Econ 100b

Created 4/30/1996
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P-Set Seven Answers

International Trade

Economics 100b; Spring 1996; Brad DeLong

1. In a closed economy, national savings must be equal to national investment. Does the same hold true in an open economy, with international trade. Why or why not?

No. Countries can borrow from abroad by running a trade deficit, or lend to other countries by running a trade surplus. The first is a "capital inflow"; the second is a "capital outflow".

2. Suppose that a TV set in the US costs $300, and sells for 6000 yuan in China. What would purchasing-power-parity suggest should be the equilibrium exchange rate between dollars and yuan?

20 yuan to the dollar

3. In a small open economy, what effect does an increase in government purchases have? How about a closed economy? How about a large open economy?

In the long run, an increase in government purchases crowds out net exports (and leaves output unchanged); in the short run it may expand output. In a closed economy in the long run an increase in government purchases crowds out investment. In a large open economy there is some crowding out of investment, and some crowding out of next exports.

4. Suppose that the government enacts an investment tax credit that boosts investment as a function of the interest rate, and offsets the effect of the credit on overall taxes by raising income taxes enough to replace the lost revenue. What effect does such an ITC have in a large open economy?

In the long run the expanded ITC raises the domestic interest rate somewhat, raises investment, raises the real exchange rate somewhat, and reduces net exports.

5. Why might purchasing-power-parity fail to hold? That is, why might there be systematic differences between the nominal exchange rate and the relative price levels in two countries?

Not all goods are traded, and countries with relative productivities in producing non-traded goods from their relative productivities in producing traded goods might well fail to exhibit purchasing power parity. Trade barriers and transportation costs can also be at work.

6. The U.S. savings rate is low relative to other industrial countries. If the U.S. was a closed economy, would its rate of investment as a share of GDP be higher or lower than that of other industrial countries? Why?

In all probability investment would be lower--because of the low savings rate and the fact that in a closed economy saving must equal investment.

7. When Francois Mitterand was first elected president in France in 1981, many investors feared that the socialist president would bring higher inflation and renewed instability. French citizens increased their lending outside the country, and their purchases of foreign assets. Foreigners became less willing to lend to the French. How would you analyze such a shift in investors' preferences for assets in one country relative to the rest of the world? What would you expect happened to the French economy (a small open economy) in the wake of Mitterand's election?

Think of it as a rise in the risk premium associated with French assets--and thus a rise in the domestic interest rate r for a given world r*. Rising r shifts the IS* curve back and to the left. The government is left with a choice between (a) a recession and a constant exchange rate, and (b) a significant depreciation. In fact Mitterand experienced both...

8. Canada's nominal interest rates are four percentage points per year above U.S.nominal interest rates. Assuming that investments in Canada and the U.S. are equally risky, what does this differential tell you about investors' expectations of the future course of the Canada-US exchange rate?

Investors expect the Canadian dollar to fall by an average of four percent per year or so against the U.S. dollar.


Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page

Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax