Full Name: Nguyen Thi Binh

Student ID: 2521002431

Class: TH-25DMA12

Assignment Title: Essay Questions Assignment – Chapter 32

Answers:

Question 1:

Why national saving increases both the supply of loanable funds and the
supply of domestic currency:

An increase in national saving means domestic agents are consuming less

In the market for loanable funds, this extra saving expands the total supply
of loanable funds, driving down the domestic real interest rate.

In the open-economy framework, the higher domestic savings that are not
absorbed by domestic investment flow abroad as net capital outflow ( NCO ).
To invest abroad, domestic investors must convert domestic currency into
foreign currency, thereby increasing the supply of domestic currency in the
foreign-exchange market.

How the exchange rate gets determined in a flexible exchange rate system:

In a flexible exchange rate system, the exchange rate is determined entirely

Specifically, the supply of domestic currency comes from net capital outflow (
NCO ), while the demand for domestic currency comes from net exports ( NX ).

The equilibrium real exchange rate settles at the precise level where the
quantity of domestic currency supplied (for foreign investment) equals the
quantity demanded (by foreigners buying domestic net exports), balancing
NCO=NX .

Question 2:

Eliminating a balance-of-payments deficit or surplus using flexible exchange

Eliminating a Deficit (NX <0 ): When a country has a deficit, the supply of its
currency in the foreign exchange market exceeds the demand. Under a
flexible exchange rate system, this excess supply causes the domestic
currency to depreciate. A weaker currency makes domestic goods cheaper to
foreigners and foreign goods more expensive to locals, boosting exports and
curbing imports until the deficit is eliminated and trade balances ( NX=0).

Eliminating a Surplus (NX >0 ): When a country runs a surplus, the demand for
its currency exceeds the supply. This shortage drives an appreciation of the
domestic currency. A stronger currency makes domestic goods more
expensive abroad and foreign goods cheaper at home, reducing exports and
increasing imports until the surplus is eliminated.

Question 3:

a. What happens to the demand for dollars in the market for foreign-
exchange exchange?

When the French develop a strong taste for California wines, U.S. wine
exports to France increase.

To purchase these American goods, French buyers must acquire more U.S.
dollars, which causes the demand for dollars in the foreign-exchange market
to increase (shift to the right).

b. What happens to the value of the dollar in the market for foreign-
exchange exchange?

With an increased demand for dollars and an unchanged supply of dollars,

Consequently, the value of the dollar appreciates.

c. What happens to U.S. net exports?

Despite the initial surge in export demand, the appreciation of the dollar
makes all U.S. goods more expensive relative to foreign goods.

This currency appreciation crowds out other exports and encourages imports,
bringing net exports back to where they were determined by national saving
and domestic investment ( S−I =NCO=NX). Thus, the net effect on U.S. net
exports (NX ) in the macroeconomic equilibrium is unchanged, even though
specific export industries (like wine) experience higher sales offset by shifts
elsewhere.

Question 4:

Effect on U.S. Net Capital Outflow (NCO ):

Higher European real interest rates make foreign assets more attractive
relative to U.S. assets.

This induces capital to flow out of the United States toward Europe, causing
U.S. net capital outflow (NCO ) to increase.

Effect on U.S. Net Exports via Formula and Diagram:

Formula linkage: NCO=NX . As NCO rises, net exports (NX ) must rise by an
identical magnitude.

In the foreign exchange market diagram, the higher NCO shifts the supply
curve of dollars to the right.

Effect on U.S. Real Interest Rate and Real Exchange Rate:

Real Interest Rate: U.S. domestic investment and saving schedules remain
initially unaffected, so the domestic real interest rate remains anchored by
domestic saving and investment, though global financial integration links
rates closely. (Alternatively, higher outward capital flow shifts the loanable
funds outflow).

Real Exchange Rate: The rightward shift in the supply of dollars in the foreign
exchange market causes the real exchange rate to depreciate (fall), lowering
the relative price of domestic goods and stimulating net exports to match the
higher NCO .

Question 5:

a. If the elasticity of U.S. net capital outflow with respect to the real interest
rate is very high, will this increase in private saving have a large or small
effect on U.S. domestic investment?

A very high elasticity means capital flows are extremely sensitive to minor
changes in the interest rate (the NCO curve is very flat).

When private saving increases, the extra funds can easily flow abroad
without substantially altering domestic interest rates. Consequently,
domestic investment will experience a small effect because the adjustment
is absorbed primarily by international capital flows rather than domestic
borrowing costs.

b. If the elasticity of U.S. exports with respect to the real exchange rate is
very low, will this increase in private saving have a large or small effect on
the U.S. real exchange rate?

A low elasticity means that exports respond weakly to changes in relative

Because exports and imports do not change much when relative prices shift,
a large change in the real exchange rate is required to bring about the
necessary adjustment in net exports to match the change in saving and NCO .
Thus, the effect on the U.S. real exchange rate will be large.