Mega International Econ (Part 6) Essay Questions

14) What is purchasing power parity?

: Purchasing power parity means "equal value of money," that is, the exchange rate adjusts so that one currency can buy the same amount of goods and services as another currency

) In the foreign exchange market, what factor leads to a movement along the demand curve for dollars?

A change in the exchange rate leads to a movement along the demand curve for dollars.

28) Define net borrower, net lender, creditor nation, and debtor nation. Discuss the difference between a net borrower and a debtor nation

A country that is borrowing more from the rest of the world than it is lending to the rest of the world is a net borrower. A country that is lending more to the rest of the world than it borrows from the rest of the world is a net lender. A country that during its entire history has borrowed more from the rest of the world than it has lent to the rest of the world is a debtor nation. A country that has invested more in the rest of the world than other countries have invested in it is a creditor nation. A net borrower is a country that is currently borrowing whereas a debtor nation has a stock of outstanding debt. Borrowing is a flow variable and the outstanding debt is a stock. Thus a net borrower could be a creditor nation that is currently borrowing or it could be a debtor nation that is currently borrowing and thereby increasing its debt.

1) Give an example of currency depreciation and appreciation.

A currency depreciates when it becomes less valuable in the foreign exchange market. For instance, if the exchange rate changes from 130 yen per dollar to 110 yen per dollar, the dollar has depreciated. A currency appreciation is the exact opposite: A currency appreciates when it becomes less valuable in the foreign exchange market. For instance, if the exchange rate changes from 130 yen per dollar to 150 yen per dollar, the dollar has appreciated

32) What is a "debtor nation?" Is the United States a debtor nation?

A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it. Although the United States was a creditor nation until the 1980s, its borrowing during the 1980s means that today the United States is a debtor nation.

13) How will an increase in the expected future exchange rate affect the current supply and demand curves for dollars?

An increase in the expected future exchange rate increases the return from holding U.S. dollars. As a result, the demand for dollars increases and the demand curve shifts rightward while the supply of dollars decreases and the supply curve shifts leftward.

4) In the foreign exchange market, how does each of the following influences affect the demand for dollars and the demand curve for dollars? a) an increase in the exchange rate. b) an increase in the U.S. interest rate. c) a fall in the expected future exchange rate.

Answer: a) The increase in the exchange rate decreases the quantity of dollars demanded and creates an upward movement along the demand curve for dollars. b) An increase in the U.S. interest rate increases the demand for dollars and shifts the demand curve for dollars rightward. c) A fall in the expected future exchange rate decreases the demand for dollars and shifts the demand curve for dollars leftward.

6) Explain the effect on the demand for dollars in the foreign exchange market of an increase in the U.S. interest rate differential.

As the U.S. interest rate differential increases, international investors can obtain a greater return by holding U.S. assets. Therefore these investors want to buy more U.S. assets, such as bonds. But in order to buy more U.S. assets, they need more dollars. Hence the increase in the U.S. interest rate differential leads to an increase in the demand for dollars in the foreign exchange market and so the demand curve for U.S. dollars shifts rightward.

7) In the foreign exchange market, how does a change in the expected future U.S. exchange rate affect the demand for dollars?

Changes in the expected future exchange rate change the demand for dollars. If the expected future exchange rate falls, the demand for dollars decreases and the demand curve shifts leftward because the expected profit from holding dollars decreases. If the expected future exchange rate rises, the demand for dollars increases and the demand curve shifts rightward because the expected profit from holding dollars increases.

10) In the foreign exchange market, how does a change in expected future U.S. exchange rate affect the supply of dollars?

Changes in the expected future exchange rate change the supply of dollars. If the expected future exchange rate falls, the supply of dollars increases and the supply curve shifts rightward because the expected profit from holding dollars decreases. If the expected future exchange rate rises, the supply of dollars decreases and the supply curve shifts leftward because the expected profit from holding dollars increases.

30) When a nation has no funds to finance economic development, how can it acquire the needed funds? Is the country a net lender or a net borrower?

Funds for development can be borrowed from other nations. In this case, the borrowing nation is a net borrower in its capital account.

25) If U.S. official reserves increase, is the official settlements account balance positive, negative, or unaffected?

If U.S. official reserves increase, the official settlements account balance is negative.

3) In the foreign exchange market, how does the quantity of U.S. dollars demanded respond to a change in the U.S. exchange rate? Why is there this response?

If the U.S. exchange rate falls, the quantity of U.S. dollars demanded increases for two reasons. The first is the exports effect. If the exchange rate falls, then U.S. goods and services are cheaper in foreign nations. These nations increase the amount of U.S. exports they demand. As exports increase the quantity of dollars demanded increases so that the importing nations can pay for the exports. The second reason the quantity of U.S. dollars demanded increases is the expected profit effect. In general, the greater the expected profit from holding U.S. dollars, the greater is the quantity demanded of U.S. dollars. When the exchange rate falls, more people will believe that it will rise again in the future and so more people want to hold U.S. dollars. As a result, the quantity of U.S. dollars demanded increases.

12) What happens in the foreign exchange market if the U.S. interest rate increases? What is the effect on the exchange rate?

In the foreign exchange market, the increase in the U.S. interest rate increases the demand for dollars and the demand curve for dollars shifts rightward. The increase in the interest rate also decreases the supply of dollars and the supply curve of dollars shifts leftward. As a result, the exchange rate rises so that the dollar appreciates.

8) Why do people and firms in the United States supply dollars to the foreign exchange market?

People and firms supply dollars in order to obtain foreign currency with which to purchase foreign goods and services and/or foreign assets

17) How does the Fed intervene in the foreign exchange market and what the effects are of the Fed's actions?

The Fed intervenes in the foreign exchange market and changes the value of the exchange rate by buying or selling dollars. If the Fed wants to raise the exchange rate and appreciate the dollar, the Fed will buy dollars. By buying dollars the Fed increases the demand for dollars and raises the exchange rate. If the Fed wants to lower the exchange rate and depreciate the dollar, the Fed will sell dollars. By selling dollars the Fed increases the supply of dollars and lowers the exchange rate.

16) What role can the Fed play in the foreign exchange market?

The Federal Reserve can intervene in the foreign exchange market by (temporarily) selling or buying dollars. If the Fed sells dollars, it drives the exchange rate lower and if the Fed buys dollars, it drives the exchange rate higher. The Fed cannot buy dollars forever because it will run out of the foreign exchange it using to buy the dollars. And, the Fed likely will not want to sell dollars forever because it would accumulate ever increasing amounts of foreign exchange.

22) What balance of payment account records foreign investment between countries?

The capital account records foreign investment between countries. The U.S. capital account equals foreign investment in the United States minus U.S. investment abroad.

23) How do the capital account and the current account differ?

The current account and the capital account differ in what is recorded in each. The current account records exports, imports, net interest, and net transfers. The capital account records foreign investment in the United States and U.S. investment abroad.

21) What are the main components of the current account? What has been the recent U.S. experience with these items?

The current account records payments for the imported of goods and services and the receipts for exported of goods and services. These two components of the current account are by far the largest components. In addition to the value of imports and exports, the current account also includes the net interest income paid abroad and net transfers. Net interest income measures the interest payments both made and received which flow from previously purchased assets. Net transfers record such items as foreign aid payments. Over recent years, the U.S. current account has been negative, that is, there has been a current account deficit. Over these years, the United States has experienced a perennial trade deficit, which means that the value of imports has exceeded the value of exports. The trade deficit has been the primary cause why the U.S. current account has been negative. Net interest income has been barely negative while net transfers are also negative and slightly larger in magnitude than net interest income.

9) In the foreign exchange market, how does a fall in the U.S. interest rate affect the supply of dollars?

The fall in the U.S. interest rate increases the supply of dollars as U.S. residents supply more dollars in order to obtain foreign currency with which to buy foreign assets that now have relatively higher interest rates.

24) Define official settlements account and U.S. official reserves. Discuss the differences between the two terms.

The official settlements account is the record of the change in a country's official reserves. U.S. official reserves are the U.S. government's holdings of foreign currency. If the U.S. official reserves increases, the official settlements account balance is negative. The reason the official settlements account decreases is that holding foreign money is similar to investing abroad insofar as both buying foreign money and buying foreign assets (that is, investing abroad) use (rather than acquire) U.S. dollars.

34) Saving is S, investment is I, net taxes is NT, government expenditure is G, exports is X, and imports is M. Using these symbols, what is the relationship among the saving, investment, net taxes, government expenditure, exports, and imports?

The relationship is that (X - M) = (S - I) + (NT - G), or net exports equals the private sector balance plus the government sector balance.

33) What is the relationship between net exports, the government sector surplus or deficit, and the private sector surplus or deficit?

The relationship is that net exports equals the government surplus or deficit plus the private sector surplus or deficit.

15) "Fluctuations in exchange rates, other things remaining the same, creates a situation in which money buys the same amount of goods and services in different currencies." What does the previous statement describe? Will these fluctuations occur in the short run or the long run?

The statement describes purchasing power parity, the proposition that money will buy the same amount of goods and services in different currencies. The effects of purchasing power parity will change the exchange rate in the long run. In the short run, deviations from purchasing power parity can occur.

"In the foreign exchange market, if the demand for the U.S. dollar increases, the U.S. dollar appreciates in value." Briefly explain whether the previous statement is correct or incorrect.

The statement is correct. The increase in the demand for dollars shifts the demand curve for dollars rightward and creates a shortage of dollars at the initial exchange rate. This shortage puts upward pressure on the exchange rate and so the exchange rate rises to its new equilibrium value.

) "If the official settlements balance is zero, a current account surplus must equal the capital account deficit." Is the previous statement correct or incorrect? Briefly explain your answer.

The statement is correct. The sum of the current account balance plus the capital account balance plus the official settlements account must equal zero. If the official settlements account balance is zero, then the sum of the current account balance plus the capital account balance must equal zero. Therefore a current account surplus must be "balanced" by an equally-sized capital account deficit.

31) "Although the United States is running a large current account deficit, it is still ranked as a major international net lender." Is the previous statement correct or incorrect? Briefly explain your answer.

The statement is incorrect. Aside from changes in the official settlements account, any nation that is running a current account deficit must be paying for the excess of imports over exports by borrowing from abroad. The United States is no exception and with its large current account deficits, the United States is a large net borrower from abroad.

20) "The current account records foreign investment in a nation minus investment abroad." Is the previous statement correct or incorrect?

The statement is incorrect. The current account equals exports minus imports plus net interest plus net transfers. The capital account records foreign investment in a nation minus investment abroad

What are the three balance of payments accounts? Briefly describe them. What is the relationship among the three?

The three balance of payment accounts are the current account, the capital account, and the official settlements account. The current account records exports, imports, net interest, and net transfers. The capital account records foreign investment in the United States and U.S. investment abroad. Finally, the official settlements account shows changes in U.S. official reserves, the government holdings of foreign currency. The relationship is that the current account balance plus capital account balance plus official settlements account must sum to zero.

5) Name three factors in the foreign exchange market that affect either the quantity of dollars demanded or the demand for dollars. Discuss whether the factor increases or decreases the number of dollars people want to hold.

Three factors are the exchange rate, the U.S. interest rate differential, and the expected future exchange rate. If the exchange rate rises, the quantity of dollars demanded decreases. If the U.S. interest rate differential is larger (either because the U.S. interest rate rose or because foreign interest rates fell) then the demand for dollars increases. And, if the expected future value of the exchange rate is higher, then the current demand for dollars increases.

18) If the Fed wants to lower the U.S. exchange rate, what action should it take in the foreign exchange market? Why does the action lower the exchange rate?

To lower the exchange rate, the Fed should sell dollars and buy foreign currency. By selling dollars, the Fed increases the supply of dollars, which lowers the U.S. exchange rate.

29) What is the relationship between net borrower, net lender, debtor nation, and creditor nation?

is a net borrower. If a nation is currently lending more to the world more than it is borrowing from the world, the nation is a net lender. If during its entire history a nation has borrowed more than it has lent, the nation is a debtor nation. If during its entire history a nation has lent more than it has borrowed, the nation is a creditor nation. The distinction between borrowing or lending and being a debtor or creditor deals is the distinction between a flow and a stock. A nation that is a net borrower is increasing its debt (or decreasing its assets). The net borrowing is the flow that adds to the stock of debt (or decreases the stock of assets). A nation that is a net lender is increasing its assets (or decreasing its debt). The net lending is the flow that adds to the stock of assets (or decreases the stock of debt)