Open Economy

1. How would the following transactions affect U.S. exports, imports, and net exports?

a. An American art professor spends the summer touring museums in Europe.

 b. Students in Paris flock to see the latest Arnold Schwarzenegger movie.

 c. Your uncle buys a new Volvo.

 d. The student bookstore at Oxford University sells a pair of Levi’s 501 jeans.

 e. ACanadian citizen shops at a store in northern Vermont to avoid Canadian sales taxes.

a.      When an American art professor spends the summer touring museums in Europe, he spends money buying foreign goods and services, so U.S. exports are unchanged, imports increase, and net exports decrease. 

         b.           When students in Paris flock to see the latest movie from Hollywood, foreigners are buying a U.S. good, so U.S. exports rise, imports are unchanged, and net exports increase. 

         c.            When your uncle buys a new Volvo, an American is buying a foreign good, so U.S. exports are unchanged, imports rise, and net exports decline. 

         d.           When the student bookstore at Oxford University sells a pair of Levi's 501 jeans, foreigners are buying U.S. goods, so U.S. exports increase, imports are unchanged, and net exports increase. 

         e.           When a Canadian citizen shops in northern Vermont to avoid Canadian sales taxes, a foreigner is buying U.S. goods, so U.S. exports increase, imports are unchanged, and net exports increase.

     

2. International trade in each of the following products has increased over time. Suggest some reasons why this might be so.

a. wheat

b. banking services

c. computer software

d. automobiles

a.      Wheat is traded more internationally than in the past because shipping costs have declined, as have trade restrictions. 

         b.           Banking services are traded more internationally than in the past because communications costs have declined, as have trade restrictions. 

         c.            Computer software is traded more internationally than in the past because the computer industry has grown and the software is easier to transport (because it can now be downloaded electronically). 

         d.           Automobiles are traded more internationally than in the past because transportation costs have declined, as have tariffs and quotas.

 3. Describe the difference between foreign direct investment and foreign portfolio investment. Who is more likely to engage in foreign direct investment—a corporation or an individual investor? Who is more likely to engage in foreign portfolio investment?

Foreign direct investment requires actively managing an investment, for example, by opening a retail store in a foreign country.

         Foreign portfolio investment is passive, for example, buying corporate stock in a retail chain in a foreign country.

         As a result, a corporation is more likely to engage in foreign direct investment, while an individual investor is more likely to engage in foreign portfolio investment.

4. How would the following transactions affect U.S. net foreign investment? Also, state whether each involves direct investment or portfolio investment.

a. An American cellular phone company establishes an office in the Czech Republic.

b. Harrod’s of London sells stock to the General Electric pension fund.

 c. Honda expands its factory in Marysville, Ohio.

d. AFidelity mutual fund sells its Volkswagen stock to a French investor.

a.      When an American cellular phone company establishes an office in the Czech Republic, U.S. net capital outflow increases, because the U.S. company makes a direct investment in capital in the foreign country. 

         b.           When Harrod's of London sells stock to the General Electric pension fund, U.S. net capital outflow increases, because the U.S. company makes a portfolio investment in the foreign country.  

         c.            When Honda expands its factory in Marysville, Ohio, U.S. net capital outflow declines, because the foreign company makes a direct investment in capital in the United States. 

         d.           When a Fidelity mutual fund sells its Volkswagen stock to a French investor, U.S. net capital outflow declines (if the French investor pays in U.S. dollars), because the U.S. company is reducing its portfolio investment in a foreign country.

5. Holding national saving constant, does an increase in net foreign investment increase, decrease, or have no effect on a country’s accumulation of domestic capital?

ANSWER:

         If national saving is constant and net capital outflow increases, domestic investment must decrease, because national saving equals domestic investment plus net capital outflow.

         If domestic investment declines, the country's accumulation of domestic

capital declines.

 6. The business section of most major newspapers contains a table showing U.S. exchange rates. Find such a table and use it to answer the following questions.

a. Does this table show nominal or real exchange rates? Explain.

 b. What are the exchange rates between the United States and Canada and between the United States and Japan? Calculate the exchange rate between Canada and Japan.

c. If U.S. inflation exceeds Japanese inflation over the next year, would you expect the U.S. dollar to appreciate or depreciate relative to the Japanese yen?

a.      The newspaper shows nominal exchange rates, because it shows the number of units of one currency that can be exchanged for another currency. 

         b.           Many answers are possible. 

         c.            If U.S. inflation exceeds Japanese inflation over the next year, you would expect the dollar to depreciate relative to the Japanese yen because a dollar would decline in value (in terms of the goods and services it can buy) more than the yen would.

7. Would each of the following groups be happy or unhappy if the U.S. dollar appreciated? Explain.

a. Dutch pension funds holding U.S. government bonds

b. U.S. manufacturing industries

c. Australian tourists planning a trip to the United States

d. an American firm trying to purchase property overseas

a.  Dutch pension funds holding U.S. government bonds would be happy if the U.S. dollar appreciated. They would then get more Dutch guilders for each dollar they earned on their U.S. investment. In general, if you have an investment in a foreign country, you are better off if that country's currency appreciates. 

         b.           U.S. manufacturing industries would be unhappy if the U.S. dollar appreciated because their prices would be higher in terms of foreign currencies, which will reduce their sales. 

         c.            Australian tourists planning a trip to the United States would be unhappy if the U.S. dollar appreciated because they would get fewer U.S. dollars for each Australian dollar, so their vacation will be more expensive. 

         d.           An American firm trying to purchase property overseas would be happy if the U.S. dollar appreciated because it would get more units of the foreign currency and could thus buy more property.

 8. What is happening to the U.S. real exchange rate in each of the following situations? Explain. a. The U.S. nominal exchange rate is unchanged, but prices rise faster in the United States than abroad.

 b. The U.S. nominal exchange rate is unchanged, but prices rise faster abroad than in the United States

. c. The U.S. nominal exchange rate declines, and prices are unchanged in the United States and abroad.

d. The U.S. nominal exchange rate declines, and prices rise faster abroad than in the United States

. All the parts of this question can be answered by keeping in mind the definition of the real exchange rate. The real exchange rate equals thenominal exchange rate times the domestic price level divided by the foreign price level.

 a.     If the U.S. nominal exchange rate is unchanged, but prices rise faster in the United States than abroad, the real exchange rate rises.

 b.    If the U.S. nominal exchange rate is unchanged, but prices rise faster abroad than in the United States, the real exchange rate declines.

          c.           If the U.S. nominal exchange rate declines and prices are unchanged in the United States and abroad, the real exchange rate declines.

         d.           If the U.S. nominal exchange rate declines and prices rise faster abroad than in the United States, the real exchange rate declines.

9. List three goods for which the law of one price is likely to hold, and three goods for which it is not. Justify your choices.

10. Acan of soda costs $0.75 in the United States and 12 pesos in Mexico. What would the peso-dollar exchange rate be if purchasing-power parity holds? If a monetary expansion caused all prices in Mexico to double, so that soda rose to 24 pesos, what would happen to the peso- dollar exchange rate?

     If purchasing-power parity holds, then 12 pesos per soda divided by $0.75 per soda equals the exchange rate of 16 pesos per dollar. If prices in Mexico doubled, the exchange rate will double to 32 pesos per dollar.

 11. Assume that American rice sells for $100 per bushel, Japanese rice sells for 16,000 yen per bushel, and the nominal exchange rate is 80 yen per dollar.

a. Explain how you could make a profit from this situation. What would be your profit per bushel ofrice? If other people exploit the same opportunity, what would happen to the price of rice in Japan and the price of rice in the United States?

b. Suppose that rice is the only commodity in the world. What would happen to the real exchange rate between the United States and Japan?

a.      To make a profit, you would want to buy rice where it is cheap and sell it where it is expensive. Because American rice costs 100 dollars per bushel, and the exchange rate is 80 yen per dollar, American rice costs 100 x 80 equals 8,000 yen per bushel. So American rice at 8,000 yen per bushel is cheaper than Japanese rice at 16,000 yen per bushel. So you could take 8,000 yen, exchange them for 100 dollars, buy a bushel of American rice, then sell it in Japan for 16,000 yen, making a profit of 8,000 yen. As people did this, the demand for American rice would rise, increasing the price in America, and the supply of Japanese rice would rise, reducing the price in Japan. The process would continue until the prices in the two countries were the same.

         b.           If rice were the only commodity in the world, the real exchange rate between the United States and Japan would start out too low, then rise as people bought rice in America and sold it in Japan, until the real exchange became one in long-run equilibrium.

12. Acase study in the chapter analyzed purchasing-power parity for several countries using the price of a Big Mac. Here are data for a few more countries:

a.       For each country, compute the predicted exchange rate of the local currency per U.S. dollar. (Recall that the U.S. price of a Big Mac was $2.43.) How well does the theory of purchasing-power parity explain exchange rates?

b.       b. According to purchasing-power parity, what is the predicted exchange rate between the South Korean won and Spanish peseta? What is the actual exchange rate?

c.        c. Which of these countries offers the cheapest Big Mac? Why do you think that might be the case?

If you take X units of foreign currency per Big Mac divided by 3.41 dollars per Big Mac, you get X/3.06 units of the foreign currency per dollar; that is the predicted exchange rate.

            a.         Indonesia: 15,900/3.41 = 4,663 rupiah/$

                        Hungary: 600/3.41 = 176 forint/$

                        Czech Republic: 52.9/3.41 = 15.5 koruna/$

                        Brazil: 6.9/3.41 = 2.02 real/$

                        Canada: 3.88/3.41 = 1.14C$/$

            b.        Under purchasing-power parity, the exchange rate of the Hungarian forint to the Canadian dollar is 600 forints per Big Mac divided by 3.88 Canadian dollars per Big Mac equals 155 forints per Canadian dollar. The actual exchange rate is 180 forints per dollar divided by 1.05 Canadian dollars per dollar equals 171 forints per Canadian dollar.

            c.         The exchange rate predicted by the Big Mac index (155 forints per Canadian dollar) is somewhat close to the actual exchange rate of 171 forints per Canadian dollar.