Solutions to Fall 2014 Week 7 Tutorial Questions (Ch5) Chapter 5: Q1: Macroeconomics P.177 Review Questions #2 Q2: Macroeconomics P.177 Review Questions #4 Q3: Macroeconomics P.177 Numerical Problems #1 Q4: Macroeconomics P.177 Numerical Problems #3 Q5: Macroeconomics P.179 Analytical Problems #8 Q1: What is the key difference that determines whether an international transaction appears in the current account or the capital account? Answer: Q2: How do a country’s current and capital account balances affect its net foreign assets? If country A has greater net foreign assets per citizen than does country B, is country A necessarily better off than country B? Answer: Q3: The current account includes only the trade of currently produced goods and services. Trades of existing assets are counted in the capital account. In any period the net amount of new foreign assets that a country acquires equals its current account surplus, which in turn must equal its capital account deficit. A country with greater net foreign assets than another is not necessarily better off. What really counts is total national wealth, which consists of both net foreign assets and net domestic assets. For example, Canada has lower net foreign assets than other countries, but has a relatively high level of total national wealth per citizen. Here are some balances of payment data (without pluses and minuses): Merchandise exports, 100 Merchandise imports, 125 Service exports, 90 Service imports, 80 Investment income receipts from assets, 110 Investment income payment on assets, 140 Transfers from home country to other countries, 10 Increase in home country’s ownership of assets abroad, 160 Increase in foreign ownership of assets in home country, 200 Increase in home reserve assets, 30 Increase in foreign reserve assets, 35 Week 7 Page 1 Solutions to Fall 2014 Week 7 Tutorial Questions (Ch5) Find the merchandise trade balance, net exports, the current account balance, the capital account balance, the official settlement balance, and the statistical discrepancy. Answer: The merchandise trade balance equals merchandise exports minus merchandise imports, which equals 100 –125 = –25. Current Account Credits (+) Debits (-) Merchandise 100 120 Services 90 80 Income from/to foreigners 110 140 Net unilateral transfers Total 10 300 355 Current account balance (CA) = 300 –355 = –55. Net exports (NX) = (100 + 90) –(125 + 80) = –15. Capital Account Credits (+) Increase in home country assets abroad Debits (–) 160 Increase in foreign assets in home country 200 Total 200 160 Notice that the increase in home reserve assets is just a subcategory of the increase in home country assets, so it is not included separately. Similarly, the increase in foreign reserve assets is just a subcategory of the increase in foreign assets in the home country. The information about the changes in home and foreign reserve assets is included Jot calculation of the official settlements balance only; it does not affect the capital account. Capital account balance (KA) = 200 –160 = 40.Statistical discrepancy (SD): CA + KA + SD = 0–55 + 40 + SD = 0SD = 15 Official settlements balance = increase in home official reserve assets minus increase in foreign official reserve assets = 30 –35 = –5. Q4: Week 7 In a small open economy, Desired national saving, Sd = $10 billion + ($100 billion)rw Page 2 Solutions to Fall 2014 Week 7 Tutorial Questions (Ch5) Desired investment, Id = $15 billion – ($100 billion)rw Output, Y = $50 billion Government purchases, G = $10 billion World real interest rate, rw = 3% a. Find the economy’s national saving, investment, current account surplus, net exports, desired consumption, and absorption. Answer: All variables but interest rates are in billions of dollars. S = 10 + (100 ×0.03) = 13 I = 15 – (100 x 0.03) = 12 NX = CA = S –I = 13 –12 = 1 C = Y – (I + G + NX) = 50 – (12 + 10 + 1) = 27 A = C + I + G= 27 + 12 + 10 = 49 b. Owing to a technological innovation, the country’s desired investment rises by $2 billion at each level of the world real interest rate. Repeat part (a). Answer: S = 13, as before. I = 17 – (100 x 0.03) = 14 NX = CA = S –I = 13 –14 = –1 C= Y–(1 + G + NX) = 50 – (14 + 10 –1) = 27 A = C + I + G=27 + 14 + 10= 51 Q5: Analyze the effects on a large open economy of a temporary adverse supply shock that hits only the foreign economy. Discuss the impact on the home country’s national saving, investment, and current account balance – and on the world real interest rate. How does your answer differ if the adverse supply shock is worldwide? Answer: Week 7 A temporary adverse supply shock hitting the foreign economy causes the foreign saving curve to shift up, from S1Forto S2Forin Fig. 5.7. This raises the equilibrium world real interest rate, increasing home country saving and decreasing home country investment. Since saving rises and investment falls, the home country's current account balance Page 3 Solutions to Fall 2014 Week 7 Tutorial Questions (Ch5) increases. If the shock is worldwide, then the effect on the current account depends on how big the shift to saving is in the home country relative to the foreign country, as well as on the slope of the investment curve. If the saving curves shift just right, the current account may be unchanged, as shown in Fig. 5.8. In any event, the world real interest rate increases, and saving and investment in both countries decline. (Graph is drawn in tutorials) Week 7 Page 4