Copy of AP Macro Problem Set 5

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Nov 24, 2024

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Unit 5: International Trade and Foreign Exchange Problem Set #5 1. ( ____/15) Define the term and explain a situation that demonstrates the ‘real world’ application of each of the following. Make sure your example clearly demonstrates your understanding of each concept. a. Trade a. Deficit and Trade Surplus ( ____/5) b. Current Account and Financial Account ( ____/5) c. Appreciation and Depreciation ( ____/5) a. A trade deficit is defined as when a country imports more than it exports. A trade deficit usually will have the opposite effect on currency as when imports exceed exports, the country's currency demand in terms of international trade will decrease. A lower demand for currency means that the currency will be less valuable in the international market. An example is the US importing more goods from loner countries than it exports. A trade surplus is defined as an economic measure of a positive balance of trade where the country's exports exceed imports. The trade surplus represents a net flow of domestic currency from foreign markets. An example would be China as they export more goods than they do import. b. The current account is defined as a reflection of the country's current trade balance combined with the net income and direct payments- measuring the import and export of goods and services. When a country has a positive current account, that means that the country is earning more than it spends. The financial account is defined as a component of the country's balance of payments that covers claims on liabilities to nonresidents- specifically with regard to financial assets. The financial account involves financial assets such as gold. The country may record part of the transaction in its capital account and others in the current account. c. Currency appreciation can be defined as the increase in value of the country's currency in respect to other countries' reference currencies. Currency depreciation can be defined as the decrease in the value of the country's currency with respect to other foreign reference currencies. Inflation and deflation is associated with these two concepts. As the price level increases in the US but other countries' price levels remain the same, the US goods will appear more expensive to foreign markets. As a result, the US will also increase foreign imports that appear to be cheaper- leading to depreciation. If the inflation rate is lower for the US compared to its trading partners, the US dollar

will appreciate. 2. ( ____/35) The Balance of Payments (BOP) measures all international transactions between two countries. The chart below shows six different transactions between the US and China United States China • Purchased $800 of goods and services • Sent $100 of humanitarian aid • Americans spent $200 in Chinese stock market • American tourists spend $1000 in China • Chinese tourists spend $1000 in the US • Purchased $300 of goods and services • Chinese purchased a $600 business in the US • Chinese government purchased $300 US. bonds a. Which country has a trade deficit and which has a trade surplus? Explain how you got your answer and calculate the value of each ( ____/5) The US has a trade deficit and China has a trade surplus. The balance of trade is the account that includes the value of transactions of both goods and services between two countries. US Balance of Trade = Purchase of US goods by China + Purchase of US services by China - Purchase of Chinese goods by US - Purchase of Chinese services by US US Balance of Trade = 1000 + 300 - 800 - 1000 = -$500 So the US has a trade deficit. China Balance of Trade = Purchase of China goods by US + Purchase of China services by US - Purchase of US goods by China - Purchase of US services by China China Balance of trade = 800 + 1000 - 1000 - 300 = $500 So China has a trade surplus. Both countries can't have a trade deficit together if one country is purchasing more from the other, then that other country is purchasing less from that country- meaning that the particular country faces a deficit while the other faces a Surplus.

b. Assuming these are all the transactions between these two countries, calculate the value of the current accounts for each country. Explain why one will have a current account deficit and the other will have a current account surplus. ( ____/5) US Current account = Purchase of US goods by China + Purchase of US services by China - Purchase of Chinese goods by US - Purchase of Chinese services by US US Current account = 1000 + 300 - 800 - 1000 = -$500 So the US has a current account deficit. US Financial account = Amount spent by China in US business + Amount of US bond by China - Amount spent by Americans in stock market US Financial account = 300 + 300 - 100 = $500 So the US has a financial account surplus. China Current account = Purchase of China goods by US + Purchase of China services by US - Purchase of US goods by China - Purchase of US services by China China Current account = 800 + 1000 - 1000 - 300 = $500 So China has a current account surplus. China Financial account = Amount spent by Americans in the stock market - Amount spent by China in US business - Amount of US bond by China China Financial account = 100 - 300 - 300 = -$500 So China has a financial account deficit. One country must have a current account deficit and financial account surplus to balance the amount of transactions. If there is a current account deficit, then it means that the country requires money to bridge the amount of deficit and to bridge that amount, a financial account surplus will be needed c. Calculate the dollar value of US bonds held by the Chinese government. Explain how you determined your answer. Identify the relationship between financial inflows and outflows for each country ( ____/5) $200, The chart says that the Chinese govt purchases 200 of US bonds. Because financial and current account balances are supposed to cancel each other out, the US must have $600 financial account meaning they have more inflow than outflow, while China must have -$600 financial account meaning they have more outflow than inflow

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d. Assume that China experience significant inflation compared to the US. In general, explain what would likely happen to the current accounts for each country and the value of each country’s currency? ( ____/5) Since China experiences significant inflation compared to the US, Chinese goods will become more expensive. Hence, Chinese exports will decrease as it will cost more in foreign markets. Therefore, Chinese export demand will decrease and import demand will increase. As a result, China will experience a lower net export- resulting in a decreased current account balance and increased current account deficit. On the other hand, the US export demand will increase and import demand will decrease- leading to increased net exports and a decrease in the current account deficit. As for China, the decreased exports will cause a decline in demand for the yuan, and higher imports will raise demand for the US dollar. As a result, the yuan will depreciate and the US dollar will appreciate. In the US, higher exports will increase demand for US dollars and decreased imports will reduce demand for yuan. Hence, the US dollar will appreciate. e. Assume instead that the interest rate increase in China compared to the US. In general, explain what would likely happen to financial accounts for each country and the value of each country’s currency? ( ____/5) If the interest rate increases in China compared to the US, then US investors will experience increased returns from investments in China than in investments in the US. Therefore, the inflow of capital in China will increase and the inflow of capital in the US will decrease. In financial accounts in China, higher capital inflow will increase the financial account balance. In the US, lower capital inflow will decrease the financial account balance. As investors increase investments in China, the demand for the yuan increases- causing the yuan to appreciate. In the US, lower capital inflow will decrease demand for the US dollar, resulting in a depreciation in the US dollar. f. Draw a Forex graph. You can use any two countries and then explain the graphs telling me which one has a strong dollar and which one has a weak dollar. (____/10) The foreign exchange graph shows the exchange rate between the Japanese yen and the US dollar. This was taken from an earlier Dropbox activity in which Japanese firms increased their imports of American cars. Hence, the US current account moves toward surplus, and the US net export increases. The US dollar is a stronger currency than the yen in terms of its value. In other words, more Japanese yen is needed to equal the US dollar. The yen isn't very strong as the yen is not as valuable due to inflation that occurred in the past. Hence, as of now, one US dollar is equal to 114.89 yen.

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