ECON 101 Tutorial: Week 23 Shane Murphy Office Hours: Monday 3:00-4:00 – LUMS C85

Outline Roll Call Problems

Chapter 28: Problem 4 How would the following transactions affect UK net capital outflow? Also, state whether each involves direct investment or portfolio investment: a)A UK mobile company establishes an office in the Czech Republic. When a British mobile phone company establishes an office in the Czech Republic, UK net capital outflow increases, because the U.S. company makes a direct investment in capital in the foreign country. b) A US company’s pension fund buys shares in BP. When a US company’s pension fund buys shares in BP, net capital outflow decreases, because the US pension fund makes a portfolio investment in the UK. (We are assuming the shares are newly issued or purchased from a UK resident. In fact, of course, many BP shares are already held by non-UK citizens.)

Chapter 28: Problem 4 How would the following transactions affect UK net capital outflow? Also, state whether each involves direct investment or portfolio investment: c) Toyota expands its factory in Derby, UK When Toyota expands its factory in Derby, England, UK net capital outflow declines, because a foreign company makes a direct investment in capital in the UK. d) A London investment trust sells VW shares to a French investor When a London-based investment trust sells its Volkswagen shares to a French investor, UK net capital outflow declines (if the French investor pays in UK pounds), because the UK company is reducing its portfolio investment in a foreign country.

Chapter 28: Problem 5 Holding national saving constant, does an increase in net capital outflow increase, decrease or have no effect on a country’s accumulation of domestic capital? If national saving is constant and net capital outflow increases, domestic investment must decrease, since national saving equals domestic investment plus net capital outflow. If domestic investment declines, the country's accumulation of domestic capital declines.

Chapter 28: Problem 6c If UK inflation exceeds EU inflation, would you expect the UK pound to appreciate or depreciate relative to the euro? If UK inflation exceeds European inflation over the next year, you would expect the pound to depreciate relative to the euro because a pound would decline in value (in terms of the goods and services it can buy) more than the euro would.

Chapter 28: Problem 8 What is happening to the Swiss real exchange rate in each of the following: a)If the Swiss nominal exchange rate is unchanged, but prices rise faster in Switzerland than abroad, the real exchange rate rises. b) If the Swiss nominal exchange rate is unchanged, but prices rise faster abroad than in Switzerland, the real exchange rate declines. c) If the Swiss nominal exchange rate declines, and prices are unchanged in Switzerland and abroad, the real exchange rate declines. d) If the Swiss nominal exchange rate declines, and prices rise faster abroad than in Switzerland, the real exchange rate declines.

Chapter 28: Problem 9 List three goes for which the law of one price is likely to hold and three goods for which it is not. Three goods for which the law of one price is likely to hold are farm goods like wheat, which are nearly identical no matter where they are produced, technological goods like computer software, which have low shipping costs because they are light, and clothing, which also has low shipping costs. Three goods for which the law of one price is not likely to hold are real estate, because you can't move land or buildings from one country to another; goods that are mainly consumed in one country and so are not traded, like frog’s legs that are consumed in France but generally not elsewhere; and services like haircuts, which cannot be arbitraged even if the price is very different in different countries.

Chapter 29: Problem 1 Why does Germany (or Japan) generally run a trade surplus? Germany generally runs a trade surplus because the Japanese saving rate is high relative to German domestic investment. The result is high net capital outflow, which is matched by high net exports, resulting in a trade surplus. The other possibilities (high foreign demand for German goods, low Japanese demand for foreign goods, and structural barriers against imports into Germany ) would affect the real exchange rate, but not the trade surplus.

Chapter 29: Problem 4 Assume a rise in the trade deficit due to a rise in government budget deficit. Assume some claim that the increased trade deficit resulted from a decline in the quality of the country’s products relative to foreign. a)If relative quality did decline, how might this affect net exports at a given exchange rate? This would reduce net exports, reducing the demand for dollars, thus shifting the demand curve for dollars to the left in the market for foreign exchange c) Does a decline in the quality of the country’s products have any effect on standards of living for its residents? The claim in the popular press is incorrect. A change in the quality of US goods cannot lead to a rise in the trade deficit. The decline in the real exchange rate means that US residents get fewer foreign goods in exchange for their goods, so their standard of living may decline.

Chapter 29: Problem 4 Assume a rise in the trade deficit due to a rise in government budget deficit. Assume some claim that the increased trade deficit resulted from a decline in the quality of the country’s products relative to foreign. b) Use a diagram to show the effect on real exchange rate and trade balance. The shift to the left of the demand curve for dollars leads to a decline in the real exchange rate. Since net capital outflow is unchanged, and net exports equals net capital outflow, there is no change in equilibrium in net exports or the trade balance.

Chapter 29: Problem 6 Suppose the French develop a taste for UK wine. a)What happens to the demand for pounds? The demand for pounds in the foreign-currency market increases at any given real exchange rate b) What happens to the value of pounds? Increased demand increases the exchange rate c) What happens to the quantity of UK net exports? The quantity of net exports remains unchanged (since NCO doesn’t change as in previous figure)

Chapter 29: Problem 9 Suppose that Germans decide to increase their saving. a)If the elasticity of German NCO with respect to the real interest rate is high, will this increase in private saving have a large or small effect on German domestic investment? If the elasticity of German net capital outflow with respect to the real interest rate is very high, the lower real interest rate that occurs because of the increase in private saving will increase net capital outflow a great deal, so German domestic investment will not increase much. b) If the elasticity of German NCO with respect to the real interest rate is low, will this increase in private saving have a large or small effect on the German real exchange rate? Since an increase in private saving reduces the real interest rate, inducing an increase in net capital outflow, the real exchange rate will decline. If the elasticity of German exports with respect to the real exchange rate is very low, it will take a large decline in the real exchange rate to increase German net exports by enough to match the increase in net capital outflow.