Chapter 5 MEL

The current account measures a​country's trade in currently produced goods and​services,
along with net transfers between countries. For​convenience, we divide the current account
into three separate​components:
(1) net exports of goods and​services,
(2) investment income from assets​abroad, and​
(3) current transfers.

Credit items are exports of goods and services and income receipts on investments abroad.
Debit items are imports of goods and services and income payments on investments to
foreign owners of assets.
A​country's current transfers equal transfers received by the country minus transfers flowing
out of the country.

Identify the categories of credit items and debit items that appear in a​country's
current account. ​(Select all that​apply.)
A.
Exports of services
B.
Exports of goods
C.
Increase in​home-country-owned assets abroad
D.
Income receipts on investments abroad
E.
Current transfers
F.
Statistical discrepancy
G.
Imports of services
H.
Income payments on investments to foreign owners of assets
I.
Imports of goods
J.
Increase in​foreign-owned assets in home country

What is the current account​balance? ​(Select all that​apply.)

A.
Payments received from abroad in exchange for currently produced goods and services​
(including factor​services), minus the analogous payments made to foreigners by the
domestic economy
B
The result from adding all the credit items and subtracting all the debit items in the current
account
C
The amount of funds that the country is able to borrow from abroad
D.
The amount of funds that the country has available for net foreign lending
Assuming no current​transfers, what is the relationship between the current account
balance​(CA) and net exports​(NX)?

What is the key difference that determines whether an international transaction

appears in the current account or the capital​account?
A.
Gold movements are entered in the capital​account, while all other transactions are entered
in the current account.
B.
Trade in currently produced goods and services is entered in the current​account, while trade
in assets is entered in the capital account.
C
Receipts are entered in the current​account, while payments are entered in the capital
account.
D.
Trade in currently produced goods and services is entered in the capital​account, while trade
in assets is entered in the current account.

A Canadian publisher sells​$200 worth of books to a resident of Brazil. By​itself, this

item is a
credit item in the Canadian current account.
Offsetting transactions that would ensure that the Canadian current account and
capital account balances would continue to sum to zero​include:
A.
any credit item in the capital account.
B.
a gold transfer from Canada to Brazil.
C.
any debit item in the capital account.
D
any credit item in the current account.

A current account surplus causes a​country's net foreign assets to increase​, a current
account deficit causes a​country's net foreign assets to decrease​, a capital account
surplus causes a​country's net foreign assets to decrease, and a capital account
deficit causes a​country's net foreign assets to increase.
If country A has greater net foreign assets per citizen than does country​B, is country
A necessarily better off than country​B?
A.
Yes.
B.
​No; net foreign assets have no bearing on the​well-being of a country.
C.
​No; country B could be better off if it has greater imports of goods and services.
D.
​No; country B could be better off if it has more domestic physical assets per citizen​and/or
greater income per citizen than country A.
—---------------------------------------------------------------------------------------------------------------------
1. Merchandise trade balance
Merchandise exports - Merchandise imports

2. Net exports equals exports of goods and services minus imports of goods and
services.
Net exports is
(Merchandise​exports + Service​exports) - (Merchandise​imports + Service​imports)

The current account measures a​country's trade in currently produced goods and​
services, along with net transfers between countries. For​convenience, we divide the
current account into three separate​components:
(1) net exports of goods and​services
(2) investment income from assets​abroad
(3) current transfers

3. The current account balance is

Net exports + (Investment income from abroad - investment income payments to foreign
owners) + Transfers from home country to other​countries

4. Capital Account Balance

Increase in foreign ownership of assets in home country - Increase in home​country's
ownership of assets abroad
*The capital account balance equals the negative of the current account. The current
account balance equals ​$64 ​billion, so the financial account balance equals negative $ 64
billion.

5. Official settlements balance

Increase in home reserve assets - Increase in foreign reserve assets

6. Statistical Discrepancy
The statistical discrepancy is the amount that would have to be added to the sum of
the current and capital account balances for their sum to reach its theoretical value of
zero.
(current account + capital account) + X = 0
—---------------------------------------------------------------------------------------------------------------------
Suppose the Japanese firm Toyota builds a new plant to produce cars in Ontario. This
is
A.
foreign direct investment in Canada.
B.
foreign direct investment in Japan.
C.
portfolio investment in Canada.
D.
portfolio investment in Japan.

​ oyota's investment in the new plant causes

T
A.
an increase​Canada's capital account balance.
B
no change in the capital account balance in either country.
C.
an increase in​Canada's current account balance.
D.
an increase in​Japan's capital account balance.

The current account reflects the total net income of a country within a year. The capital
account reflects the net change in the ownership of national assets of a country within a
year.

Explain how each of the following transactions would enter the Canadian balance of
payments accounts. Discuss only the transactions described. Do not be concerned
with possible offsetting transactions.

a. The Canadian government sells military equipment to a foreign​government: plus entry in

current account

b. A London bank sells yen​to, and buys Canadian dollars​from, a Swiss​bank: no entry

c. The Bank of Canada sells yen​to, and buys dollars​from, a Swiss​bank: plus entry in
capital account

d. A Canadian bank receives the interest on its loans to​Brazil: plus entry in current account

e. A Canadian collector buys some modern art from a collection in​Japan: negative entry in
capital account
f. A Canadian oil company buys insurance from Lloyds of London to insure its oil rigs in the
Beaufort​Sea: negative entry in current account

g. A Canadian company borrows from a U.S.​bank: plus entry in capital account

For each of the following transactions that may by themselves change the sum of the
Canadian current account​balance, CA, and the Canadian capital account​balance,
KA, give an example of an offsetting transaction that would leave CAplusKA
unchanged.
Current account balance ​(CA) = 200
Capital account balance ​(KA) = - 215.
What is the amount of statistical discrepancy in the balance of payments​accounting?
Statistical discrepancy equals 15

Which of the following types of changes in desired saving and desired investment
does NOT lead to a larger current account deficit in a small open​economy?
A.
A temporary adverse supply shock.
B.
An increase in taxes to finance government infrastructure investment projects.
C
An increase in government purchases to finance a military expansion.
D.
An increase in the expected future marginal product of capital.

If a French firm buys soda from a Canadian firm and the Canadian firm uses the euros
it gets to buy French​bonds, how are these transactions recorded in the Canadian
balance of payments​accounts?
A.
Decrease in trade​balance; increase in capital account balance
B.
Increase in trade​balance; increase in capital account balance
C.
Decrease in trade​balance; decrease in capital account balance
D.
Increase in trade​balance; decrease in capital account balance

The balance of payments

A.
equals the net increase​(domestic less​foreign) in a​country's official reserve assets.
B
is always positive when there is a current account deficit.
C.
equals the capital account balance minus the current account balance.
D.
equals the capital account balance plus the current account balance.

You just read that forecasters predict the Canada will run a current account surplus in
2025. From this you would infer that the Canada will also
A.
run a balance of payments surplus in 2025.
B.
increase its net foreign assets in 2025.
C
decrease its official reserve assets in 2025.
D.
run a capital account surplus in 2025.

In a small open​economy, national saving​_____ investment and output​_____

absorption.
A.
must​equal; must equal
B.
must​equal; does not have to equal
C.
does not have to​equal; must equal
D.
does not have to​equal; does not have to equal

In an open economy you find that desired savings Sd is exactly equal to desired
investment. What must be true with respect to the current account balance ​'CA​'?
It's equal to zero

Formula for CA

Formula for desired savings

Given the following​data:

Desired Investment Id​: ​$250
Current Account Balance CA​: ​$600
Net Factor Payments from abroad NFP​: ​$75

1. Calculate the value of Net Exports ​'NX​': ​$ 525

2. Calculate the value of Desired Savings Sd​: ​$ 850

Desired Consumption Formula

*Absorption equals spending by domestic​residents, which equals Cd​+ Id​+ G.
Given the following​data:
Desired Investment Id​: ​$100
Current Account Balance CA​: ​$300
Net Exports NX​: ​$300
Domestic Output Y​: ​$1,200
Government Expenditure G​: ​$200
1. Calculate the value of Desired Consumption ​'Cd​': ​$600
2. Calculate the value of domestic​absorption: ​$900

The diagram to the right shows equilibrium in the goods market of a small open
economy at point A. Assume that this small open economy is under capital​controls,
meaning domestic residents are prohibited from borrowing and lending from the
world capital market.

identify the amount of desired saving at this world real

interest rate. Label this point​'B'
identify the amount of desired saving at this world real
interest rate. Label this point​'B'

This situation is one with a current account deficit

A large current account deficit is most likely to come about when desired investment​
_____ substantially and if desired national saving​_____ substantially.
A.
​increases; declines
B
​declines; declines
C.
​declines; increases
D.
​increases; increases

Example Question: In a small open​economy, output​(gross domestic​product) is ​$20

​billion, government purchases are ​$4 ​billion, and net factor payments from abroad are
zero. Desired consumption and desired investment are related to the world real
interest rate in the following​manner:
Consider a small open economy with zero current transfers and zero net factor
payments.
a. A temporary adverse supply shock will decrease the current account balance
b. An increase in the expected future marginal product of capital will decrease the
current account balance
c. Upper A decrease in the government purchases is likely to increase the current
account balance

In a world with two large open​economies, the world real interest rate is determined as
the rate at which
A.
desired international lending by one country equals desired investment by the other country.
B.
desired international lending by one country equals desired international borrowing by the
other country.
C.
desired national saving in the larger country equals desired investment in the larger country.
D.
desired national saving in one country equals desired investment in the other country.
What relationship between the current accounts of the two countries is satisfied when
the world real interest rate is at its equilibrium​value?
A.
The current account surplus of one country is equal to the other​country's current account
deficit.
B
Both countries have either the same current account surplus or the same current account
deficit.
C.
Both current account balances are zero.
D.
The current account balance of the larger country is greater than the current account
balance of the smaller country.

In a large open​economy, an increase in desired national saving causes the world real
interest rate to​_____, and an increase in desired investment causes the world real
interest rate to​_____.
A.
​decline; increase
B
​increase;decline
C.
​decline; decline
D.
​increase; increase

A large country imposes capital controls that prohibit foreign borrowing and lending
by domestic residents. Assume that before the capital controls were​imposed, the
large country was running a capital account surplus.

After the large country imposes capital​controls, the large​country's current account balance
increases​, its national saving increases, and its investment decreases. The domestic real
interest rate increases​, and the world real interest rate decreases.

Consider a large open economy​(the home​country) that currently has a zero current
account balance. Suppose that the country now runs a government budget deficit that
affects desired national saving.

In the new​equilibrium, the world real interest rate​_____ and investment in the home
country​_____.
A.
​declines; rises
B.
​declines; declines
C.
​rises; rises
D.
​rises; declines
In the new​equilibrium, in the foreign​country, investment​_____ and the current
account balance​_____.
A.
​declines; rises
B
​rises; declines
C.
​rises; rises
D.
​declines; declines

How would the following event affect national​saving, investment, the current account​
balance, and the real interest rate in a large open​economy?

- ​ vent: An increase in the domestic willingness to save left parenthesis which

E
raises desired national saving at any given real interest rate right

- Event: An increase in the willingness of foreigners to save.

Suppose that in Canada and in the United​States, the interest rates on government
bonds of identical maturity and risk are​8% and​6%, respectively.
Assuming savers are indifferent between owning Canadian or U.S. bonds with respect
to all other​properties, we would expect
A.
the Canadian interest rate to rise and the U.S. interest rate to fall.
B.
the U.S. interest rate to rise to near​8% and the Canadian interest rate to remain near​8%.
C.
the U.S. interest rate to fall to​7% and the Canadian interest rate to rise to​7%.
D
the interest rates on these bonds to remain​2% apart as they rise and fall together over time.
E.
the Canadian interest rate to fall to​6% or slightly higher and the U.S. interest rate to remain
at​6% or slightly rise.

Explain how this would happen. ​(Select all that​apply.)

A.
The U.S. savings curve would shift to the left.
B.
The Canadian savings curve would shift to the right.
C.
Savers will purchase Canadian bonds rather than U.S. bonds at the given interest​rates,
enabling the Canadian government to offer a lower interest rate.
D
The U.S. investment curve would shift to the right.
E.
The Canadian investment curve would shift to the left.

Herb lives in Calgary. When it was time to shop for the best interest rate on a​
mortgage, Herb checked out interest rates at all of the major lending institutions. Just
to be on the safe​side, for every lending​institution, Herb checked the interest rates
available at a branch in Toronto with the rate available at branches in Calgary. He
found​that, in every​case, the interest rates were identical.
Herb should have known this because
A.
Canadian law requires that banks offer the same interest rates for the same types of loans at
all locations across Canada in which they operate.
B.
mortgage interest rates across Canada are uniformly set by the Bank of Canada.
C.
all lenders operating with identical information about borrowers must reach identical
conclusions about the interest rate to offer due to mathematical properties of saving and
investment.
D.
if the interest rate at one branch was higher than the interest rate at​others, then no borrower
with complete information would borrow from that branch.

Suppose a large open economy​(the home​country) currently has a current account

balance of zero.​Then, the foreign country is hit by a temporary adverse supply shock.
In the new​equilibrium, the world real interest​_____ and investment in the home
country​_____.
A.
​declines; declines
B
r​ ises; rises
C.
​declines; rises
D.
​rises; declines

In the new​equilibrium, saving in the home country​_____ and the current account
balance in the home country​_____.
A.
​rises; rises
B
​rises; declines
C.
​declines; rises
D.
​declines; declines

How would the results change if the temporary adverse supply shock hit both
countries instead of just the foreign​country? In the new​equilibrium, the world real
interest rate
A.
would fall less than if the shock just hit the foreign country.
B.
would rise more than if the shock just hit the foreign country.
C
would fall more than if the shock just hit the foreign country.
D.
would rise less than if the shock just hit the foreign country.
Your answer is not correct.

The chief economic advisor of a small open economy makes the following​
announcement: “We have good news and bad​news: The good news is that we have
just had a temporary beneficial productivity shock that will increase​output; the bad
news is that the increase in output and income will lead domestic consumers to buy
more imported​goods, and our current account balance will​fall.” Analyze this​
statement, taking as given that a beneficial productivity shock has indeed occurred.

The shock​_____ the desired saving curve​_____.

A. ​shifts; to the right

The shock​_____ the desired investment curve​_____.

A. does not​shift; at all

The current account balance​_____ because the equilibrium amount of saving ​_____
and the equilibrium amount of investment​_____.
A. ​rises; rises; is unchanged
The world is made up of only two large​countries: Eastland and Westland. Westland is
running a large current account deficit and often appeals to Eastland for help in
reducing this current account deficit.​Currently, the government of Eastland
purchases​$10 billion of goods and​services, and all of these goods and services are
produced in Eastland. The finance minister of Eastland proposes that the government
purchase half of its goods from Westland.​Specifically, the government of Eastland
will continue to purchase​$10 billion of​goods, but​$5 billion will be from Eastland and​
$5 billion will be from Westland. The finance minister gives the following​rationale:
"Both countries produce identical​goods, so it does not really matter to us which
country produced the goods we purchase.​Moreover, this change in purchasing policy
will help reduce​Westland's large current account​deficit."

What are the effects of this change in purchasing policy on the current account
balance in each country and on the world real interest​rate? ​(Hint​: What happens to
net exports by the private sector in each country after the government of Eastland
changes its purchasing​policy?)

​ astland's current account balance does not change, ​Westland's current account balance
E
does not change​, and the world real interest rate does not change.

We distinguish between small open economies and large open economies based​on:
A.
whether they are net lenders or net borrowers to the world economy.
B.
rates of inflation.
C.
their influence on the world interest rate.
D
GDP or output measures.

The graphs below show the saving and investment schedules for two large open
economies.

The equilibrium world real interest rate​is: 10​%

At this equilibrium interest​rate, 'Home' is a net borrower and has a current account deficit
Consider two large open​economy, the home economy and the foreign economy.
Which of the following lowers the world real interest rate ​(rw​)?
A.
An increase in foreign government purchases.
B.
An increase in foreign expected marginal product of capital.
C.
A decrease in the domestic expected marginal product of capital.
D
A decrease in the willingness of foreigners to save.

Which of the following outcomes of a change in the government budget deficit would
increase the current account deficit of a small open​economy?
A.
an increase in the budget surplus that has no effect on national saving because of Ricardian
equivalence.
B.
an increase in the budget surplus that raises national saving.
C.
an increase in the budget deficit that reduces national saving.
D
an increase in the budget deficit that has no effect on national saving because of Ricardian
equivalence.

If a change in the government budget deficit changes the current account deficit of a
small open​economy, by how much does the current account deficit​change?
A.
By the amount that national investment changes.
B.
By the average change in national saving and investment.
C.
By zero.
D.
By the amount that national saving changes.

What is the connection between the government budget deficit and the current
account​balance, if an increase in the budget deficit reduces national​saving?
A.
They move in opposite directions.
B.
Their movements are uncorrelated.
C.
They move in the same direction in expansions and in opposite directions in recessions.
D.
They move in the same direction.
The twin deficits are the government budget deficit and the current account deficit. They are
connected because if an increase in the government budget deficit reduces national​saving,
it leads to an increased current account deficit.​So, the government budget deficit and the
current account deficit move in the same direction.

What are the twin​deficits?

The​"twin deficits" refer to the government budget deficit and the current account deficit.

In a small open​economy, output​(gross domestic​product) is ​$26 ​billion, government

purchases are ​$6 ​billion, taxes are ​$5 ​billion, and net factor payments from abroad are
zero. Desired consumption and desired investment are ​$17 billion and ​$3 ​billion,
respectively.
There is a temporary increase in government purchases of ​$0.5 billion without
changing taxes left that is by borrowing. Assume desired consumption is not affected
by this temporary change. What are the changes in budget deficit and the current
account balance ​(CA​)?
The budget deficit increases by ​$0.5 ​billion, CA changes by ​$ - 0.5 ​billion, and in this case
the theory of​"twin deficits" is valid.

The goods market equilibrium condition for a small open​economy, assuming zero
current transfers and zero net factor​payments, is

Net exports = Y - Absorption or Desired saving = Desired investment + Net exports.

Supporters of the​twin-deficits idea claim that an increase in the budget deficit reduces
desired national saving and​that, if the change in fiscal policy does not affect the tax
treatment of​investment, this necessarily reduces net exports
The figure shows a case of a small open economy after
a government budget deficit increase. The initial
desired saving and desired investment curve were
Upper S 1 and I before the deficit increase. The world
real interest rate is fixed at​6%.

Suppose the increase in the government budget deficit

reduces desired national saving from Upper S1 to
Upper S2. In this​case, the current account surplus is
reduced by BC and the​twin-deficit hypothesis seems to
work.

If the increase in the government budget deficit does

not affect desired national saving or reduces desired
consumption by the equal​amount, the current account surplus remains at AC and the​
twin-deficit hypothesis doesn't work.

**Economists generally agree that an increase in the budget deficit caused by a temporary
increase in government purchases will reduce national​saving, but whether an increase in
the budget deficit caused by a tax cut reduces national saving remains controversial.

If Ricardian equivalence​holds, a reduced government budget deficit caused by a​

lump-sum tax increase in an open economy leads to
A.
a rise in the current account balance in a large open​economy; no change in the current
account balance in a small open economy.
B
a decline in the current account balance.
C.
no change in the current account balance.
D
a rise in the current account balance.

If Ricardian equivalence does not​hold, a reduced government budget deficit caused

by a​lump-sum tax increase in an open economy leads to
A.
no change in the current account balance.
B.
a decline in the current account balance.
C
a rise in the current account balance.
D
a rise in the current account balance in a large open​economy; no change in the current
account balance in a small open economy.