NX2NX1

1

Net Export

€2

€1

S1-I1 S2-I1

Real excchange rate (€)

2

3

NX (€)

Tugas Makroekonomi (Pertemuan 5)

Nama : Utami Ratnasari (1406534001)

Ghea Lita U (14065)

1. Use the model of the small open economy to predict what would happen to the trade

balance, The real exchange rate, and the nominal exchange rate in response to each of the

following Events.

A. A fall in consumer confidence about the future induces consumers to spend less and

Save more.

B. The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars

over domestic cars.

C. The introduction of automatic teller machines reduces the demand for money.

Answer :

a. Increase in saving cause :

1. Supply of exchange rate increase (S1-I1) to (S2-I1).

2. Then, this increase will cause the real exchange rate decrease (€1 to €2), causing the price

of the domestic good is cheaper;

3. Since the price of the domestic good is cheaper, there will be increase in export and decrease

import ( positive increase in Trade Balance, NX1 to NX2). The nominal interest rate is

determined by real interest rate (in this case, real interest rate is decrease) and the price level

(doesn’t affected), so the Nominal Interest rate is also decreasing.

NX1

1

Net Export

€2

€1

S-I

Real exchange rate (€)

2

3

b. When consumer prefer foreign cars than domestic,

1. It means the import will be high causing the net export decrease (shifting to the left).

2. Given the same (S-I) curve, the decrease will lead to lowering real exchange rate and

nominal interest rate. But the decrease in real exchange rate means the foreign goods is more

expensive so import will also decrease. This effect offset the increase in import (step 1) and

causing Net Export do not change.

c. Since the ATM reduce the demand for money. Since the demand of money is nominal

variable, so it doesn’t affect the real exchange rate (classical dichotomy). The Net export also

not effected because the NX determined by Y (output), Consumption, Government expenditure,

and Investment (NX = Y-C-G-I).

Recall the real money balance determine the Money demand function, so real money balance

(M/P). If we assume the Quantity of Money do not change, we can assume also that the decrease

in the demand of money will lead to increase in Price level. The increase in price level affect the

nominal interest rate ;

Since Nominal exchange rate = real exchange rate x (Foreign Price Level/Domestic Price Level)

The increase in Domestic Price level will decrease the nominal exchange rate.

NX (€)1

NX (€)2

2. Consider an economy described by the following equation :Y = C + I + G + NXY = 5,000G = 1,000T = 1,000C = 250 + 0.75 (Y-T)I = 1,000 - 50rNX = 500 - 500ɛr = r˟ = 5

a. In this economy, solve for national saving, investment, the trade balance, and the equilibrium exchange rate.b. Suppose now that G rises to 1,250. Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find.c. Now suppose that the world interest rate rises from 5 to 10 percent. (G is again 1,000)

Answer :

a. S = Y – C – G = 5,000 – (250 + 0.75(Y-T)) – 1,000 = 5,000 – (250 + 0.75(5,000-1,000)) – 1,000 = 5,000 – 3,250 – 1,000 = 750, so National Saving is 750

I = 1,000 - 50r = 1,000 - 50(5) = 750

Trade Balance (NX) = S – I = 750 – 750 = 0

Equilibium exchange rate (ɛ)NX = 500 - 500ɛ 0 = 500 - 500ɛ500ɛ = 500 ɛ = 1%

b. S = Y – C – G = 5,000 – (250 + 0.75(Y-T)) – 1,250 = 5,000 – 3,250 – 1,250 = 500

I = 1,000 - 50r = 1,000 - 50(5) = 750

Trade Balance (NX) = S – I = 500 – 750 = - 250

Equilibrium exchange rate (ɛ)NX = 500 - 500ɛ-250 = 500 - 500ɛ500ɛ = 750 ɛ = 1.5%

In this case I find that when G rises, it will make the saving decrease. When saving decreases and the investment stayed the same, the amount of money in the economy face is lower than the demand so it will make money from abroad enter that country’s economy (net capital outflow). Net capital outflow make the trade balance (NX) become negative (decrease) and the exchange rate increased by 0.5.

c. S = Y – C – G = 5,000 – (250 + 0.75(Y-T)) – 1,000 = 5,000 – (250 + 0.75(5,000-1,000)) – 1,000 = 5,000 – 3,250 – 1,000 = 750

I = 1,000 - 50r = 1,000 - 50(10) = 500

Trade Balance (NX) = S – I = 750 – 500 = 250

Equilibium exchange rate (ɛ)NX = 500 - 500ɛ 250 = 500 - 500ɛ500ɛ = 250

S1-I1

Real exchange rate (€)

ɛ = 0.5In this case I find that when world interest rate (r˟) rises it will make investment decrease. When investment decrease and the saving stayed the same, the amount of money in the economy face excess supply so it will make money will out to abroad (net capital inflow). Net capital inflow make the trade balance (NX) become positive (increase) and the exchange rate decrease by 0.5.

3. The country of Leverett is a small open economy. Suddenly, a change in world fashions

makes the exports of Leverett unpopular.

a. What happens in Leverett to saving,investment, net exports, the interest rate, and the

exchange rate?

b. The citizens of Leverett like to travel abroad. How will this change in the exchange rate

affect them?

c. The fiscal policymakers of Leverett want to adjust taxes to maintain the exchange rate at

its previous level. What should they do? If they do this, what are the overall effects on

saving, investment, net exports, and the interest rate?

Answer :

a. Since the export is decreasing, so the Net Exports will decrease given the same amount of

import, described by ;

1. The NX curve shifting to the left. Saving, Investment, and Interest rate is not affected.

The reason is saving is determined by C,I,G, Investment is determined by interest rate, while it is

stated that Leveret is a small open economy that rely on world interest rate.

2. since the NX shift to the left, the real exchange rate is decrease. The dollar seems less

valuable, and the price of domestic good is cheaper. But since the domestic good is cheaper, it

induces the export and offset the decrease in export, so the Net Exports remain the same.

NX1

1

Net Export

€2

€1

S1-I1

Real exchange rate (€)

2

3

NX(€)

b. Since the citizen like to travel abroad, so the demand for domestic money is decrease. Since

the demand of currency is shown by NX(€) curve, this curve will shift to the left. With given

level of supply, the real exchange rate will decrease and dollar of Leveret become less valuable

(buy less foreign currency)

c. Fiscal Policy can be used to change saving and investment, including tax. If government want

the real exchange rate adjusted to original (E1), Then it must reduce saving in order to make the

curve shift to the left. So , the government can reduce the tax, so that the Consumption increase

and the saving decrease. (S=Y-C-G). So the Saving will decrease, investment is not affected, Net

export is decrease, and increase in real exchange rate to the original rate.

5. What will happen to the trade balance and real exchange rate of a small open economy when government purchases increase, such as during war? Does your answer depend on whether this is local war or a world war?

Answer :

NX(€)1

S1-I1

Real exchange rate (€)

When a government purchases increase in small open economy it will make the saving decrease because S = Y – C – G. The decreasing of saving that did not followed by the decrease of investment (constant) because in the small open economy the change of saving do not affect the world interest rate (r˟) whereas they should use world interest rate (r˟). It makes the economy face excess demand of money. The excess demand of money will make the money from abroad enter the economy. This case is also called net capital outflow because S < I. Because trade balances (NX) is NX = S – I, so the net trade balances will be negative (decrease) and the real exchange rate (ɛ) increase. This explanation happens when there is a local war.

7. The president is considering placing a tariff on the import of Japanese luxury cars.

Discuss the economics and politics of such a policy. In particular, how would the policy

affect the U.S. trade deficit? How would it affect the exchange rate? Who would be hurt by

such a policy? Who would benefit?

Answer :

The tariff policy is one of trade policy that has aim to protect the country’s trade of balance,

beside quota. Since import causing the deficit trade balance, government think that placing a

tariff will reduce the trade balance deficit.

But actually, the tariff is not absolutely reduce the trade balance deficit .

1. tariff policy will reduce the number of Import, so the Net export will increase, and Net Export

(€ ) will shifting to the right.

2. This increase will lead the real exchange rate to increase (from €1 to €2). Since this policy

doesn’t affect the saving, investment, and interest rate, so the S-I curve remain constant.

3. The increase in the real exchange rate makes dollar become more valuable, the domestic

goods is more expensive, so the export will decrease and import will increase. This effect offset

the decrease in import (direct effect no.1), so the Net Export remain the same.

From the illustration above, we can conclude that the tariff policy is not effective to reduce the

trade deficit (although it can reduce both the number export and impor since the real exchange

rate is increased). But, it is causing the dollar to appreciate. The parties that will be hurt is the

American exporters because the increase in real exchange rate will make the American goods

and service more difficult to compete due to higher price. Besides, directly, the exporter in

Japan also will be hurt because of the tariff.

The parties that will be benefited is obviously the domestic car producer since they lose some

competitors (Japan’s car producer).

9. Suppose that some foreign countries begin to subsidize investment by instituting an investment tax credit.a. What happens to world investment demand function of the world interest rate?b. What happens to world interest rate?c. What happens to investment in our small open economy?d. What happens to our trade balance?e. What happens to our exchange rate?

Answer :

a. The world investment demand will increase because the investment tax credit (tax credit is low). In a given world interest rate, the increase of investment demand leads to higher investment.b. The increase of investment make the world interest rate increase because I = I(r˟). This equation can tell us that when investment increase it also make the world interest rate increase.c. The investment in our small open economy will increase because the when the investment tax credit make the world interest rate increase and the small country should use the world interest rate. This case make the investment in the small country is also increase.d. The trade balances will surplus because the increase of investment reduce the supply of money, NX = S – I. When investment increase it means that S < I (net capital inflow)

NX(€)1

e. The exchange rate in this case will decrease because NX = NX(ɛ). That equation show us that when trade balance (NX) decrease, the exchange rate also will decrease.