Chapter 4 Mishkin (4)

Macreconomics: Policy and Practice (Mishkin) Chapter 4 Saving and Investment in Closed and Open Economies 4.1 Relationship Between Saving and Wealth 1) Private saving refers to ________. A) disposable income minus consumption expenditure B) total expenditure minus purchases of capital goods C) taxes plus consumption minus income D) consumption expenditure divided by disposable income E) none of the above Answer: A Topic: 4.1 Saving and Wealth 2) Private saving refers to ________. A) after-tax income minus consumption expenditures B) a flow variable which adds to the stock of wealth C) the private saving rate times disposable income D) all of the above E) none of the above Answer: D Topic: 4.1 Saving and Wealth 3) Government saving refers to ________. A) tax revenues minus transfers minus government purchases B) tax revenues plus transfers minus government consumption C) the saving rate times transfers D) national plus private saving E) none of the above Answer: A Topic: 4.1 Saving and Wealth 4) Government saving refers to ________. A) tax revenues minus transfers minus government consumption minus government investment B) the government's tax receipts minus its outlays C) national saving minus private saving D) all of the above E) none of the above Answer: D Topic: 4.1 Saving and Wealth

1 Copyright © 2012 Pearson Education, Inc.

5) How can the U.S. federal government induce increases in the national saving rate? A) by lowering the sales tax B) by levying taxes on individual retirement (IRA) accounts C) by reducing budget deficits D) all of the above E) none of the above Answer: C Topic: 4.1 Saving and Wealth AACSB: Reflective Thinking 6) How can the U.S. federal government induce increases in the national saving rate? A) implementing a value added tax B) lowering the capital gains tax C) reducing budget deficits D) all of the above E) none of the above Answer: D Topic: 4.1 Saving and Wealth AACSB: Reflective Thinking 7) Net capital outflows ________. A) are also known as net foreign investment B) are positive if saving is greater than investment C) are also known as the trade balance D) all of the above E) none of the above Answer: D Topic: 4.1 Saving and Wealth 8) When a U.S. firm sells a good abroad for, say, 100 euros (assume $1=1euro) , U.S. net exports increase by $100. These $100 in exports can be accounted for as $100 increase in capital outflow because ________. A) If the 100 euros are kept in the foreign bank, the U.S. firm is giving a loan to that bank B) If the U.S. firm uses the 100 euros to buy a share of stock in a foreign firm, the firm is supplying U.S. capital to that foreign firm C) If the U.S. firm uses the proceeds to build a new factory in that country, it is supplying U.S. capital to that country D) all of the above E) none of the above Answer: D Topic: 4.1 Saving and Wealth AACSB: Reflective Thinking

2 Copyright © 2012 Pearson Education, Inc.

9) When a U.S. firm sells a good abroad for, say, 100 euros (assume $1.5=1euro) , U.S. net exports increase by $150. These $150 in exports can be accounted for as $150 increase in capital outflow because ________. A) private consumption in the foreign country increases by $150 B) If the U.S. firm uses the 100 euros to buy a share of stock in a foreign firm, the firm is supplying U.S. capital to that foreign firm C) If the U.S. firm uses the proceeds to buy a U.S. bond, capital investment in the foreign country has increased. D) all of the above E) none of the above Answer: B Topic: 4.1 Saving and Wealth AACSB: Reflective Thinking 10) If a U.S. citizen deposits $10,000 in a foreign bank, and the bank uses the $10,000 to buy assets in the U.S., then ________. A) the U.S. has experienced a net capital outflow B) the U.S. has experienced an increase in net exports C) the foreign economy has experienced a net capital outflow D) the foreign economy has experienced an increase in net exports E) none of the above Answer: E Topic: 4.1 Saving and Wealth AACSB: Reflective Thinking 11) A foreign bank receives a deposit of $10,000 from a U.S. citizen. As a result, there is a net capital outflow from the U.S., if ________. A) the bank buys a U.S.-made computer B) the bank buys a bond issued by a U.S. company C) the bank keeps the $10,000 in a vault D) all of the above E) none of the above Answer: A Topic: 4.1 Saving and Wealth AACSB: Reflective Thinking 12) Which of the following is a correct statement? A) Wealth can increase even if there is no saving B) An increase in net foreign assets always increases wealth C) Low U.S. national saving is the principal cause of the trade deficits the U.S. has run since the 1980s D) The U.S will be a net debtor nation for the foreseeable future. E) all of the above Answer: E Topic: 4.1 Saving and Wealth AACSB: Reflective Thinking 3 Copyright © 2012 Pearson Education, Inc.

13) Which of the four government policies to stimulate saving is essential? That is, which policy can on its own, regardless of the other policies, determine the level of the national saving rate? Answer: Reduce budget deficits. A higher tax on consumption will increase national saving only if the government doesn't spend all of the increased tax revenue. Tax incentives that reward private saving directly, or encourage private saving by increasing the return on assets, will raise national saving only if government spending is reduced to correspond to the decrease in tax revenues. If nothing is done to promote private saving, national saving can be raised by lowering the government's budget deficit. Topic: 4.1 Saving and Wealth AACSB: Reflective Thinking 14) Why is it important, for an open economy, that investment not be consistently higher than saving? Answer: When investment is higher than saving, the difference is a net capital inflow. The extra investment that is financed by foreigners is an addition to their wealth, rather than an increase in the wealth of domestic citizens. The income from such investment must be paid to the foreign owners, thus is not available to contribute to domestic income and saving. The source of the capital inflow is a continual excess of imports over exports (negative trade balance). Imports are being financed through the sale of assets to foreigners. It is not so much investment but consumption that is unsustainably high; saving is unsustainably low. Topic: 4.1 Saving and Wealth AACSB: Reflective Thinking 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy 1) The real interest rate ________. A) is the cost of borrowing not adjusted for inflation B) keeps the market for saving and consumption in equilibrium C) describes the real benefit of saving D) all of the above E) none of the above Answer: C Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy 2) In the model for desired saving, autonomous is roughly synonymous with ________. A) policy-determined B) endogenous C) intended D) inflation-adjusted E) exogenous Answer: E Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy

4 Copyright © 2012 Pearson Education, Inc.

3) The real interest rate ________. A) is the cost of borrowing adjusted for inflation B) keeps the market for saving and investment in equilibrium C) describes the real benefit of saving D) all of the above E) none of the above Answer: D Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy 4) Consumption expenditures are a function of ________. A) the real interest rate B) disposable income C) autonomous consumption D) all of the above E) none of the above Answer: D Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy 5) Increases in ________ typically lead to decreases in consumption A) the interest rate B) disposable income C) autonomous consumption D) all of the above E) none of the above Answer: A Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Analytical Skills 6) Increases in ________ typically lead to decreases in private saving. A) the interest rate B) disposable income C) autonomous consumption D) all of the above E) none of the above Answer: C Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Analytical Skills 7) Increases in ________ typically lead to decreases in ________. A) the interest rate; saving B) disposable income; consumption C) autonomous consumption; consumption D) all of the above E) none of the above Answer: E Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Analytical Skills 5 Copyright © 2012 Pearson Education, Inc.

8) In the equation S = - - C - , which of the following is an endogenous variable? A) r B) C) D) all of the above E) none of the above Answer: A Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy 9) ________ typically lead to increases in ________. A) decreases in interest rates ; investment B) increases in disposable income; consumption C) increases in autonomous investment; investment D) all of the above E) none of the above Answer: D Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Analytical Skills 10) Ceteris paribus, in a closed economy, if consumers become more pessimistic ________. A) autonomous consumption will fall B) investment will fall C) saving will increase D) all of the above E) none of the above Answer: D Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Reflective Thinking 11) Ceteris paribus, in a closed economy, if consumers become more optimistic ________. A) autonomous consumption would decrease B) the equilibrium interest rate should increase C) saving should increase D) all of the above E) none of the above Answer: B Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Reflective Thinking

6 Copyright © 2012 Pearson Education, Inc.

12) If government cuts taxes ________. A) national saving goes up B) the equilibrium interest rate would decrease C) all of the above D) discretionary income goes up E) none of the above Answer: D Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Reflective Thinking 13) In the long run, if government increases spending ________. A) interest rates decrease B) it crowds out private investment C) saving increases D) all of the above E) none of the above Answer: B Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Reflective Thinking 14) In the long run, larger budget deficits lead to ________. A) higher saving levels B) a fall in investment C) lower interest rates D) all of the above E) none of the above Answer: B Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Reflective Thinking 15) A budget deficit ________. A) may have stimulative effects on economic activity in the short run B) contributes to lower interest rates in the long run C) is likely to increase future productive capacity in the long run D) all of the above E) none of the above Answer: A Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Reflective Thinking

7 Copyright © 2012 Pearson Education, Inc.

16) An investment tax credit ________. A) is designed to incentivize higher capital stock expenditures at any given interest rate B) may lead to increases in autonomous investment C) may put upward pressure on the interest rate D) all of the above E) none of the above Answer: D Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Reflective Thinking 17) How does a decline in the real interest rate cause an increase in investment? Answer: The real interest rate is the reward for saving and the cost of borrowing. A reduced interest rate will encourage more spending on both consumption and investment. Business firms, in particular, will use available funds to purchase new capital goods from which to generate future income, instead of holding financial assets (e.g., government bonds) that offer a reduced income. The purchase of capital goods will be financed by borrowing, as well, so long as the expected income from use of the capital goods exceeds the (reduced) cost of borrowing. Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Reflective Thinking 18) If taxes are reduced, will most people save more or less than before? Does national saving rise or fall? Explain. Answer: Lower taxes mean higher disposable income, which should encourage increases in both consumption and saving. Reduced government revenue, given government spending, means a decrease in government saving. Since private saving does not rise as much as the decrease in government saving, national saving falls. Topic: 4.2 Saving, Investment, and Goods Market Equilibrium in a Closed Economy AACSB: Analytical Skills

8 Copyright © 2012 Pearson Education, Inc.

4.3 Response to Changes in Saving and Investment in a Closed Economy 1) There are no questions for this section. Answer: 4.4 Saving, Investment, and Goods Market Equilibrium in an Open Economy 1) The domestic real interest rate (r) for a given country must be the same as the world real interest rate (rw)________. A) if perfect capital mobility is assumed B) because with no barriers to capital flows, if rw > r domestic residents would just borrow abroad putting upward pressures on the domestic rate until both rates equal each other C) because with no barriers to capital flows, if rw < r domestic residents would only lend to foreigners putting downward pressures on the domestic rate until both rates equal each other D) all of the above E) none of the above Answer: A Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Analytical Skills 2) In the model of the open economy with perfect capital mobility, ________ is an exogenous variable. A) Y B) C C) I D) S E) r Answer: A Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy 3) The domestic real interest rate (r) for a given country must be the same as the world real interest rate (rw)________. A) only if capital is not perfectly mobile B) because with no barriers to capital flows, if rw > r domestic residents would just lend abroad putting upward pressures on the domestic rate until both rates equal each other C) because with no barriers to capital flows, if rw < r domestic residents would only lend to foreigners putting downward pressures on the domestic rate until both rates equal each other D) all of the above E) none of the above Answer: B Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Analytical Skills

9 Copyright © 2012 Pearson Education, Inc.

4) In an economy open to international trade ________. A) saving equals investment in equilibrium B) saving is the difference between net exports and investment C) saving equals investment as long as the economy has no exports D) saving equals investment as long as NX=0 E) none of the above Answer: D Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Analytical Skills 5) In an economy open to international trade ________. A) saving is net exports added to investment B) saving equals investment as long as NX=0 C) the domestic real interest rate should equal the world real interest rate as long as there is perfect capital mobility D) all of the above E) none of the above Answer: D Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Analytical Skills 6) In an economy open to international trade ________. A) saving is the difference between net exports and consumption B) saving equals investment as long as the domestic real interest rate is equal to the world real interest rate C) the domestic real interest rate should equal the world real interest rate as long as the economy is relatively small D) all of the above E) none of the above Answer: E Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Analytical Skills 7) In an open economy, Y = C + I + G + NX. From this we may infer that ________. A) output is greater in an open economy than in a closed economy B) the condition for goods market equilibrium is that S = I + G + NX C) net exports can be zero only if the domestic real interest rate is equal to the world real interest rate D) if saving is greater than zero, NX cannot be zero E) none of the above Answer: E Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Analytical Skills

10 Copyright © 2012 Pearson Education, Inc.

8) Suppose an economy has a GDP of $10 trillion, and that its national saving rate is 20%. If investment is 25% of GDP, the value of net exports is ________. A) negative $500 billion B) $4.5 trillion C) negative $250 billion D) $2 trillion E) none of the above Answer: A Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Analytical Skills 9) Suppose consumption is $500 billion, investment is $120 billion, government purchases equal  S  is ________.  Y

$90 billion, and net exports are negative $20 billion. The saving rate 

A) 20% B) 83.3% C) 14.5% D) 3% E) none of the above Answer: C Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Analytical Skills 10) Suppose GDP is $800 billion, net taxes equal $150 billion, government purchases are $160 billion, investment is $120 billion, and net exports are $5 billion. The private saving rate 

 SP      YD 

is ________. A) 19% B) 16% C) 21% D) 18% E) none of the above Answer: C Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Analytical Skills 11) When an economy becomes attractive to global investors, sparking a capital inflow, one result is often a decrease in net exports. Why? Answer: The capital inflow reflects an increase in desired investment in the economy. With no change in desired saving, and total output fixed in the short run, the increase in investment spending must either displace exports or increase spending on imports, causing net exports to fall. Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Analytical Skills 12) In an open economy, an increase in saving might not cause an increase in domestic investment. Why not? Does that mean that an increase in saving is undesirable? 11 Copyright © 2012 Pearson Education, Inc.

Answer: An increase in saving can affect the domestic real interest rate only by changing the world interest rate. If the world interest rate does not change, domestic investment is not affected. More saving means less consumption, which reduces both imports and domestic demand for domestic output, so exports (and net exports) rise. The increase in saving must correspond to investment somewhere, but not necessarily in the economy where the saving originates. Nonetheless, wealth rises for those who accomplish the higher saving. Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Reflective Thinking 13) If policymakers in an open economy want to increase the wealth of their citizens, should they seek to increase saving, or to increase investment? Explain. Answer: Policies to increase investment will increase the domestic capital stock. However, this adds nothing to citizens' wealth, unless saving has increased. If saving is fixed, the increase in investment is financed either by foreigners (net capital inflow) or by a diversion of domestic saving from foreign assets to domestic assets (reduced net capital outflow). Policies to increase saving, if effective, will increase domestic wealth, regardless of the level of domestic investment. Topic: 4.3 Saving, Investment, and Goods Market Equilibrium in an Open Economy AACSB: Reflective Thinking 4.5 Saving, Investment, and the Trade Balance in a Small Open Economy 1) In an economy open to international trade where the interest rate at which saving and investment would be equal is ________ the world real interest rate ________. A) above; a trade surplus ensues B) below; a trade deficit ensues C) above; there is a net capital outflow D) below; there is a net capital inflow E) none of the above Answer: E Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills 2) In an economy open to international trade where the interest rate at which saving and investment would be equal is ________ the world real interest rate ________. A) above; a trade deficit ensues B) below; there is a net capital outflow C) above; there is a net capital inflow D) all of the above E) none of the above Answer: D Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills

12 Copyright © 2012 Pearson Education, Inc.

3) If the world real interest rate were to fall below the rate at which domestic saving and investment would be equal ________. A) saving would be greater than investment so the economy would be running a trade deficit B) investment would be greater than saving so the economy would be running a trade deficit C) investment would be greater than saving so the economy would be running a trade surplus D) saving would be greater than investment so the economy would be running a trade surplus E) none of the above Answer: B Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills Saving-Investment Diagram

4) Based on the Saving-Investment Diagram, if the world real interest rate is indicated by A, then ________. A) the difference between values G and E measures the trade surplus B) the difference between values G and F measures the trade surplus C) the domestic real interest rate is indicated by B D) desired saving has decreased E) none of the above Answer: A Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills

13 Copyright © 2012 Pearson Education, Inc.

5) Based on the Saving-Investment Diagram, if the world real interest rate is indicated by C, then ________. A) the difference between values H and D measures the net capital outflow B) the difference between values H and D measures the trade deficit C) the domestic real interest rate is indicated by B D) the difference between values H and F measures the trade deficit E) none of the above Answer: B Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills 6) Based on the Saving-Investment Diagram, if the difference between values G and E measures the net capital outflow, then ________. A) the difference between values G and E measures the trade surplus B) the difference between values H and D measures the trade surplus C) the domestic real interest rate is indicated by B D) desired saving has decreased E) none of the above Answer: A Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills 7) Based on the Saving-Investment Diagram, if the difference between values G and E measures the net capital outflow, then ________. A) the difference between values G and E measures the trade deficit B) the difference between values H and D measures the trade deficit C) the domestic real interest rate is indicated by C D) desired investment has increased E) none of the above Answer: E Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills 8) Based on the Saving-Investment Diagram, if the difference between values G and E measures the net capital outflow, then ________. A) the difference between values H and E measures the trade deficit B) the difference between values F and D measures the trade surplus C) the domestic real interest rate is indicated by A D) the difference between values F and E measures the trade deficit E) none of the above Answer: C Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills

14 Copyright © 2012 Pearson Education, Inc.

9) Based on the Saving-Investment Diagram, the difference between values H and E could measure the net capital inflow, if ________. A) the difference between values H and D measures the trade surplus B) the domestic real interest rate is indicated by A C) desired saving has increased D) desired investment has decreased E) none of the above Answer: C Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills 10) Based on the Saving-Investment Diagram, if the domestic real interest rate is indicated by B, then ________. A) the value of net exports is zero B) the diagram represents a closed economy C) the world real interest rate is indicated by A D) the difference between values F and E measures the net capital inflow E) none of the above Answer: A Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills 11) Based on the Saving-Investment Diagram, if the world real interest rate declines from A to C, then the change in net exports is measured by the difference between values ________. A) G and E B) H and G plus E and D C) H and G minus E and D D) G and F plus F and E E) none of the above Answer: B Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills 12) If there is a decline in world autonomous consumption ________. A) the domestic real interest rate would fall B) domestic investment would rise C) net exports would fall D) all of the above E) none of the above Answer: D Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking

15 Copyright © 2012 Pearson Education, Inc.

13) If there is a decline in world autonomous consumption ________. A) domestic investment would decline B) the domestic real interest rate would fall C) net exports would go up D) all of the above E) none of the above Answer: B Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking 14) Which of the following would lead domestic investment to rise? A) a decline of government spending throughout the world B) an increase in world taxes C) a decrease in world autonomous consumption D) all of the above E) none of the above Answer: D Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking 15) Which of the following would lead domestic investment to rise? A) an increase in government spending throughout the world B) an increase in world taxes C) an increase in world autonomous consumption D) all of the above E) none of the above Answer: B Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking 16) If there is a decrease in world taxes ________. A) domestic investment would fall B) net exports would increase C) domestic interest rates would go up D) all of the above E) none of the above Answer: D Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking

16 Copyright © 2012 Pearson Education, Inc.

17) If there is an increase in world taxes ________. A) domestic investment would fall B) net exports would increase C) the domestic interest rate would go down D) all of the above E) none of the above Answer: C Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking 18) If there is a decrease in world investment ________. A) domestic investment would fall B) net capital outflow would increase C) the domestic interest rate would go up D) all of the above E) none of the above Answer: E Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking 19) If there is a decrease in world investment ________. A) domestic saving would rise B) net exports would decrease C) domestic output would go up D) all of the above E) none of the above Answer: B Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking 20) A small open economy would typically enjoy a higher trade balance if, in the domestic economy, ________. A) autonomous consumption expenditures decrease B) taxes go up C) government spending decreases D) all of the above E) none of the above Answer: D Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking

17 Copyright © 2012 Pearson Education, Inc.

21) A small open economy would typically enjoy a higher trade balance if, in the domestic economy, ________. A) autonomous consumption expenditures increase B) taxes decrease C) government spending decreases D) all of the above E) none of the above Answer: C Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking 22) The concept of twin deficits refers to ________. A) the phenomenon of simultaneous trade and government budget deficits B) the phenomenon of simultaneous government and private budget deficits C) the phenomenon of simultaneous state and federal budget deficits D) all of the above E) none of the above Answer: A Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking 23) An increase in autonomous investment in a small open economy will cause ________. A) a trade surplus to shrink B) a trade deficit to increase C) lower net capital outflows D) all of the above E) none of the above Answer: D Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills 24) An increase in autonomous investment in a small open economy will cause ________. A) a trade surplus to shrink B) a trade deficit to shrink C) higher net capital outflows D) all of the above E) none of the above Answer: A Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Analytical Skills

18 Copyright © 2012 Pearson Education, Inc.

25) In a small open economy, goods market equilibrium occurs when desired saving minus desired investment equals net exports. Explain. Answer: The domestic interest rate equals the world interest rate, regardless of the quantities of saving and investment. If saving is greater than investment at this interest rate, the excess of saving is used to purchase foreign assets. Then, the money paid to acquire foreign assets returns to purchase domestic goods, increasing net exports. If saving is lower than investment, domestic assets are being sold to foreigners, a capital inflow that enables the purchase of imports, reducing net exports. Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking 26) If desired saving increases in a small open economy, net exports (net capital outflow) rise. What happens to net exports if desired saving rises in most of the world's economies at the same time? Answer: An increase in global saving reduces the world real interest rate, which lowers saving and raises investment in all open economies. This counteracts the initial increase in saving. In some economies, where the initial increase in saving is relatively small, the effect of the reduced interest rate will dominate, so that net exports (net capital outflow) will decline. Topic: 4.4 Saving, Investment, and the Trade Balance in a Small Open Economy AACSB: Reflective Thinking 4.6 Response to Changes in Saving and Investment in a Small Open Economy 1) There are no questions for this section. Answer: 4.7 Large Versus Small Open Economies 1) The saving-investment analysis for large open economies is somewhat more complicated than the analysis for small open economies mainly because ________. A) there is more information to keep track of for larger economies B) there are more unknowns in larger economies C) a larger economy may actually affect the world economy D) all of the above E) none of the above Answer: C Topic: 4.5 Large versus Small Open Economies AACSB: Analytical Skills

19 Copyright © 2012 Pearson Education, Inc.

2) Which of the following is an exogenous variable in the model of a small open economy, but an endogenous variable in the model of a large open economy? A) rw B) C C) Y D) NX E) G Answer: A Topic: 4.5 Large versus Small Open Economies 3) Which of the following is true of a small open economy, but not of a large open economy? A) Net exports are unlikely to be close to zero. B) The domestic real interest rate is equal to the world real interest rate. C) Changes in desired investment result in changes in the trade balance. D) Changes in desired investment result in changes in actual investment. E) none of the above Answer: E Topic: 4.5 Large versus Small Open Economies AACSB: Reflective Thinking 4) If we observe an economy in which desired saving has changed, but there has been no change in actual investment, we may infer that ________. A) net exports have changed B) actual saving has changed C) the domestic real interest rate has not changed D) all of the above E) none of the above Answer: D Topic: 4.5 Large versus Small Open Economies AACSB: Analytical Skills 5) If we observe an economy in which desired saving has changed, but there has been no change in actual investment, we may infer that ________. A) this is a closed economy B) this is a large economy C) the trade balance has changed in the same direction as the change in desired saving D) all of the above E) none of the above Answer: C Topic: 4.5 Large versus Small Open Economies AACSB: Analytical Skills

20 Copyright © 2012 Pearson Education, Inc.

6) If we observe an economy in which desired saving has changed, but there has been no change in actual investment, we may infer that ________. A) this is a closed economy B) this is a large economy C) the world real interest rate has not changed D) all of the above E) none of the above Answer: C Topic: 4.5 Large versus Small Open Economies AACSB: Analytical Skills 7) Suppose the world economy is divided into two halves. In Region A, all economies experience a decrease in desired saving, while desired saving is unchanged in Region B. If there is open trade and perfect capital mobility across the two regions, which of the following is true? A) Actual saving in Region B has increased. B) Actual investment in Region A has increased. C) Region A's imports from Region B have decreased. D) all of the above E) none of the above Answer: A Topic: 4.5 Large versus Small Open Economies AACSB: Analytical Skills 8) Suppose the world economy is divided into two halves. In Region A, all economies experience a decrease in desired saving, while desired saving is unchanged in Region B. If there is open trade and perfect capital mobility across the two regions, which of the following is true? A) Actual investment in Region B has increased. B) There is a net capital flow from Region B to Region A. C) Actual investment in Region A has increased. D) all of the above E) none of the above Answer: B Topic: 4.5 Large versus Small Open Economies AACSB: Analytical Skills 9) An increase in ________ in an open economy of any size leads to ________. A) desired saving; an increase in net capital outflows B) desired investment; a decrease in net capital outflows C) desired saving; an increase in the trade balance D) all of the above E) none of the above Answer: D Topic: 4.5 Large versus Small Open Economies AACSB: Analytical Skills

21 Copyright © 2012 Pearson Education, Inc.

10) In a large open economy, an increase in ________ leads to ________. A) desired saving; an increase in the domestic interest rate B) desired investment; an decrease in the domestic interest rate C) desired saving; an increase in desired investment D) desired saving; a decrease in actual investment E) none of the above Answer: E Topic: 4.5 Large versus Small Open Economies AACSB: Reflective Thinking 11) In a large open economy ________. A) the direction of the shifts in saving and investment on the trade balance are the same as in a closed economy B) the direction of the shifts in saving and investment on net capital flows are the same as in a closed economy C) the direction of the effect on the domestic real interest rate and the actual levels of saving and investment are the same as in a closed economy D) all of the above E) none of the above Answer: C Topic: 4.5 Large versus Small Open Economies AACSB: Reflective Thinking 12) In a large open economy ________. A) direction of the shifts in saving and investment on the trade balance are the same as for a small open economy B) the direction of the shifts in saving and investment on net capital flows are the same as for a small open economy C) the direction of the effect on the domestic real interest rate and the actual levels of saving and investment are the same as in a closed economy D) all of the above E) none of the above Answer: D Topic: 4.5 Large versus Small Open Economies AACSB: Reflective Thinking

22 Copyright © 2012 Pearson Education, Inc.

13) In a large open economy ________. A) direction of the shifts in saving and investment on the trade balance are the same as for a small open economy B) the direction of the shifts in saving and investment on net capital flows are the same as in a closed economy C) the direction of the effect on the domestic real interest rate and the actual levels of saving and investment are the same as in a small open economy D) all of the above E) none of the above Answer: A Topic: 4.5 Large versus Small Open Economies AACSB: Reflective Thinking 14) China is a large open economy with an extraordinarily high saving rate. If, as seems likely, there is a decrease in desired saving in the coming years, what effects should we expect to see on China's trade balance (net capital flow), domestic real interest rate, and actual levels of saving and investment? Answer: A decrease in desired saving leads to a decrease in the trade balance (net capital outflow), and an increase in the domestic real interest rate. The higher interest rate will prevent actual saving from falling as much as it would otherwise, but actual saving does decline. The higher interest rate causes actual investment to decline, reducing the size of the decline in the trade balance (net capital outflow). Topic: 4.5 Large versus Small Open Economies AACSB: Reflective Thinking

23 Copyright © 2012 Pearson Education, Inc.