Principles ProblemSet11

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Universidad Carlos III de Madrid – Department of Economics

Principles of Economics
Problem Set 11
These answers and solutions are only a general guide because they are
preliminary.
Conceptual Questions
Write down a short and concise answer. When you are asked to solve
the question in class, explain the concept clearly and give examples or
pieces of evidence.
1. Define net exports and net foreign investment.
The net exports are a nations exports minus its imports, also known as the trade
balance. The net foreign investment measures the purchase of foreign assets by
domestic residents minus the purchase of domestic assets by foreigners. They both are
equal mathematically.
2. Explain the relationship among saving, investment, and net foreign

investment.
In an open economy Savings = Investment + Net Exports; in this case NX is equal to
NFI.
3. Describe the difference between foreign direct investment and foreign

portfolio investment. Who is more likely to engage in foreign direct
investment—a corporation or an individual investor? Who is more likely
to engage in foreign portfolio investment?
The difference between foreign direct investment and foreign portfolio investment is
the type of involvement with the investment. In the case of FDI the owner is actively
managing the investment. Whereas in the case of the FPI the activity of the owner is
more passive.
4. Keeping the national savings constant, does an increase in the net capital
outflows increase, decrease or has no effect on the capital accumulation of
a country?
When the national savings are kept constant the net capital outflows decrease because
there is less money being spent and in contrast is being saved. Hence, the capital
accumulation of the country increases.
5. Define nominal and real exchange rate and write a mathematical
expression that relates them.
The nominal exchange rate is the rate at which one can purchase currency from
another country with one`s currency. The real exchange rate is the rate at which one
can trade goods and services from one country to any other.
Mathematically they are correlated through the RER (real exchange rate) formula:
6. Describe the economic logic behind the theory of purchasing-power

parity.
Economically speaking the logic behind the purchasing-power parity is that a
currency must have the same purchasing-power in all countries.
Problems
1. How would the following transactions affect U.S. exports, imports,

and net exports?
a. A retail seller from the USA buys a shipment of phones produced at Korea.
Imports increase and NX decreases.
b. Students in Paris flock to see the latest Arnold Schwarzenegger movie.
Exports increase and NX increases.
c. An American resident buys a new Volvo.
Imports increase and NX decreases.
d. The student bookstore at Oxford University buys a shipment of Levi’s 501
jeans.
e. A Canadian citizen shops at a store in northern Vermont to avoid Canadian
sales taxes.
2. What is happening to the U.S. real exchange rate in each of the

following situations? Explain.
a. The U.S. nominal exchange rate is unchanged, but prices rise faster in the
United States than abroad.
The real exchange rate will change negatively, goods and services will be more
expensive in the US than abroad.
b. The U.S. nominal exchange rate is unchanged, but prices rise faster abroad
than in the United States.
The real exchange rate will change positively, goods and services abroad will be more
expensive than in the US.
c. The U.S. nominal exchange rate rises, and prices are unchanged in the United
States and abroad.
The dollar appreciates making it able to buy more foreign currency.
d. The U.S. nominal exchange rate declines, and prices rise faster in the United
States than abroad.
The dollar depreciates making it weaker in front of foreign currencies.
3. A case study in the chapter analyzed purchasing-power parity for

several countries using the price of a Big Mac. Here is the data for a
few more countries:
Country……Big Mac Price……Predicted exchange rate…Actual Exchange rate

Chile 1750 pesos …………________pesos/$ 549 pesos/$
Hungary 720 Forint _______ Forint/$ 199 Forint/$
Czech Republic 67,9 Koruna _______Koruna/$ 18.7 Koruna/$
Brazil 8.03 Real _______Reales/$ 2.0 Reales/$
Canada 3.89 $Cad. _______ $ cad/$ 1.16$Cad./$
a. For each country, compute the predicted exchange rate (this is, the
exchange rate under the assumption that the Purchasing Power Parity
theory holds) of the local currency per U.S. dollar. (The U.S. price of a
Big Mac is 3.57$)
b. According to purchasing-power parity, what is the predicted exchange

rate between the Brazilian real and the Canadian dollar? What is the
actual exchange rate?
The predicted for Brazil is 2.25 reales per dollar and the actual is 2 reales per dollar.
The predicted for Canada is 1.09 cad dollar per dollar and the actual is 1.16 per dollar.
c. How well does the theory of purchasing power parity explain exchange
rates?
It helps explaining the rates with a simple model and for understanding many
phenomena works well.
Other questions
1. The country of Elbia has a GDP of $2,000, consumption of

$1,300, and government purchases of $400. Which of the
following is equal to $300?
a. domestic investment
b. domestic investment plus net capital outflow
c. domestic investment minus net capital outflow
d. None of the above is correct.
2. In an open economy, gross domestic product equals $1,650 billion,

government expenditure equals $250 billion, and savings equals
$550 billion. What is consumption expenditure?
a. $250 billion
b. $300 billion
c. $550 billion
d. $850 billion
3. From 1980 to 1987

a. foreigners were buying more assets from the United States than
Americans were buying abroad. The United States was going into debt. F
b. Americans were buying more assets abroad than foreigners were buying
from the United States. The United States was going into debt. T
c. foreigners were buying more assets from the United States than
Americans were buying abroad. The United States was moving into
surplus. T
d. Americans were buying more assets abroad than foreigners were buying
from the United States. The United States was moving into surplus. F
4.The nominal exchange rate is .80 euros per dollar and the real
exchange rate is 4/3 between the USA and Italy. Which of the
following prices for a particular good are consistent with these
exchange rates?
a. $4 in the U.S. and 3 euros in Italy.
b. $4 in the U.S. and 3.75 euros in Italy.
c. $5 in the U.S. and 3 euros in Italy.
d. $6 in the U.S. and 2.50 euros in Italy.
5.Other things the same, which of the following could be a
consequence of an appreciation of the U.S. real exchange rate?
a. John, a French citizen, decides that Iowa pork is now relatively less
expensive and orders more for his restaurant.
b. Nick, a U.S. citizen, decides that the trip to Nepal he’s been thinking
about is now affordable.
c. Roberta, a U.S. citizen, decides to import fewer windshield wipers for
her auto parts company.
d. All of the above are correct
6.If over the next few years inflation is higher in Mexico than in the
U.S., then according to purchasing-power parity which of the
following should rise?
a. the U.S. real exchange rate but not the U.S. nominal exchange rate
b. the U.S. nominal exchange rate but not the U.S. real exchange rate
c. the Mexican real exchange rate but not the Mexican nominal exchange
rate
d. neither the U.S. real nor the U.S. nominal exchange rate.

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NEW

Universidad Carlos III de Madrid – Department of Economics

1. Define net exports and net foreign investment.

2. Explain the relationship among saving, investment, and net foreign

3. Describe the difference between foreign direct investment and foreign

6. Describe the economic logic behind the theory of purchasing-power

1. How would the following transactions affect U.S. exports, imports,

2. What is happening to the U.S. real exchange rate in each of the

3. A case study in the chapter analyzed purchasing-power parity for

Country……Big Mac Price……Predicted exchange rate…Actual Exchange rate

b. According to purchasing-power parity, what is the predicted exchange

1. The country of Elbia has a GDP of $2,000, consumption of

2. In an open economy, gross domestic product equals $1,650 billion,

3. From 1980 to 1987

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