[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Review and Practice
SUMMARY
1. In the open economy, net exports are a component of
aggregate spending. Both imports and exports depend
on the real exchange rate. A lower real exchange rate
increases exports and reduces imports.
2. Changes in the real interest rate affect investment, the
exchange rate, and net exports. A rise in the real interest
rate reduces domestic investment and net exports,
leading to a downward shift in aggregate expenditures.
3. The aggregate demand–inflation (ADI) curve in an open
economy has a negative slope—the level of output consistent
with equilibrium falls as inflation rises. The ADI
curve can shift if incomes abroad fluctuate or if foreign
interest rates rise or fall relative to the U.S. interest rate.
4. Exchange rate movements can have a temporary but
direct effect on U.S. inflation. If the dollar depreciates,
the prices of imported inputs rise, and firms may pass
this increase through in the form of higher prices.
5. Exchange rate movements can directly affect the consumer
price index (CPI) measure of inflation, because
the CPI includes the prices of imported goods purchased
by households.
6. Monetary policy is more effective in an open economy—
changes in interest rates affect private investment, but
they also cause reinforcing changes in net exports
through the exchange rate channel.
7. Fiscal policy is less effective in an open economy—the
change in exchange rate causes net exports to offset the
initial fiscal action.
3. If firms import a lot of raw materials, what impact
would a depreciation in the dollar have on the inflation
adjustment (IA) curve?
4. How does a fiscal expansion affect the real exchange
rate and net exports?
5. How does a monetary policy expansion affect the real
exchange rate and net exports?
6. If the United States raises its interest rate and Canada
does not, will the Canadian dollar appreciate or will it
depreciate? If Canada follows the United States and also
raises its interest rate, what will happen to the value of
the Canadian dollar?
PROBLEMS
1. Explain how U.S. net exports would be affected by each
of the following:
(a) An economic expansion in western Europe
(b) Financial crises in Asia and Latin America that
cause the U.S. dollar to appreciate
(c) An interest rate increase by the European Central
Bank
2. Using the information in the table below, calculate the
real exchange rate between the nations of Nordamer
and Sudamer (the nominal exchange rate is the number
of Nordamer dollars that can be purchased with one
Sudamer dollar):
KEY TERM
interest parity condition
REVIEW QUESTIONS
1. What is the relationship between the interest rate and
the exchange rate? What is the relationship between the
exchange rate and net exports?
2. As we move up and to the left on a given ADI curve,
what happens to the value of the domestic currency and
net exports?
Price level Price level Nominal
in Nordamer in Sudamer exchange rate
Year 1 100 100 1
Year 2 110 100 1.1
Year 3 121 100 1.21
Year 4 133 100 1.33
(a) Has the Sudamer dollar appreciated or depreciated
in nominal terms?
(b) Has the real exchange rate appreciated or depreciated?
(c) Have Nordamer goods become less expensive for
Sudamers to buy? Explain.
790 ∂ CHAPTER 35 POLICY IN THE OPEN ECONOMY