Problem set 6

THE GEOMETRY OF EXCHANGE RATE OVERSHOOTING

The 1980s was a period of expansionary fiscal policy for the U.S. Consider the following information about the U.S. economy:

Year	Real exchange rate (1973=100.0)	Current account balance ($billion)
1980	84.9	+2.3
1985	132.5	-125.4
1987	90.9	-167.1

Suppose that 1985 represented the consequences of the expansionary fiscal policy in the short run, while 1987 represented the long run. Draw a foreign-sector diagram for the U.S. which includes a short-run NX line and a long-run NX line (NXLR) and which shows the shift in NFI resulting from the expansionary fiscal policy. Use your diagram to label each of the numerical values in the table above.

Indicate in your diagram the portion of the short-run dollar appreciation which illustrates exchange rate overshooting.

THE GEOMETRY OF THE J-CURVE

In the early 1980s, the U.S. Fed adopted contractionary monetary policy. Consider the following information about the U.S. economy:

Year	Real exchange rate (1973=100.0)	Current account balance ($billion)
1979	83.2	-0.3
1981	101.5	+5.0

Draw a foreign-sector diagram for the U.S. which includes a short-run NX line (NX) compatible with the information above, and then show the shift in NFI resulting from the contractionary monetary policy. Use your diagram to label each of the numerical values in the table above.

What must be true for the short-run NX line to have the slope you've drawn in your diagram?

6.	(No diagrams are required to receive full credit for this problem.) The following passages come from past issues of the Los Angeles Times:
	a.	"Strong Dollar Bodes Well for U.S. Market," April 23, 2000:
			"The demand for dollar assets from around the world has been phenomenal," says economist Stephen Roach of Morgan Stanley....What's going on? In simplest terms, the rest of the world is making a living by selling goods to the United States, which is paying them in dollars. But then, the nations receiving those dollars are investing them back in U.S. government bonds and notes and in the stocks and bonds of private companies.
		What is the impact of the activity described here on each of the following for the U.S.: (1) net foreign investment (NFI), (2) real exchange rate, and (3) current-account balance (net exports)? Discuss the reasoning behind your answers.
	b.	"Strong Dollar Bodes Well for U.S. Market," April 23, 2000:
			[I]f ... the Federal Reserve slam[s] the brakes on the U.S. economy, ... the resulting slowdown would reduce imports and the international flow of investments.
		What sort of monetary policy is this passage describing? Do you agree that such a monetary policy would likely "reduce imports and the international flow of investments"? Why or why not?
	c.	"Dollar Tumbles to New Multiyear Lows," May 7, 2005:
			The weak dollar is slashing Americans' purchasing power abroad. But it can help the economy....
		Do you agree with the first sentence? Why or why not? Do you agree with the second sentence? Why or why not?
	d.	"Dollar Tumbles to New Multiyear Lows," May 7, 2005:
			If the dollar's weakness snowballs, it could cause foreigners to pull out of U.S. assets rather than risk further devaluation of their holdings. That is already happening on some scale. Foreigners pulled a net $418 million out of U.S. stocks in the week ended May 2, according to UBS Warburg. That's the fourth week in five that outflows rose.
		Do you think the drop in the value of the dollar is better understood as the cause or the effect of the "outflows" described in the passage? Explain briefly.

1.	THE FUNDAMENTAL OPEN-ECONOMY RELATIONSHIP:
	a.	State the fundamental open-economy relationship.
	b.	Write out the full expression for a country's net production (which is also its net foreign investment (NFI)), and use it to show the four ways a country can increase the amount it has available for net foreign investment.

2.	THE BASICS OF THE FOREIGN SECTOR GEOMETRY
	a.	Draw a basic foreign sector (NFI-NX) diagram to depict an initial long-run situation in which a country has balanced trade. Be sure to label your axes and your curves.
	b.	(1) Why does NXLR slope down? (2) Why does NFI slope up?

3.	CLINTON'S FISCAL POLICY
	a.	Use a foreign sector (NFI-NX) diagram to depict an initial situation in which the U.S. experiences a current account deficit (NX < 0) at its full-employment equilibrium.
	b.	Suppose the U.S. implements contractionary fiscal policy sufficient to eliminate its current account deficit in the long run. Depict in your diagram the new short-run equilibrium which results.

7.	Fall 2007: omit THE WORLD TRADE ORGANIZATION: Fill out the following WTO worksheets (click on the orange bullets in the worksheets to find the answers).
	(1)	The WTO FAQsheet (1)
	(2)	The WTO FAQsheet (2)
	(3)	The WTO FAQsheet (3)