Econ Ch 13

real exchange rate =

(e x P) / P*

when a foreigner purchases a good from the US,

- US exports and NX increase - the foreigner pays with currency or assets, so the US acquires some foreign assets, causing NCO to rise

when a US citizen buys foreign goods,

- US imports rise - NX falls - the US buyer pays with US dollars or assets, so the other country acquires US assets, causing US NCO to fall

variables that influence net exports

1. consumers' preferences for foreign and domestic goods 2. prices of goods at home and abroad 3. incomes of consumers at home and abroad 4. the exchange rates at which foreign currency trades for domestic currency 5. transportation costs 6. government policies toward international trade

Two limitations of PPP theory

1. many goods cannot easily be traded 2. foreign, domestic goods not perfect substitutes

variables that influence NCO

1. real interest rates paid on foreign assets 2. real interest rates paid on domestic assets 3. perceived risks of holding foreign assets 4. government policies affecting foreign ownership of domestic assets

A farmer in Mexico purchases a tractor made in the U.S. This purchase is an example of

A US export and a Mexican import

When Jamie, a U.S. citizen, purchases a wool jacket made in Ireland, the purchase is

A US import and an Irish export

The law of one price states that

A good must sell at the same price at all locations

A country purchases more goods and services from residents of foreign countries than residents of foreign countries purchase from it. This country has

A trade deficit and negative net exports

A country purchases more goods and services from residents of foreign countries than residents of foreign countries purchase from it. This country has:

A trade deficit and negative net exports

If purchasing-power parity holds, a dollar will buy:

As many goods in foreign countries as it does in the US

A Finnish corporation builds a factory that produces ceiling fans in the United States. This is an example of Finish:

Foreign direct investment that increases Finnish net capital outflow

example of foreign direct investment

McDonalds opens a fast-food outlet in Moscow

NCO must always equal

NX

Other things the same, if a country has a trade deficit and saving rises,

Net capital outflow rises, so the trade deficit decreases

If a dollar currently purchases 12.5 pesos and someone forecasts that in a year it will purchase 14 pesos, then the forecast is given in

Nominal terms and implies the dollar will appreciate

If a dollar currently purchases 12.5 pesos and someone forecasts that in a year it will purchase 14 pesos, then the forecast is given in:

Nominal terms and implies the dollar will appreciate

what does each variable mean in: (e x P)/P*

P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate

e =

P*/P

The theory of purchasing-power parity primarily explains

The determination of the real exchange rate

A depreciation (fall) in the US real exchange rate means that

US goods have become cheaper relative to foreign goods. as a result, US exports rise and US imports fall

An appreciation (rise) in the US real exchange rate means that

US goods have become more expensive compared to foreign goods. as a result, US net exports fall

Depreciation (or "weakening"):

a decrease in the value of a currency as measured by the amount of foreign currency it can buy

Purchasing-power parity

a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries

trade surplus

an excess of exports over imports E > I

trade deficit

an excess of imports over exports E < I

Appreciation (or "strengthening"):

an increase in the value of a currency as measured by the amount of foreign currency it can buy

Other things the same, if the U.S. real exchange rate appreciates, U.S. net exports

and U.S. net capital outflow both decrease.

If the exchange rate changes so that a dollar buys more foreign currency, that change is called an ________________ of the dollar

appreciation

If the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate - the relative price of domestic and foreign goods -

cannot change

NCO < 0 =

capital inflow (-)

NCO > 0 =

capital outflow (+)

A Swiss company sells chocolates to a retailer in the United States. These sales by themselves

decrease US net exports and increase Swiss net exports (increase US imports)

If the exchange rate changes so that a dollar buys less foreign currency, that change is called a ______________ of the dollar

depreciation

closed economy

does not interact with other economies in the world Y=C + I + G

When NCO > 0, "capital outflow"

domestic purchases of foreign assets exceed foreign purchases of domestic assets (trade surplus)

foreign direct investment

domestic residents actively manage the foreign investment

foreign portfolio investment

domestic residents purchase foreign stocks and bonds, supplying "loanable funds" to a foreign firm

net capital outflow (NCO)

domestic residents' purchases of foreign assets minus foreigners' purchases of domestic assets

exports

domestically-produced g&s sold abroad

net exports =

exports - imports

net exports

exports - imports aka. trade balance

If inflation is higher in the US than in Japan, then P rises faster than P*, so e

falls - the dollar depreciates against the yen

When NCO < 0, "capital inflow"

foreign purchases of domestic assets exceed domestic purchases of foreign assets

imports

foreign-produced g&s sold domestically

when S < I,

foreigners are financing some of the country's investment and have negative net capital inflow (NCO < 0) - trade deficit

example of foreign portfolio investment

if an American buys stock in a Russian corporation

open economy

interacts freely with other economies around the world Y = C + I + G + NX

Saving =

investment + net exports or investment + NCO

A depreciation of the U.S. real exchange rate induces U.S. consumers to buy

more domestic goods and fewer foreign goods.

When a nation's domestic investment exceeds its saving (I > S), its net capital outflow is

negative, indicating that foreigners are financing some of this investment by purchasing domestic assets (trade deficit)

A country has a trade deficit. Its net capital outflow must be _____ and its saving is ______

net capital outflow must be negative and saving is smaller than investment.

Every international transaction involves the exchange of an asset for a good or service, so

net exports equal net capital outflow

When a nation's saving exceeds its domestic investment (S > I), its net capital outflow is

positive, indicating that the nation is using some of its saving to buy assets abroad (trade surplus)

According to the theory of purchasing-power parity, the nominal exchange rate between the currencies of two countries must reflect the _________ in those countries

price levels

Nominal exchange rates change when

price levels change

Net capital outflow equals the difference between a country's

purchases of foreign assets and sales of domestic assets abroad.

If inflation is higher in Mexico than in the US, then P* rises faster than P, so e

rises - the dollar appreciates against the peso

If France had positive net exports last year, then it

sold more abroad than it purchased abroad and had a trade surplus.

When the Mexican peso gets "stronger" relative to the dollar,

the U.S. trade deficit with Mexico falls.

when S > I,

the excess loanable funds flow abroad in the form of positive net capital outflow (NCO > 0) - trade surplus

The dollar is said to appreciate against the euro if

the exchange rate rises. Other things the same, it will cost more euros to buy U.S. goods.

Law of one price:

the notion that a good should sell for the same price in all markets

the real exchange rate measures

the price of a basket of g&s available domestically relative to a basket of g&s available abroad

arbitrage

the process of taking advantage of price differences for the same item in different markets

Nominal exchange rate:

the rate at which one country's currency trades for another

Real exchange rate:

the rate at which the goods and services of one country trade for the goods and services of another

PPP implies that the nominal exchange rate between two countries should equal

the ratio of price levels

The nominal exchange rate equals

the ratio of the foreign price level (measured in units of the foreign currency) to the domestic price level (measured in units of domestic currency)

The nominal exchange rate is

the relative price of the currency of two countries

The real exchange rate is

the relative price of the goods and services of the two countries

If saving is greater than domestic investment, then

there is a trade surplus and Y > C + I + G.

balanced trade

when exports = imports E = I