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CHAPTER 5 The Open Economy

Questions for Review

1. By rewriting the national income accounts identity, we show in the text that
S – I = NX.
This form of the national income accounts identity shows the relationship between the international
flow of funds for capital accumulation, S – I, and the international flow of goods and services, NX.
Net capital outflow refers to the (S – I) part of this identity: it is the excess of domestic saving
over domestic investment. In an open economy, domestic saving need not equal domestic
investment, because investors can borrow and lend in world financial markets. The trade balance
refers to the (NX) part of the identity: it is the difference between what we export and what we
import.
Thus, the national accounts identity shows that the international flow of funds to finance capital
accumulation and the international flow of goods and services are two sides of the same coin.
2. The nominal exchange rate is the relative price of the currency of two countries. The real exchange
rate, sometimes called the terms of trade, is the relative price of the goods of two countries. It tells
us the rate at which we can trade the goods of one country for the goods of another.
3. A cut in defense spending increases government saving and, hence, increases national saving.
Investment depends on the world rate and is unaffected. Hence, the increase in saving causes the (S
– I) schedule to shift to the right, as in Figure 5–1. The trade balance rises, and the real exchange
rate falls.

Chapter 5 1
4. If a small open economy bans the import of Japanese DVD players, then for any given real
exchange rate, imports are lower, so that net exports are higher. Hence, the net export schedule
shifts out, as in Figure 5–2.

Chapter 5 2
 The protectionist policy of banning DVD players does not affect saving, investment, or the world
interest rate, so the S – I schedule does not change. Because protectionist policies do not alter either
saving or investment in the model of this chapter, they cannot alter the trade balance. Instead, a
protectionist policy drives the real exchange rate higher.
5. We can relate the real and nominal exchange rates by the expression

Nominal Real Ratio of

Exchange = Exchange × Price
Rate Rate Levels
e = ε × (P*/P).
*
Let P be the Mexican price level and P be the Japanese price level. The nominal exchange rate e is
the number of Mexican pesos per Japanese yen (this is as if we take Japan to be the “domestic”
country). We can express this in terms of percentage changes over time as
% Change in e = % Change in ε + (π* − π),

where π* is the Mexican inflation rate and π is the Japanese inflation rate. If Mexican inflation is
higher than Japanese inflation, then this equation tells us that a yen buys an increasing amount of
pesos over time: the yen rises relative to the peso. Alternatively, viewed from the Mexican
perspective, the exchange rate in terms of yen per peso falls.

Problems and Applications

Chapter 5 3
1. a. An increase in saving shifts the (S – I) schedule to the right, increasing the supply of dollars
available to be invested abroad, as in Figure 5–3. The increased supply of dollars causes the
equilibrium real exchange rate to fall from 1 to 2. Because the dollar becomes less valuable,
domestic goods become less expensive relative to foreign goods, so exports rise and imports fall.
This means that the trade balance increases. The nominal exchange rate falls following the
movement of the real exchange rate, because prices do not change in response to this shock.

b. The introduction of a stylish line of Toyotas that makes some consumers prefer foreign
cars over domestic cars has no effect on saving or investment, but it shifts the NX() schedule
inward, as in Figure 5–4. The trade balance does not change, but the real exchange rate falls from
1 to 2. Because prices are not affected, the nominal exchange rate follows the real exchange
rate.

Chapter 5 4
 c. In the model we considered in this chapter, the introduction of ATMs has no effect on
any real variables. The amounts of capital and labour determine output Y . The world interest rate
r* determines investment I(r*). The difference between domestic saving and domestic
investment (S – I) determines net exports. Finally, the intersection of the NX() schedule and the
(S – I) schedule determines the real exchange rate, as in Figure 5–5.

Chapter 5 5
 The introduction of ATMs, by reducing money demand, does affect the nominal exchange rate
through its effect on the domestic price level. The price level adjusts to equilibrate the demand
and supply of real balances, so that
M/P = (M/P)d.
If M is fixed, then a fall in (M/P)d causes an increase in the price level: this reduces the supply of
real balances M/P and restores equilibrium in the money market.
Now recall the formula for the nominal exchange rate:
*
e =  × (P /P).
We know that the real exchange rate  remains constant, and we assume that the foreign price
level P* is fixed. When the domestic price level P increases, the nominal exchange rate e
depreciates.
2. a. National saving is the amount of output that is not purchased for current consumption by
households or the government. We know output and government spending, and the consumption
function allows us to solve for consumption. Hence, national saving is given by:
S=Y–C–G
= 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000
= 750.
Investment depends negatively on the interest rate, which equals the world rate r* of 5. Thus,
I = 1,000 – 50 × 5
= 750.

Chapter 5 6
 Net exports equals the difference between saving and investment. Thus,
NX = S – I
= 750 – 750
= 0.
Having solved for net exports, we can now find the exchange rate that clears the foreign-
exchange market:
NX = 500 – 500 × ε
0 = 500 – 500 × ε
ε = 1.
b. Doing the same analysis with the new value of government spending we find:
S=Y–C–G
= 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,250
= 500
I = 1,000 – 50 × 5
= 750
NX = S – I
= 500 – 750
= –250
NX = 500 – 500 × ε
–250 = 500 – 500 × ε
ε = 1.5.
The increase in government spending reduces national saving, but with an unchanged world real
interest rate, investment remains the same. Therefore, domestic investment now exceeds
domestic saving, so some of this investment must be financed by borrowing from abroad. This
capital inflow is accomplished by reducing net exports, which requires that the currency
appreciate.
c. Repeating the same steps with the new interest rate,
S=Y–C–G
= 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000
= 750
I = 1,000 – 50 × 10
= 500
NX = S – I
= 750 – 500
= 250
NX = 500 – 500 × ε
250 = 500 – 500 × ε
ε = 0.5.

Chapter 5 7
 Saving is unchanged from part (a), but the higher world interest rate lowers investment. This
capital outflow is accomplished by running a trade surplus, which requires that the currency
depreciate.
3. a. When Leverett’s exports become less popular, its domestic saving Y – C – G does not change.
This is because we assume that Y is determined by the amount of capital and labour,
consumption depends only on disposable income, and government spending is a fixed exogenous
variable. Investment also does not change, since investment depends on the interest rate, and
Leverett is a small open economy that takes the world interest rate as given. Because neither
saving nor investment changes, net exports, which equal S – I, do not change either. This is
shown in Figure 5–6 as the unmoving S – I curve.
The decreased popularity of Leverett’s exports leads to a shift inward of the net exports
curve, as shown in Figure 5–6. At the new equilibrium, net exports are unchanged but the
currency has depreciated.

Even though Leverett’s exports are less popular, its trade balance has remained the same. The reason for
this is that the depreciated currency provides a stimulus to net exports, which overcomes the
unpopularity of its exports by making them cheaper.

b. Leverett’s currency now buys less foreign currency, so traveling abroad is more expensive. This
is an example of the fact that imports (including foreign travel) have become more expensive—
as required to keep net exports unchanged in the face of decreased demand for exports.
c. If the government reduces taxes, then disposable income and consumption rise. Hence, saving
falls so that net exports also fall. In Figure 5-6, the S – I curve shifts to the left, lowering net
exports until the exchange rate is again equal to its initial value. This fall in net exports puts
upward pressure on the exchange rate that offsets the decreased world demand. Investment and
the interest rate would be unaffected by this policy since Leverett takes the world interest rate as
given.

Chapter 5 8
4. The increase in government spending decreases government saving and, thus, decreases national
*
saving; this shifts the saving schedule to the left, as in Figure 5–8. Given the world interest rate r ,
the decrease in domestic saving causes the trade balance to fall.

Figure 5–9 shows the impact of this increase in government purchases on the real exchange rate. The
decrease in national saving causes the (S – I) schedule to shift to the left, lowering the supply of dollars
to be invested abroad. The lower supply of dollars causes the equilibrium real exchange rate to rise. As a
result, domestic goods become more expensive relative to foreign goods, which causes exports to fall
and imports to rise. In other words, as we determined in Figure 5–8, the trade balance falls.

Chapter 5 9
The answer to this question does depend on whether this is a local war or a world war. A local war will
not have an effect on the world interest rate while a world war will. A world war causes many
*
governments to increase expenditures; this increases the world interest rate r . The effect on a country’s
external accounts depends on the size of the change in the world interest rate relative to the size of the
decrease in saving. For example, an increase in the world interest rate could cause a country to have a
smaller trade deficit, as in Figure 5–10, or even a trade surplus, as in Figure 5–11.

Chapter 5 10
5. Governor Bernanke’s statement is consistent with the models in the chapter. Suppose we consider
the United States as a small open economy, for example. The increase in the global supply of

Chapter 5 11
 saving pushes the global interest rate down, which encourages U.S. investment. If we assume that
this is primarily non-U.S. saving, then for the United States, the saving curve doesn’t shift but we
get a movement along the investment curve from point A to point B in Figure 5–7. The interest rate
falls, and the trade deficit rises (S-I falls).

6. a. If poor nations offered better production efficiency and legal protections, then the
marginal product of capital would rise. To increase the amount of capital that they have, firms
need to increase the amount of investment. Hence, their investment demand curve shifts out—at
any given interest rate, firms have a higher level of investment spending than they did
previously.
b. Assuming that together, the poor nations account for a noticeable share of world demand for
investment, the demand for loanable funds in world financial markets rises. For the world
overall, the picture looks like Figure 5–12, which follows.

Chapter 5 12
 c. In global financial markets, the increase in demand for loanable funds raises the interest
rate.
d. For rich countries, the increase in global interest rates reduces desired investment. Hence, S – I(r)
rises, which means that the trade balance rises.
7. The tariff on luxury cars would not affect net exports because it does not affect national saving
(because it would not affect Y, C, or G) or investment. It would, however, shift the NX curve by
decreasing U.S. demand for Japanese auto imports. This shift of the curve, shown in Figure 5–13,
would raise the exchange rate. Although net exports would not change, the volume of both imports
and exports would fall by the same amount.

Chapter 5 13
 There are also important compositional effects of this policy. On the production side, the higher
exchange rate increases imports and puts pressure on the sales of American companies with the
exception of American luxury car production, which is shielded by the tariff. Also, American
exporters will be hurt by the higher exchange rate, which makes their imported goods more
expensive to foreign countries. Consumers of Japanese luxury cars will be hurt by the tariffs while
all other consumers will benefit from the appreciated dollar, which allows them to purchase goods
more cheaply. In sum, the policy would shift demand to American luxury car producers at the
expense of the rest of American production and also shift consumption from Japanese luxury cars to
all other imports.
8. The real exchange rate measures the rate at which the goods of one country can be traded for the
goods of the other country. In this case, the real exchange rate measures the number of bottles of
vodka that must be exchanged for one TV. If Russia is experiencing no technological progress in
vodka production, then the number of bottles produced is fixed. Since China is experiencing
positive technological progress in TV production, the number of TVs produced will be increasing.
Given that TVs are relatively more abundant and vodka is relatively more scarce, we would expect
the real exchange rate to decrease—that is, it takes fewer bottles of vodka to buy one TV. The
nominal exchange rate (e), measured as rubles per yuan, is determined by the following equation:

 P *
e=
 
 P
Chapter 5 14
 where ε. measures the real exchange rate, P* measures the price level in Russia, and P measures the
price level in China. Given China has stable money growth and Russia has rapid money growth,
Russia’s price level will be increasing at a faster rate than the price level in China. The effect on the
nominal exchange rate is ambiguous. The decline in the real exchange rate will push the nominal
exchange rate down, but the rapidly rising price level in Russia relative to China will push the
nominal exchange rate up.
9. a. If the countries that institute an investment tax credit are large enough to shift the world
investment demand schedule, then the tax credits shift the world investment demand schedule
upward, as in Figure 5–14.

b. The world interest rate increases from r * to r * because of the increase in world
1 2

investment demand; this is shown in Figure 5–14. (Remember that the world is a closed
economy.)
c. The increase in the world interest rate increases the required rate of return on investments in our
country. Because the investment schedule slopes downward, we know that a higher world
interest rate means lower investment, as in Figure 5–15.

Chapter 5 15
Another random document with
no related content on Scribd:
 Clarification of Vinegar.

For those who desire an extra fancy product of extraordinary brightness,

suitable for bottling, it will be necessary to subject the vinegar to a special
process of clarification known as fining. According to Bioletti[*], the best
results are obtained by using isinglass. This is employed at the rate of from
one-half to three-fourths of an ounce of isinglass to each one hundred
gallons of vinegar.
[*] Bioletti, Frederic T., Grape Vinegar, Bull. 227, California Exp. Sta.,
1912.

"The isinglass is cut into small pieces and soaked for twelve to twenty-
four hours in a little water containing acetic or tartaric acid equal in weight
to the isinglass used. When thoroughly soft it is then rubbed several times
through a fine sieve, gradually adding a little more water until a perfectly
fluid liquid is obtained. This fluid is then well mixed with a little vinegar
and thoroughly stirred into the cask. With some vinegars it is necessary to
add a little tannin, from one-half to one-seventh the amount of the isinglass
used. This tannin should be added at least twenty-four hours before the
finings.

When the finings have settled and the vinegar is perfectly bright it is
ready for bottling."

Pure Cultures for Vinegar Making.

Reference has been made above to the use of pure cultures, both yeast
and acetic acid bacteria, for vinegar making. For a little more than one year,
the Bacteriological Laboratory of the Colorado Experiment Station has been
supplying these at fifty cents (50c) per set, post paid, sufficient for one
barrel, to those who care to give them a trial. Full printed directions for
their use are included. These cultures have been selected because of certain
properties which they possess which make them especially suited to the
vinegar industry. No guarantee, either expressed or [Page 14] implied, goes
with the cultures, since it is not the purpose of the Experiment Station to
exploit these products, but rather to distribute them at the cost of production
for experimental purposes. Inasmuch as one of the cultures is to be added to
the sweet cider, the set should be obtained a few days, not longer, before the
cider is to be made.

Requests for cultures should be addressed to the Bacteriological

Laboratory, Colorado Experiment Station, Fort Collins, Colorado, and
should be accompanied by a remittance of fifty cents (50c).

Directions For Using Pure Cultures in Making Vinegar

Preparation of Yeast Culture.

1. For each barrel of sweet cider, sterilize one two-quart Mason jar by
washing thoroughly and boiling for five minutes in clean water.

2. Cover the top of the jar with a single layer of clean muslin or cheese
cloth just removed from boiling water and secure it in place by a string tied
about the neck of the can.

3. Select 6 or 8 medium sized ripe apples; pare and quarter or slice

them; add one quart of water and boil till soft; strain liquid through clean
cloth while hot into Mason jar, first removing the cloth covering from the
top.

4. Make up the volume of liquid to approximately one quart with

boiling water; add 4 tablespoonfuls of sugar and replace the cloth
immediately.

5. When the liquid has cooled thoroughly, partly remove the cloth
covering and add the contents of the culture bottle marked "Yeast." Replace
the cloth. Just previous to opening the culture bottle, shake thoroughly and
immerse the lip and cork only, ten second in boiling water. Do not touch the
lip while removing cork.

6. Keep the jar in subdued light at a temperature of 75 degrees F. to 90

degrees F. After two to four days the foaming characteristic of alcoholic
fermentation should appear.
 7. After four to six days, add the entire contents of the yeast jar to the
barrel of freshly made sweet cider. The barrel must not be more than two-
thirds full; it should be placed on its side, and the bung-hole be left open, or,
better, plugged loosely with a tuft of clean cotton batting.

8. Keep the barrel at 75 degrees F. to 85 degrees F.

[Page 15]

Preparation of Acetic Culture.

1. Three to four weeks after the yeast culture has been added to the cider
prepare the Acetic Culture in precisely the same manner as described for
the yeast in paragraphs 1 to 6 above. See that all of the culture is removed
from the bottle; rinse with a little cooled boiled water if necessary. Do not
shake the jar while the culture is developing.

2. By the end of one to two weeks, a white, gelatinous film or

membrane should be visible on the surface of the liquid. This is a growth of
acetic acid bacteria and constitutes the "Mother of Vinegar."

3. When this acetic membrane is well formed, which will require about
two weeks, with a clean sliver of wood, previously dipped into boiling
water, remove the membrane from the jar, but do not lay it down; pour the
contents of the jar into the barrel of cider, now fermented, to which the
yeast was added some five or six weeks before; next drop the sliver with the
attached acetic film into the barrel through the bung-hole. The wood will
serve to float the acetic membrane on the surface of the hard cider and
thereby hasten its development by keeping it in contact with the air.

4. Keep the barrel at 65 degrees F. to 75 degrees F. till the vinegar has

formed.

5. When vinegar of satisfactory quality has been obtained, in three to six

months, draw off and store at a cool, even temperature in casks which are
kept full and tightly bunged.
 6. Both of these cultures can be propagated indefinitely by employing a
small portion of the jar cultures in the same manner as the original bottle
starters.
 *** END OF THE PROJECT GUTENBERG EBOOK HOME-MADE
CIDER VINEGAR ***

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