Macroeconomics Exam 3: Chapter 18

A US company uses UK pounds it already owned to purchase bonds issued by a UK company.

-There is no transaction in goods/services so NX stays the same -NX=NCO so NCO stays the same -US loses its holds of UK pounds, so NCO decreases; US acquires UK corporate bonds, so NCO increases --> these cancel each other out, leaving NCO unchanged -NCO=NX so NX stays the same

Appreciation

-an increase in the value of a currency ‐"strengthening" ‐one can buy more foreign currency with one unit of domestic currency

Depreciation

-decrease in the value of a currency ‐"weakening" -one can buy less foreign currency with one unit of domestic currency

2 Types of NCO Investments

1) Foreign Direct Investment (FDI) 2) Foreign Portfolio Investment (FPI)

What is an example of a U.S. foreign direct investment?

A U.S. furniture maker opens a plant in Mexico

Trade Deficit

Exports < Imports (NX<0)

Balanced Trade

Exports = Imports (NX=0)

Capital Inflow

NCO < 0

Net Capital Outflow (NCO) Equation

NCO = Our purchase of foreign assets - foreign purchase of our assets

Capital Outflow

NCO > 0

Net Exports (NX) Equation

NX = Exports - Imports

Net Exports vs. Net Capital Outflow

NX = NCO ALWAYS

Imports

foreign goods and services purchased by us

Net Capital Outflow increases if...

i. U.S. residents buy foreign assets. ii. Foreigners sell U.S. assets. (negative purchase)

S - I = NCO when...

i. national saving is larger than investment ( S > I ) ii. there is a saving shortage ( S < I ) iii. trade deficits (negative NX)

When there is trade deficits (negative NX)...

it simply means that the country invests more than it saves (I > S)

Real Exchange Rate under PPP

measures the quantity of consumption basket of one country per consumption basket to the other country, so PPP implies that this should be ONE --> E = 1

Foreign Portfolio Investment (FPI)

‐ Purchase of financial assets in a foreign country ‐ EX: foreign stocks, bonds, or currencies

Foreign Direct Investment (FDI)

‐ Purchase of physical assets in a foreign country ‐ EX: machines, tools, and structures

Why does NX = NCO?

‐Because every transaction of goods and services, a financial transaction should be made. ‐This is an accounting identity

Types of Exchange Rates

-Nominal -Real

If two countries have different inflation rates, then the nominal exchange rate will change over time:

a. If inflation is higher in Mexico than in the US: ‐ P* rises faster than P (e rises) ‐ US dollar appreciates against the peso. b. If inflation is higher in US than in Mexico: ‐ P rises faster than P* (e falls) ‐ US dollar depreciates against the peso

When national saving is larger than investment ( S > I )...

the excess supply of loanable funds flows abroad to finance investment of foreign countries.

A US based company sells semiconductors to an Italian firm. Italian firm pays with US dollar it previously purchased.

-Italian firm buys US semiconductors so US NX increases -NX=NCO so US NCO increases -Italy imports US semiconductors so Italian NX decreases -NX=NCO so Italian NCO decreases

A Mexican firm exchanges Pesos for US dollars.

-No transactions for goods/services so US NX stays the same -NX=NCO so US NCO stays the same -US dollars went from US to Mexico, Mexican Pesos went from Mexico to US; these cancel each other out, so no change in US/Mexico NCO -US/Mexico NCO=NX so NX stays the same

Nominal Exchange Rate

-the rate at which one country's currency trades for another. ‐usually expressed as foreign currency per unit of domestic currency. (e.g. ¥90/$) -Appreciation/Depreciation

Real Exchange Rate

-the rate at which the goods and services of one country trade for the goods and services of another -It measures the number of foreign baskets of goods & services that is comparable to one basket of US goods & services

What affects Net Exports? (5)

1) The incomes of consumers at home and abroad 2) The tastes of consumers for domestic and foreign goods 3) Government policies toward international trade (Tariffs/Quotas) 4) The prices of goods at home and abroad 5) The exchange rates at which people can use domestic currency to buy foreign currencies 1-3: Shift NX curve 4-5: No shift, move along curve

Limitations of PPP Theory

1. There are many non‐tradable goods. ‐ Cannot be arbitraged, so law of one price does not apply. 2. Foreign and domestic goods are not perfect substitutes. ‐ Even the corolla in Japan and US are not perfect substitute (due to different safety standards) *PPP is rather a long‐run phenomenon. ‐ explains long‐run trend quite well

Higher inflation tends to be associated with...

Depreciation

Real Exchange Rate Equation

E = eP / P* e: nominal exchange rate (foreign currency per domestic currency) P: domestic price index (e.g. CPI) P* : foreign price index

Trade Surplus

Exports > Imports (NX>0)

A Turkish firm exchanges lira (Turkish currency) for dollars. It then uses these dollars to purchase computers from the U.S. These actions decrease U.S. net capital outflow and increase U.S. net exports.

False

A country must have a positive net outflow of capital if it has a trade deficit.

False

A country with negative net exports has a trade surplus.

False

According to purchasing-power parity theory, the nominal exchange rate between the U.S. and another country should equal the U.S. price level divided by the price level in the foreign country.

False

By itself, when a Japanese bank purchases a bond issued by a U.S. corporation, U.S. net capital outflow rises.

False

If a country's imports exceed its exports it has a trade surplus.

False

If a country's trade surplus falls, its net capital outflow rises.

False

If the exchange rate is 80 yen per dollar, then a hotel room in Tokyo that costs 25,000 yen costs $200.

False

Net capital outflow is the purchase of domestic assets by foreign residents minus the purchase of foreign assets by domestic residents.

False

Other things the same, an increase in foreign prices raises the real exchange rate.

False

Other things the same, an increase in the foreign price level leads to an increase in the real exchange rate.

False

Other things the same, an increase in the real exchange rate raises U.S. net exports.

False

Purchasing-power parity says that the nominal exchange rate must equal the real exchange rate.

False

To increase domestic investment, a country must increase its national saving.

False

When U.S. national saving rises, domestic investment also necessarily rises.

False

From National Income Accounting:

S - I = NCO S = domestic supply (saving) of loanable funds I = domestic demand (investment) for loanable funds NCO = excess supply of loanable funds from domestic market (outflow)

What is an example of U.S. foreign portfolio investment?

Toni, a US citizen, buys bonds issued by a Swedish corporation

A nation with a trade surplus will necessarily have saving that is greater than domestic investment.

True

Both foreign direct investment and foreign portfolio investment by U.S. residents increase U.S. net capital outflow.

True

By itself, if a U.S. firm builds a new factory overseas, U.S. net capital outflow rises.

True

If Walmart buys $50 million worth of consumer goods from China and sells them in the U.S., and China uses the $50 million to purchase U.S. bonds, U.S. net exports and U.S. net capital outflow both fall.

True

If a German firm buys goods from a U.S. firm with dollars it obtains by exchanging euros for dollars, both U.S. net exports and U.S. net capital outflow increase.

True

If a U.S. firm buys Chinese toys using previously obtained Chinese currency, then both U.S. net exports and U.S. net capital outflow decrease.

True

If a country sells more goods and services abroad than it purchases abroad, it has positive net exports and a trade surplus.

True

If a country's net exports fall, then its net capital outflow falls by the same amount.

True

If over the next year the inflation rate in the euro area is higher than the inflation rate in Japan, then the euro should depreciate relative to the Japanese yen.

True

If prices in Mexico rise at a higher rate than prices in the U.S., then according to purchasing-power parity the U.S. nominal exchange rate with Mexico should rise.

True

If purchases of foreign assets by U.S. residents exceed purchases of U.S. assets by foreign residents, then U.S. net capital outflow is positive

True

If the U.S. real exchange rate is greater than 1, then there is the possibility of arbitraging by buying foreign goods to sell in the U.S.

True

If the exchange rate is 12.5 pesos per U.S. dollar, it is also 1/12.5 U.S. dollars per peso.

True

If the price of a good in the U.S. is $10, the exchange rate is 2 units of foreign currency per dollar, and the foreign price of the same good is 30 units of foreign currency, then the real exchange rate is 2/3.

True

In an open economy national saving equals domestic investment plus net capital outflow.

True

In an open economy, national saving can be less than investment.

True

It is possible for a country to have domestic investment that exceeds national saving.

True

Jason plans to buy shrimp in Florida and sell them in Manhattan, Kansas where the price is higher. Jason plans to engage in arbitrage.

True

Many economists believe that the theory of purchasing-power parity describes the forces that determine exchange rates in the long run.

True

Other things the same, an increase in domestic prices raises the real exchange rate.

True

Other things the same, an increase in the U.S. real exchange rate makes U.S. goods more expensive relative to foreign goods.

True

Other things the same, an increase in the nominal exchange rate raises the real exchange rate.

True

The theory of purchasing power parity states that a unit of a country's currency should be able to buy the same quantity of goods in foreign countries as it does in the domestic economy.

True

When a company from Germany builds an automobile factory in the United States, the German firm has engaged in foreign direct investment.

True

When the central bank of some country prints large quantities of money, that county's currency loses value both in terms of the goods and services it buys and in terms of the amount of foreign currencies it can buy.

True

A US purchase oil from overseas and pay for it with foreign currency it already owned.

US imports oil, so NX decreases NX=NCO so NCO decreases

Purchasing‐Power Parity (PPP)

a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries ‐ This requires the cost of consumption basket to be equal across countries. - Law of One Price

When there is a saving shortage ( S < I )...

domestic investment is funded by foreign fund through capital inflow.

Exports

domestically produced goods and services purchased by foreigners

Law of One Price

the notion that a good should sell for the same price in all markets (Ensured by Arbitrage)

Nominal Exchange Rate under PPP

the ratio of foreign price index to domestic price leve - e = P* / P

What affects NCO?

• Real interest rates paid on foreign and domestic assets. • Perceived risks of holding foreign assets. -Political and economic stability • Government policies affecting foreign ownership of domestic assets. -Restriction on asset holding by foreigners