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SOLUTIONSTOTEXTPROBLEMS:QuickQuizzes1.Thesupplyofloanablefundscomesfromnationalsaving.Thedemandforloanablefundscomesfromdomesticinvestmentandnetcapitaloutflow.Supplyinthemarketforforeign-currencyexchangecomesfromnetcapitaloutflow.Demandinthemarketforforeign-currencyexchangecomesfromnetexports.2.Thetwomarketsinthemodeloftheopeneconomyarethemarketforloanablefundsandthemarketforforeign-currencyexchange.Thesemarketsdeterminetworelativeprices:(1)themarketforloanablefundsdeterminestherealinterestrate;and(2)themarketforforeign-currencyexchangedeterminestherealexchangerate.3.IfAmericansdecidedtospendasmallerfractionoftheirincomes,theincreaseinsavingwouldshiftthesupplycurveforloanablefundstotheright,asshowninFigure1.Thedeclineintherealinterestrateincreasesnetcapitaloutflowandshiftsthesupplyofdollarstotherightinthemarketforforeign-currencyexchange.Theresultisadeclineintherealexchangerate.Sincetherealinterestrateislower,domesticinvestmentincreases.Sincenetcapitaloutflowincreases,thetradebalancealsoincreases.Overall,savinganddomesticinvestmentincrease,therealinterestrateandrealexchangeratedecrease,andthetradebalanceincreases.Figure1QuestionsforReview1.Thesupplyofloanablefundscomesfromnationalsaving;thedemandforloanablefundscomesfromdomesticinvestmentandnetcapitaloutflow.Thesupplyofdollarsinthemarketforforeignexchangecomesfromnetcapitaloutflow;thedemandfordollarsinthemarketforforeignexchangecomesfromnetexports.Thelinkbetweenthetwomarketsisnetcapitaloutflow.2.Governmentbudgetdeficitsandtradedeficitsaresometimescalledthetwindeficitsbecauseagovernmentbudgetdeficitoftenleadstoatradedeficit.Thegovernmentbudgetdeficitleadstoreducednationalsaving,causingtheinterestratetoincrease,thusreducingnetcapitaloutflow,whichinturnreducesnetexports.3.IfaunionoftextileworkersencouragespeopletobuyonlyAmerican-madeclothes,importswouldbereduced,sonetexportswouldincreaseforanygivenrealexchangerate.Thiswouldcausethedemandcurveinthemarketforforeignexchangetoshifttotheright,asshowninFigure2.Theresultisariseintherealexchangerate,butnoeffectonthetradebalance.Thetextileindustrywouldimportless,butotherindustries,suchastheautoindustry,wouldimportmorebecauseofthehigherrealexchangerate.Figure24.Capitalflightisalargeandsuddenmovementoffundsoutofacountry.Capitalflightcausestheinterestratetoincreaseandtheexchangeratetodepreciate.ProblemsandApplications1.JapangenerallyrunsatradesurplusbecausetheJapanesesavingrateishighrelativetoJapanesedomesticinvestment.Theresultishighnetcapitaloutflow,whichismatchedbyhighnetexports,resultinginatradesurplus.Theotherpossibilities(highforeigndemandforJapanesegoods,lowJapanesedemandforforeigngoods,andstructuralbarriersagainstimportsintoJapan)wouldaffecttherealexchangerate,butnotthetradesurplus.2.AreductionintheU.S.governmentbudgetdeficitwouldincreasenationalsaving,shiftingthesupplycurveofloanablefundstotherightinFigure3.ThiswouldreducetherealinterestrateintheUnitedStates,thusincreasingnetcapitaloutflow,andreducingtherealexchangerate.Thustherealvalueofthedollarwoulddecline,notincreaseasthepresidentsuggested.Figure33.IfCongresspassesaninvestmenttaxcredit,itsubsidizesdomesticinvestment.Thedesiretoincreasedomesticinvestmentleadsfirmstoborrowmore,increasingthedemandforloanablefunds,asshowninFigure4.Thisraisestherealinterestrate,thusreducingnetcapitaloutflow.Thedeclineinnetcapitaloutflowreducesthesupplyofdollarsinthemarketforforeignexchange,raisingtherealexchangerate.Thetradebalancealsodeclines,sincenetcapitaloutflow,hencenetexports,arelower.Thehigherrealinterestratealsoincreasesthequantityofnationalsaving.Insummary,savingincreases,domesticinvestmentincreases,netcapitaloutflowdeclines,therealinterestrateincreases,therealexchangerateincreases,andthetradebalancedecreases.Figure44.a.AdeclineinthequalityofU.S.goodsatagivenrealexchangeratewouldreducenetexports,reducingthedemandfordollars,thusshiftingthedemandcurvefordollarstotheleftinthemarketforforeignexchange,asshowninFigure5.b.Theshifttotheleftofthedemandcurvefordollarsleadstoadeclineintherealexchangerate.Sincenetcapitaloutflowisunchanged,andnetexportsequalsnetcapitaloutflow,thereisnochangeinequilibriuminnetexportsorthetradebalance.c.Theclaiminthepopularpressisincorrect.AchangeinthequalityofU.S.goodscannotleadtoariseinthetradedeficit.Thedeclineintherealexchangeratemeansthatwegetfewerforeigngoodsinexchangeforourgoods,soourstandardoflivingmaydecline.Figure55.Areductioninrestrictionsofimportswouldreducenetexportsatanygivenrealexchangerate,thusshiftingthedemandcurvefordollarstotheleft.Theshiftofthedemandcurvefordollarsleadstoadeclineintherealexchangerate,whichincreasesnetexports.Sincenetcapitaloutflowisunchanged,andnetexportsequalsnetcapitaloutflow,thereisnochangeinequilibriuminnetexportsorthetradebalance.Butbothimportsandexportsrise,soexportindustriesbenefit.6.a.WhentheFrenchdevelopastrongtasteforCaliforniawines,thedemandfordollarsintheforeign-currencymarketincreasesatanygivenrealexchangerate,asshowninFigure6.b.Theresultoftheincreaseddemandfordollarsisariseintherealexchangerate.c.Thequa