I n t h I s c h a p t e r y o u w I l L

The Wall Street Journal,
March 30, 1998,
The Outlook, p. 1.
1.
Japan generally runs a significant trade surplus. Do you
think this is most related to high foreign demand for
Japanese goods, low Japanese demand for foreign
goods, a high Japanese saving rate relative to Japanese
investment, or structural barriers against imports into
Japan? Explain your answer.
2.
An article in 
The New York Times
(Apr. 14, 1995)
regarding a decline in the value of the dollar reported
that “the president was clearly determined to signal that
the United States remains solidly on a course of deficit
reduction, which should make the dollar more attractive
to investors.” Would deficit reduction in fact raise the
value of the dollar? Explain.
3.
Suppose that Congress passes an investment tax credit,
which subsidizes domestic investment. How does this
policy affect national saving, domestic investment, net
foreign investment, the interest rate, the exchange rate,
and the trade balance?
4.
The chapter notes that the rise in the U.S. trade deficit
during the 1980s was due largely to the rise in the U.S.
budget deficit. On the other hand, the popular press
sometimes claims that the increased trade deficit
resulted from a decline in the quality of U.S. products
relative to foreign products.
a.
Assume that U.S. products did decline in relative
quality during the 1980s. How did this affect net
exports 
at any given exchange rate?
b.
Use a three-panel diagram to show the effect of this
shift in net exports on the U.S. real exchange rate
and trade balance.
P r o b l e m s a n d A p p l i c a t i o n s

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c.
Is the claim in the popular press consistent with the
model in this chapter? Does a decline in the quality
of U.S. products have any effect on our standard of
living? (Hint: When we sell our goods to foreigners,
what do we receive in return?)
5. An economist discussing trade policy in 
The New
Republic
wrote: “One of the benefits of the United States
removing its trade restrictions [is] the gain to U.S.
industries that produce goods for export. Export
industries would find it easier to sell their goods
abroad—even if other countries didn’t follow our
example and reduce their trade barriers.” Explain in
words why U.S. 
export
industries would benefit from a
reduction in restrictions on 
imports
to the United States.
6. Suppose the French suddenly develop a strong taste for
California wines. Answer the following questions in
words and using a diagram.
a.
What happens to the demand for dollars in the
market for foreign-currency exchange?
b.
What happens to the value of dollars in the market
for foreign-currency exchange?
c.
What happens to the quantity of net exports?
7. A senator renounces her past support for protectionism:
“The U.S. trade deficit must be reduced, but import
quotas only annoy our trading partners. If we subsidize
U.S. exports instead, we can reduce the deficit by
increasing our competitiveness.” Using a three-panel
diagram, show the effect of an export subsidy on net
exports and the real exchange rate. Do you agree with
the senator?
8. Suppose that real interest rates increase across Europe.
Explain how this development will affect U.S. net
foreign investment. Then explain how it will affect U.S.
net exports by using a formula from the chapter and by
using a diagram. What will happen to the U.S. real
interest rate and real exchange rate?
9. Suppose that Americans decide to increase their saving.
a.
If the elasticity of U.S. net foreign investment with
respect to the real interest rate is very high, will this
increase in private saving have a large or small
effect on U.S. domestic investment?
b.
If the elasticity of U.S. exports with respect to the
real exchange rate is very low, will this increase in
private saving have a large or small effect on the
U.S. real exchange rate?
10. Over the past decade, some of Japanese saving has been
used to finance American investment. That is, American
net foreign investment in Japan has been negative.
a.
If the Japanese decided they no longer wanted to
buy U.S. assets, what would happen in the U.S.
market for loanable funds? In particular, what
would happen to U.S. interest rates, U.S. saving,
and U.S. investment?
b.
What would happen in the market for foreign-
currency exchange? In particular, what would
happen to the value of the dollar and the U.S.
trade balance?
11. In 1998 the Russian government defaulted on its debt
payments, leading investors worldwide to raise their
preference for U.S. government bonds, which are
considered very safe. What effect do you think this
“flight to safety” had on the U.S. economy? Be sure
to note the impact on national saving, domestic
investment, net foreign investment, the interest rate,
the exchange rate, and the trade balance.
12. Suppose that U.S. mutual funds suddenly decide to
invest more in Canada.
a.
What happens to Canadian net foreign investment,
Canadian saving, and Canadian domestic
investment?
b.
What is the long-run effect on the Canadian
capital stock?
c.
How will this change in the capital stock affect the
Canadian labor market? Does this U.S. investment
in Canada make Canadian workers better off or
worse off?
d.
Do you think this will make U.S. workers better off
or worse off? Can you think of any reason why the
impact on U.S. citizens generally may be different
from the impact on U.S. workers?

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I N T H I S C H A P T E R
Y O U W I L L . . .
S e e h o w s h i f t s i n
a g g r e g a t e d e m a n d o r
a g g r e g a t e s u p p l y c a n
c a u s e b o o m s a n d
r e c e s s i o n s
U s e t h e m o d e l o f
a g g r e g a t e d e m a n d
a n d a g g r e g a t e s u p p l y
t o e x p l a i n e c o n o m i c
f l u c t u a t i o n s
L e a r n t h r e e k e y f a c t s
a b o u t s h o r t - r u n
e c o n o m i c
f l u c t u a t i o n s
C o n s i d e r h o w t h e
e c o n o m y i n t h e
s h o r t r u n d i f f e r s f r o m
t h e e c o n o m y i n
t h e l o n g r u n
Economic activity fluctuates from year to year. In most years, the production of
goods and services rises. Because of increases in the labor force, increases in the
capital stock, and advances in technological knowledge, the economy can produce
more and more over time. This growth allows everyone to enjoy a higher standard
of living. On average over the past 50 years, the production of the U.S. economy as
measured by real GDP has grown by about 3 percent per year.
In some years, however, this normal growth does not occur. Firms find them-
selves unable to sell all of the goods and services they have to offer, so they cut
back on production. Workers are laid off, unemployment rises, and factories are
left idle. With the economy producing fewer goods and services, real GDP and
other measures of income fall. Such a period of falling incomes and rising
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unemployment is called a