178.

200 Intermediate Macroeconomics

Tutorial (8)
Open Economy

1
Short Answer Questions

1. Suppose that the NZ government passes

new tax laws that provide a tax credit for
those who invest in new capital. If a
change in the tax laws induces more
investment projects and increases the
investment demand,
(1) What happens to the NZ trade balance?

2
Answer:

An investment tax credit provided by the

NZ government makes an outward shift in
the investment schedule from I(r)1 to I(r)2
and raises the domestic interest rate to rd.
As rd raises above the world interest rate rw,
foreign capital flows in to obtain a claim to
the future returns to domestic capital.
Hence, at rw, the amount of investment
correspondingly increases from I0 to I(rw).
3
Answer: (continued)
r S
Since saving S is
unchanged, I(rw) is then
greater than S. That is S-
I(rw) < 0 which means the rd
net capital outflow is NX < 0
negative. S- I(rw) < 0 ⇔
NX < 0. Therefore, an rw
I(r)2
increase in investment
demand leads to a trade I(r)1
deficit. S = I0 I(rw) S,I

4
Answer: (continued)
r
S
NX > 0

rw

rd I(r)1
I(r)2

I(rw) S = I0 S,I

5
Short Answer Questions

(2) What happens to the real exchange rate?

Answer:
An increase in investment demand shifts the
vertical S-I line to the left due to the
negative net capital outflow. Meanwhile,
the increase in international capital flow
stimulate the demand of domestic currency
and bids up the value of domestic currency.

6
Answer: (continued)

Consequently, the real ε

exchange rate raises S-I(rw2) S-I(rw1)
from ε1 to ε2. The
higher real exchange
rate implies that the
NZ goods are ε2
expensive relative to ε1 NX(ε)
foreign goods. As a
result, the net export
falls from NX1 to NX2. NX2 NX1 NX

7
Answer: (continued)
ε
S-I(rw1) S-I(rw2)

ε1
ε2 NX(ε)

NX1 NX2 NX

8
Short Answer Questions

2. Suppose that the NZ government adopts a

tariff by placing a tax on imports. What
happens to the real exchange rate?
Answer:
For any given real exchange rate, a
protectionist trade policy forces imports
being lower which implies that net exports
would be higher.

9
Answer: (continued)

Hence, the net export ε

schedule shifts upward S-I
from NX(ε1) to NX(ε2). In
consequence, the real
exchange rate raises from
ε1 to ε2. The equilibrium
level of net exports is ε2
unchanged because the NX(ε)2
protectionist policy does ε1 NX(ε)1
not alter either saving S or
investment I.
NX1 = NX2 NX

10
Multiple-Choice Questions
(2005 Exam Question)

(1) The false statement below is:

a. net capital outflow is the excess of domestic saving over
domestic investment.
b. the trade surplus and net capital outflow must both equal
zero.
c. according to the national income accounts identity, net
capital outflow must equal net export.
d. according to the national income accounts identity, net
capital outflow must equal the trade balance.
Answer: b.
Hint: P118
11
Multiple-Choice Questions
(2005 Exam Question)

(2) If domestic investment exceeds domestic

savings, one would observe:
a. Negative net capital outflow.
b. A government budget deficit.
c. A trade deficit.
d. both a and c.
Answer: d.
Hint: P118
12
Multiple-Choice Questions
(2005 Exam Question)

(3) With a constant world interest rate, full

employment, and an initial trade surplus of zero, a
tax cut in a small open economy will result in:
a. A trade deficit.
b. A reduction in national saving.
c. Negative net capital outflow.
d. All of the above.
Answer: d.
Hint: T↓→C↑→S↓→S-I< 0 ⇔ NX< 0.
13
Multiple-Choice Questions
(2005 Exam Question)
(4) Suppose that several large foreign countries
decrease government spending, leading to a
decrease in the world interest rate. In a small open
economy, which of the following is most likely to
happen?
a. A decreasing in saving.
b. A decreasing in investment.
c. An increase in the trade deficit.
d. An increase in net capital outflow.
Answer: c.
14
Hint:
r
S

rw1 NX < 0

rw2 I(r)

S = I0 I(rw) I,S
(I(rw)>S)
15
Multiple-Choice Questions
(2005 Exam Question)

(5) As the real exchange rate of the US

dollar increases
a. foreign goods become cheaper to US
citizens.
b. US net exports fall.
c. the US trade surplus decreases.
d. all of the above occur.
Answer: d.
16
Multiple-Choice Questions
(2005 Exam Question)

(6) If the government of a small open economy

increases personal income taxes, that country’s
a. net exports increase.
b. investment increases.
c. equilibrium real exchange rate rises.
d. consumption rises.
Answer: a.
Hint: T↑→C↓→S↑→S-I> 0 ⇔ NX> 0.
17
Multiple-Choice Questions
(2005 Exam Question)

(7) If the governments of several large

foreign countries raise taxes,
a. the world interest rate will rise.
b. the NZ trade surplus will rise.
c. the real exchange rate of the NZ dollar
will rise.
d. NZ net exports will increase.
Answer: c.
18
 Hint: Foreign Domestic
rw
Sw1 Sw2 ε S-I(rw2) S-I(rw1)
(1) (3)

rw1
(2) ε2
rw2 I(rw) (4)
NX(ε)
ε1

I(rw),Sw NX2 NX1 NX

(5)

19
Multiple-Choice Questions
(2005 Exam Question)

(8) If investment demand decreases in a

small open economy,
a. the equilibrium real exchange rate rises.
b. net exports increase.
c. national saving increases.
d. net capital outflow decreases.
Answer: b.
20
Multiple-Choice Questions
(2005 Exam Question)

(9) In the long run, if the New Zealand government

places high tariffs on all imports,
a. NZ’s net exports rise.
b. NZ’s real foreign exchange rate increases.
c. net capital outflow in NZ decreases.
d. all of the above.
Answer: b.
Hint: P134
21
Multiple-Choice Questions
(2005 Exam Question)

(10) Slower growth in the Japanese money supply

will lead to:
a. an increase in inflation in Japan.
b. a decrease in inflation in NZ.
c. a depreciation of the NZ dollar relative to the
Japanese yen.
d. all of the above.
Answer: c.
Hint: (M/P) ↑ → e↓. P319
22
Multiple-Choice Questions
(2005 Exam Question)

(11) According to PPP, if a TV set sells for $500

in NZ and 2000 yuan in China, the nominal
exchange rate, expressed in yuan per dollar, is
a. 2.5.
b. 10.
c. 4.
d. 1.
Answer: c.
Hint: e = 2000/500 = 4 (yuan/NZ$).
23
Multiple-Choice Questions
(2005 Exam Question)
(12) In a small open economy with a floating
exchange rate, fiscal policy will be ineffective
because:
a. monetary policy will completely offset it.
b. the exchange rate will remain constant.
c. a fall in net exports will offset any increases in
government purchases or consumption.
d. the exchange rate will rise by the same amount
as the interest rate.
Answer: c. e↑→NX↓
Hint: If IS↑ Y↑ offset P318 24
Multiple-Choice Questions
(2005 Exam Question)

(13) In a small open economy with a floating

exchange rate, monetary expansion does all of the
following EXCEPT:
a. lower the interest rate.
b. increase the equilibrium income level.
c. decrease the exchange rate.
d. cause net exports to rise.
Answer: a.
Hint: rd = rw. P315-316.
25
Multiple-Choice Questions
(2005 Exam Question)

(14) Trade restrictions have no effect on income

under floating exchange rates because
a. net exports increase but investment decreases.
b. the exchange rate rises to offset the initial
increase in net exports.
c. the fall in imports equals the rise in exports.
d. all of the above.
Answer: b.
Hint: NX↑→IS↑→e↑→NX↓.
26
Multiple-Choice Questions
(2005 Exam Question)
(15) If the current exchange rate ¥200/$ is above
the fixed exchange rate set by the central bank
(¥150/$), arbitragers can make profits by
a. buying yen in foreign exchange markets and
selling them to the central bank.
b. buying yen from the central bank and selling
them in foreign exchange markets.
c. buying dollars in foreign exchange markets
and selling them to the central bank.
d. none of the above.
Answer: a. 27
Hint: P321
Multiple-Choice Questions
(2005 Exam Question)
(16) An expansionary fiscal policy under fixed
exchange rates will
a. force the central bank to increase the money
supply in order to prevent the exchange rate from
falling.
b. increase real income.
c. eventually lead the IS* and LM* curves to the
right.
d. all of the above.
Answer: d.
Hint: P323-324 28
Multiple-Choice Questions
(2005 Exam Question)
(17) If the central bank tries to increase the money
supply under fixed exchange rates,
a. national income will be unaffected.
b. the initial increase in the money supply will be
offset if the central bank maintains the original
fixed exchange rate.
c. the LM* curve on a Y/e graph will shift first to
the right and then to the left, back to its original
position.
d. all of the above.
Answer: d. 29
Hint:P324-325
Multiple-Choice Questions
(2005 Exam Question)
(18) The risk premium in a country’s interest rate
will rise, if
a. people expect the country’s exchange rate to
fall.
b. fears arise that the government may not pay all
of its debt.
c. the country’s foreign exchange reserves are
quickly being depleted.
d. all of the above.
Answer: d.
Hint: P327-328 30
Multiple-Choice Questions
(2005 Exam Question)
(19) If the value of the currency is reduced via a
devaluation, the
a. LM* curve shifts to the right, and both net
exports and income rise.
b. LM* curve shifts to the right, net exports fall,
and income rise.
c. LM* curve shifts to the left, and both net
exports and income fall.
d. IS* and LM* curves both shift to the right.
Answer: a.
Hint: P325 31
Multiple-Choice Questions
(2005 Exam Question)

(20) A restrictive trade policy under a fixed

exchange rate will
a. have the same effect as under a floating
exchange rate.
b. raise the equilibrium level of national income.
c. shift the IS* curve to the right and the LM*
curve to the left on a Y/e graph.
d. lead to a devaluation of the currency.
Answer: b.
Hint:P326
32