Jim Whitney Economics 311

Problem Set 6: Key

1. THE FUNDAMENTAL OPEN-ECONOMY RELATIONSHIP:
a. State the fundamental open-economy relationship.
    The fundamental open-economy relationship. NX = NFI
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.
    NFI = Y - (C+I+G)
    => the four ways a country can increase NFI: raise Y, lower C, lower G, lower I
 
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.
    See diagram to the right.		 ps6k1f1.gif (2515 bytes)
b. (1) Why does NXLR slope down? 
    NX slopes down because of international competitiveness: real depreciation lowers the price of domestic products relative to foreign products, increasing exports, decreasing imports and therefore raising NX.
(2) Why does NFI slope up?
    NFI slopes up because of how savers respond to exchange rate changes (as reflected by the interest parity condition). An overvalued currency relative to its LR equilibrium makes savers fear depreciation, causing capital outflows as they shift their savings abroad.
 
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.
    A=initial		 ps6k2f1.gif (4847 bytes)
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.
    B=fiscal policy
 

 

4. THE GEOMETRY OF EXCHANGE RATE OVERSHOOTING
a. 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.
    See diagram
b. Indicate in your diagram the portion of the short-run dollar appreciation which illustrates exchange rate overshooting.
    From B to C (132.5-90.0) = overshooting
 
 
5. 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.
 
 
5. 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
  a. 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.    See diagram to right
  b. What must be true for the short-run NX line to have the slope you've drawn in your diagram?
    The Marshall-Lerner condition must fail. The tradables sector must be inelastic (export + import elasticities < 1).
    Answer key checklist: Did you note that the Marshall-Lerner condition did NOT hold in this case? ML says eX + eM > 1 => elastic tradables => the normal case where R and NX move in opposite directions and NXsr slopes down. Here, the reverse happens.
       

 

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.
    (1) Savers shift to US => K-inflows => NFI falls (becomes more negative as US borrows
    (2) R rises: as savers shift to US, demand for $ rises in FX markets
    (3) CAB falls: As R rises, US loses international competitiveness => -X, +M.

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?
    This describes contractionary MP.
    Disagree: contractionary MP --> rdom rises --> savers shift to US --> $ appreciation (+R) --> more imports and more external borrowing, not less

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?
    Agree: $ depreciation makes foreign stuff more expensive to US when valued in $.
    Agree: $ depreciation increases US international competitiveness --> +NX, which can stimulate the economy and boost output.

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.
    It's better understood as the effect of K-outflows. NFI must shift to the right in order for the $ to depreciate. So, savers must shift out of the US in order to make the $ fall.
    Note: A cycle can then get started where the fall in the $ can make savers worry that the $ will fall some more, making more savers leave the US. However, the whole process has to start with a shift of savers out of the country; otherwise the dollar won't fall in the first place.