Homework 8: Open Economy: Basic concepts (compulsory)

1. Explain the relationship among saving, investment, net exports and net capital outflow.
- Saving and Investment: In a closed economy, saving and investment are equal. This means that
the total amount of saving in the economy is used to finance domestic investment. Saving
represents the portion of national income that is not consumed for government purchases. It is the
income that is left after deducting consumption (C) and government purchases (G) from the total
output (Y) (S = I = Y – C – G). Investment (I) refers to the expenditure on capital goods and the
accumulation of physical capital in the economy.
- Net Exports: Net exports (NX) represent the difference between the value of a country's exports
and imports. A positive value of net exports indicates a trade surplus, where exports exceed
imports, while a negative value indicates a trade deficit, where imports exceed exports. In a closed
economy, net exports are zero because there are no international trade flows.
- Net Capital Outflow: Net capital outflow (NCO) measures the difference between the domestic
investment in a country and the foreign investment in that country. It represents the net flow of
capital from a country to the rest of the world. A positive value of net capital outflow means that a
country is investing more abroad than it is receiving from foreign investors, while a negative value
means that a country is receiving more foreign investment than it is investing abroad.
The relationship among these variables can be expressed by the equation:
Saving (S) = Domestic Investment (I) + Net Capital Outflow (NCO)
This equation shows that a nation's saving must be equal to the sum of its domestic investment and
its net capital outflow. In an open economy, saving can be used to finance both domestic
investment and the purchase of foreign assets (net capital outflow). When saving exceeds domestic
investment, there is a positive net capital outflow, indicating that the country is using some of its
saving to invest abroad. Conversely, when domestic investment exceeds saving, there is a negative
net capital outflow, indicating that the country is relying on foreign investment to finance its
domestic investment.
2. 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 (FDI): FDI involves direct investment in the productive assets (such
as factories, real estate, infrastructure, etc.) of a foreign country. FDI represents a long-term
commitment to the foreign economy and implies a deeper involvement in the host country’s
business operations. It provides the investor with control over the business entity in which the
investment is made, and thus, is more suitable for large corporations, institutions, and private
equity investors who seek strategic expansion or market presence abroad.
Examples: Establishing a subsidiary in another country, Acquiring or merging with an existing
foreign company, Starting a joint venture partnership with a foreign company…
Foreign Portfolio Investment (FPI): FPI refers to investing in the financial assets (such as stocks,
bonds, and other securities) of a foreign country. It is often viewed as a short-term move to make
money. Portfolio investments are easily tradable, providing liquidity. Investors can easily buy and
sell securities on exchanges, diversify their portfolios, and benefit from short-term market
movements. Thus, individual investors are more likely to engage in FPI.
Examples: Purchasing stocks, bonds, or mutual funds of foreign companies, Investing in
exchange-traded funds (ETFs)…
* In summary, FDI involves direct ownership and control over productive assets, while FPI
focuses on financial securities. Corporations favor FDI, while individual investors prefer FPI due
to accessibility and liquidity.
3. 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:
Effect: If the U.S. dollar appreciated, the value of U.S. government bonds would denominate in
dollars increases for foreign investors.
Happiness: Dutch pension funds would be happy because their bond holdings’ value rises. They
can sell these bonds at a higher price or earn more interest income.
Explanation: Currency appreciation makes dollar-denominated assets more attractive, benefiting
foreign investors.
b. U.S. Manufacturing Industries:
Effect: An appreciating U.S. dollar makes U.S. exports more expensive for foreign buyers.
Unhappiness: U.S. manufacturing industries would be unhappy because their products become less
competitive in international markets.
Explanation: Higher export prices reduce demand for U.S. goods abroad, potentially leading to
lower sales and profits.
c. Australian Tourists Planning a Trip to the United States:
Effect: A stronger U.S. dollar means that Australian dollars can buy more U.S. dollars.
Happiness: Australian tourists would be happy because their travel expenses (hotels, shopping,
dining) in the U.S. become relatively cheaper.
Explanation: Currency appreciation benefits tourists by increasing their purchasing power in the
foreign country.
d. An American Firm Trying to Purchase Property Overseas:
Effect: When the U.S. dollar appreciates, it means that the value of the U.S. dollar increases
relative to other currencies
Happiness: The American firm would be happy because it needs to spend less dollars to purchase
the property overseas.
Explanation: An appreciating dollar would make it relatively cheaper for the American firm to
convert their U.S. dollars into the foreign currency required to purchase the property overseas. As
a result, the firm would be able to acquire the property at a more favorable exchange rate,
potentially reducing the cost of the purchase.
4. A can of soda costs $1.25 in the United States and 25 pesos in Mexico. What is the peso–
dollar exchange rate (measured in pesos per dollar) if purchasing power parity holds? If a
monetary expansion caused all prices in Mexico to double, so that soda rose to 50 pesos, what
would happen to the peso–dollar exchange rate?
To determine the peso-dollar exchange rate under purchasing power parity (PPP), we can set up an
equation based on the relative price levels of the same good in both countries.
Initially, the price of a can of soda is $1.25 in the United States and 25 pesos in Mexico.
Therefore, the initial exchange rate can be calculated as:
Exchange rate = Price in Mexico / Price in the United States
Exchange rate = 25 pesos / $1.25
Exchange rate = 20 pesos per dollar
Under purchasing power parity, the exchange rate should reflect the relative purchasing power of
the two currencies. In this case, if the exchange rate is 20 pesos per dollar, it means that 20 pesos
have the same purchasing power as 1 dollar.
Now, let's consider the scenario where a monetary expansion causes all prices in Mexico to
double, including the price of soda rising to 50 pesos. In this case, we need to calculate the new
exchange rate based on the updated price levels.
New exchange rate = New price in Mexico / Price in the United States
New exchange rate = 50 pesos / $1.25
New exchange rate = 40 pesos per dollar
In summary, if purchasing power parity holds, the exchange rate adjusts to reflect changes in
relative prices between countries. The doubling of prices in Mexico leads to a higher exchange rate
(more pesos per dollar).