ones.

a) Assume that the country’s products did decline in relative quality during this period. How might that affect net exports at any given exchange rate? If there has been a decline in relative quality, this might have affected net exports by decreasing them. Because the country’s products are not as good as the foreign ones, and this would cause a decrease in exports for the country. Foreign people won’t buy their products. This reduction of NX would cause the demand curve of dollars to shift to the left in the market for foreign exchange. This would cause a depreciation in the real exchange rate. A decline in the quality of US goods at a given real exchange rate would reduce net exports, reducing the demand for dollars, thus shifting the demand curve for dollars to the left in the market for foreign exchange, as shown in Figure 5.

b) Use a three-panel diagram to show the effect of this shift in net exports on the country’s real exchange rate and trade balance. The shift to the left of the demand curve for dollars leads to a decline in the real exchange rate. Since net capital outflow is unchanged, and net exports equals net capital outflow, there is no change in the equilibrium of the net exports or the trade balance.

c) Does a decline in the quality of the country’s products have any effect on standards of living for its residents? (Hint: when a country’s residents sell goods to noncountry residents, what do they receive in return?) The claim is NOT CORRECT. A change in the quality of US goods cannot lead to a rise in the trade deficit. The decline in the real exchange rate means that US residents get fewer foreign goods in exchange for their goods, so their standard of living may decline. A decline in the quality of the country’s products (↓) cannot contribute to an increase in the trade deficit. This decrease would cause the declining effect on standards of living for its residents (↓), because reduction in the real exchange rate (↓E) means that the country gets fewer foreign goods in exchange for its goods.

5. Explain in words why European exports industries would benefit from a reduction in restrictions on imports into the European Union. European exports industries have the purpose to get money from foreign countries, when a restriction on imports is given, they have many problems. So, if there is a reduction in this restriction, it means that in comparison of before, now they might be able to sell more to other countries, and so, to do benefits. If this restriction is reduced, people will be able to import more and also to export more. A reduction in restrictions of imports would reduce net exports at any given real exchange rate, thus shifting the demand curve for dollars to the left. The shift of the demand curve for dollars leads to a decline in the real exchange rate, which increases net exports. Since net capital outflow is unchanged, and net exports equals net capital outflow, there is no change in equilibrium in net exports or the trade balance. But both imports and exports rise, so export industries benefit.

6. Suppose the French suddenly develop a strong taste for British wine. Answer the following questions in words and using a diagram. a) What happens to the demand for pounds in the market for foreign currency exchange?

When the French develop a strong taste for British wines, the demand for pounds in the foreign-currency market increases at any given real exchange rate, as shown in Figure 6.

b) What happens to the value of pounds in the market for foreign currency exchange? The result of the increased demand for pounds is a rise in the real exchange rate.

c) What happens to the quantity of UK net exports? The quantity of net exports is unchanged.

7. Suppose your country is running a trade deficit and you hear your trade minister on the radio, saying: ‘The trade deficit must be reduced, but import quotas only annoy our trading partners. If we subsidize our exports instead, we can reduce the deficit by increasing our competitiveness.’ Using a three-panel diagram, show the effect of an export subsidy on net exports and the real exchange rate. Do you agree with the trade minister? Trade deficit it means that the country has more imports than exports, and so, the net exports are negative. An export subsidy means that there will be an increase in exports at any given real exchange rate, so the trade deficit would decrease. An export subsidy increases net exports at any given real exchange rate. This causes the demand for currency to shift to the right in the market for foreign exchange, as shown in

Figure 7. The effect is a higher real exchange rate, but no change in net exports. So, the trade minister is wrong; an export subsidy will not reduce the trade deficit.

8. Suppose that real interest rates increase across Europe. Explain how this development will affect UK net capital outflow. Then explain how it will affect UK net exports by using a formula from the chapter and by using a diagram. What will happen to the UK real interest rate and real exchange rate? Higher real interest rates in Europe lead to increased UK net capital outflow. Higher net capital outflow leads to higher net exports, since in equilibrium net exports equal net capital outflow ( NX = NCO ). Figure 8 shows that the increase in net capital outflow leads to a lower real exchange rate (value of money depreciates), higher real interest rate, and increased net exports.

10. Assume that saving in China has been used to finance investment into the EU. That is, the Chinese have been buying European capital assets. a) If the Chinese decided they no longer wanted to buy European assets, what would happen in the European market for loanable funds? In particular, what would happen to European interest rates, European saving, and European investment? If China decided they no longer wanted to buy EU assets, EU net capital outflow would increase, increasing the demand for loanable funds, as shown in Figure 9. The result is a rise in EU interest rates, an increase in the quantity of EU saving (because of the higher interest rate), and lower EU domestic investment.

b) What would happen in the market for foreign currency exchange? In particular, what would happen to the value of the euro and the European trade balance? In the market for foreign exchange, the real exchange rate (value of euro) declines and the balance of trade increases....