Page 494 - Krugmans Economics for AP Text Book_Neat

2. Assume the United States is operating below potential output. labeled graph of the market for loanable funds to show the
a. Draw a correctly labeled aggregate demand and supply effect of increased borrowing on the interest rate.
graph showing equilibrium in the economy. d. Given the effect on the interest rate from part c, draw a
b. Suppose the government decreases taxes. On your graph, correctly labeled graph of the foreign exchange market
show how the decrease in taxes will affect AD, SRAS, LRAS, showing the effect of the change in the interest rate on the
equilibrium aggregate price level, and output. supply of U.S. dollars. Explain how the interest rate affects
c. Assume the decrease in taxes led to an increased budget the supply of U.S. dollars.
deficit and that the deficit spending was funded through e. According to your graph from part d, what has happened to
government borrowing from the public. Use a correctly the value of the U.S. dollar? How will this affect U.S. exports
and aggregate demand?

Section 8 Review

Summary

1. A country’s balance of payments accounts summarize chasing power parity is a good predictor of actual
its transactions with the rest of the world. The balance changes in the nominal exchange rate.
of payments on the current account, or the current 5. Countries adopt different exchange rate regimes, rules
account, includes the balance of payments on goods governing exchange rate policy. The main types are fixed
and services together with balances on factor income exchange rates, where the government takes action to
and transfers. The merchandise trade balance, or trade keep the exchange rate at a target level, and floating ex-
balance, is a frequently cited component of the balance change rates, where the exchange rate is free to fluctu-
of payments on goods and services. The balance of pay- ate. Countries can fix exchange rates using exchange
ments on the financial account, or the financial ac- market intervention, which requires them to hold for-
count, measures capital flows. By definition, the balance eign exchange reserves that they use to buy any surplus
of payments on the current account plus the balance of of their currency. Alternatively, they can change domes-
payments on the financial account is zero. tic policies, especially monetary policy, to shift the de-
2. Capital flows respond to international differences in in- mand and supply curves in the foreign exchange market.
terest rates and other rates of return; they can be usefully Finally, they can use foreign exchange controls.
analyzed using an international version of the loanable 6. Exchange rate policy poses a dilemma: there are economic
funds model, which shows how a country where the in- payoffs to stable exchange rates, but the policies used to
terest rate would be low in the absence of capital flows fix the exchange rate have costs. Exchange market inter-
sends funds to a country where the interest rate would be vention requires large reserves, and exchange controls dis-
high in the absence of capital flows. The underlying de- tort incentives. If monetary policy is used to help fix the
terminants of capital flows are international differences exchange rate, it isn’t available to use for domestic policy.
in savings and opportunities for investment spending.
7. Fixed exchange rates aren’t always permanent commit-
3. Currencies are traded in the foreign exchange market; ments: countries with a fixed exchange rate sometimes
the prices at which they are traded are exchange rates. engage in devaluations or revaluations. In addition to
When a currency rises against another currency, it ap- helping eliminate a surplus of domestic currency on the
preciates; when it falls, it depreciates. The equilib- foreign exchange market, a devaluation increases aggre-
rium exchange rate matches the quantity of that gate demand. Similarly, a revaluation reduces shortages
currency supplied to the foreign exchange market to the of domestic currency and reduces aggregate demand.
quantity demanded.
8. Under floating exchange rates, expansionary monetary
4. To correct for international differences in inflation policy works in part through the exchange rate: cutting
rates, economists calculate real exchange rates, which domestic interest rates leads to a depreciation, and
multiply the exchange rate between two countries’ re- through that to higher exports and lower imports,
spective currencies by the ratio of the countries’ price which increases aggregate demand. Contractionary
levels. The current account responds only to changes in monetary policy has the reverse effect.
the real exchange rate, not the nominal exchange rate.
Purchasing power parity is the exchange rate that 9. The fact that one country’s imports are another coun-
makes the cost of a basket of goods and services equal try’s exports creates a link between the business cycles
in two countries. While purchasing power parity and in different countries. Floating exchange rates, however,
the nominal exchange rate almost always differ, pur- may reduce the strength of that link.
452 section 8 The Open Economy: Inter national Trade and Finance