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Flashcards · AP® Macroeconomics · Unit 6

Unit 6: Open Economy—International Trade and Finance flashcards

37 cards on topics 6.1 to 6.6. Pick a topic or study the whole unit.

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6.1 Balance of Payments Accounts

What are the two parts of the balance of payments?
The current account (net exports, net income from abroad, net unilateral transfers) and the capital and financial account (purchases and sales of assets between countries). CA + CFA = 0.
What is in the current account?
The balance of trade (exports − imports of goods and services), net income from abroad (interest, dividends, profits, wages) and net unilateral transfers (remittances, aid, gifts). The trade balance is only one part.
What does a capital and financial account surplus mean?
A net financial capital inflow: foreigners' purchases of domestic assets exceed residents' purchases of foreign assets. It does not mean lending abroad.
Net exports −15, net income from abroad +4, net transfers −2 (VD bn). Find the current account and the CFA.
CA = −15 + 4 − 2 = −13. Since CA + CFA = 0, the CFA = +13, a net inflow.
A Valdorian buys a flat in Kestria and later receives rent from it. How is each recorded?
Buying the flat: capital and financial account, a debit (money leaves). The rent: current account, net income from abroad, a credit.
Are remittances exports?
No. They are unilateral transfers in the current account.

6.2 Exchange Rates

What is an exchange rate?
The price of one currency in terms of another. The same rate can be quoted both ways, and the two quotes are reciprocals: if 1 VD = 4 KS, then 1 KS = VD 0.25.
What are appreciation and depreciation?
Appreciation: a currency buys more of the other currency. Depreciation: it buys less. Against each other, if one currency appreciates the other must depreciate.
The rate moves from 1 VD = 4.0 KS to 1 VD = 3.2 KS. Which currency appreciated, and by how much?
The kesta, by 25% (from VD 0.25 to VD 0.3125). The valda depreciated by 0.8 ÷ 4.0 = 20%.
How do you convert prices between currencies?
Home price to foreign: multiply by KS per VD (VD 30 × 4 = KS 120). Foreign price to home: divide (KS 2,000 ÷ 4 = VD 500). Check that the units cancel.
Why can't you flip the sign of one currency's % change to get the other's?
Each currency's change is measured from its own price, which is the reciprocal of the other's. A 25% rise for one is a 20% fall for the other.
What sets the exchange rate in a flexible system?
The people and firms buying and selling the currencies, both for trade in goods and services and for buying assets.

6.3 The Foreign Exchange Market

Graph: describe the foreign exchange market for valdas.
Vertical axis: ostros per valda (OS per VD); horizontal axis: quantity of valdas. Demand for valdas slopes down; supply slopes up. The equilibrium exchange rate is where they cross.
Who demands and who supplies a currency?
Demand for valdas: foreigners buying Valdorian exports, services such as tourism, and financial assets; it is a derived demand. Supply: Valdorians paying for imports, travel abroad and foreign assets.
Why does demand for a currency slope down and supply slope up?
A cheaper valda makes Valdorian goods cheaper abroad, so more valdas are demanded. A dearer valda makes foreign goods cheaper for Valdorians, so more valdas are supplied.
At OS 1.8 per valda, 70 million valdas are demanded and 95 million supplied. What happens?
A surplus of 25 million valdas, so the valda depreciates. A shortage would make it appreciate. Measure the gap as a quantity of currency.
How are the markets for two currencies linked?
Supply of valdas = demand for ostros, and demand for valdas = supply of ostros. A Valdorian buying Ostrian shares supplies valdas and demands ostros.
Does a change in the exchange rate shift the currency's demand curve?
No. Moves towards equilibrium are movements along the curves; shifts come from other causes.

6.4 Effect of Changes in Policies and Economic Conditions on the Foreign Exchange Market

What shifts the demand for a currency?
Foreigners wanting more or fewer of the country's goods, services or assets: foreign tastes, foreign incomes, relative price levels, relative interest rates and expectations.
What shifts the supply of a currency?
Residents wanting more or fewer foreign goods, services or assets: domestic tastes, domestic incomes, relative price levels, relative interest rates, and tariffs or quotas on the other country's goods.
Valdorian incomes rise. What happens to the valda?
Valdorians buy more imports, so the supply of valdas increases and the valda depreciates. Higher domestic incomes raise the supply of the domestic currency, not the demand for it.
Graph: Valdoria's central bank raises interest rates. Describe the market for valdas.
Vertical axis: OS per VD; horizontal: quantity of valdas. Demand for valdas shifts right (supply may shift left) as funds seek the higher return. The new equilibrium rate is higher: the valda appreciates and the ostro depreciates.
How do fiscal and monetary policy affect the exchange rate?
Deficit-financed fiscal expansion raises the real interest rate, raising demand for the currency: appreciation. Monetary expansion lowers the interest rate, cutting demand for the currency: depreciation. Contraction does the opposite.
Valdoria's inflation is higher than Ostria's. What happens to the valda?
Demand for valdas falls and supply rises, so the valda depreciates.
How does a tariff on imports affect the domestic currency?
Fewer imports are bought, so the supply of the domestic currency decreases and it appreciates.

6.5 Changes in the Foreign Exchange Market and Net Exports

How does an appreciation affect net exports?
The country's goods become dearer abroad and foreign goods cheaper at home: exports fall, imports rise and net exports fall. A depreciation does the opposite.
A Valdorian good costs VD 80. What does it cost in Kestria at 1 VD = 6 KS, and then at 1 VD = 5 KS?
KS 480, then KS 400. The valda depreciated, so Valdorian goods became cheaper abroad and Valdoria's net exports rise.
Why does a change in net exports caused by the exchange rate shift AD?
NX is a component of AD = C + I + G + NX, and this change is not caused by the price level, so it is a shift, not a movement along AD.
Graph: the valda depreciates. Describe the short-run effect in the AD–AS model.
Price level on the vertical axis, real GDP on the horizontal. Net exports rise, so AD shifts right. Real output, employment and the price level rise in the short run.
What chain should you write for an exchange-rate question?
Cause → currency demand or supply shifts → appreciation or depreciation → exports and imports change → NX changes → AD shifts → output, employment and the price level change in the short run.
Exports are VD 90 billion and imports VD 100 billion. What are net exports?
90 − 100 = −VD 10 billion, a trade deficit. Imports are subtracted in AD, never added.

6.6 Real Interest Rates and International Capital Flows

Why does financial capital flow between countries?
It seeks the best real return, so funds flow towards the country whose real interest rate (nominal rate − expected inflation) is relatively higher.
What happens when a country's real interest rate rises relative to others'?
Capital flows in, demand for its currency rises and it appreciates, and its net exports fall. The inflow raises its supply of loanable funds.
Graph: describe the loanable funds effect of a capital inflow into Valdoria from Kestria.
Real interest rate on the vertical axis, quantity of loanable funds on the horizontal. In Valdoria, supply of loanable funds shifts right and the real rate falls. In Kestria, supply shifts left and its real rate rises. The two rates move closer together.
Valdoria: nominal rate 6%, expected inflation 2.5%. Kestria: nominal 4%, expected inflation 0.5%. Which way does capital flow?
Neither, other things equal: both real rates are 3.5%. Always compare real, not nominal, rates.
How does a larger net capital inflow relate to the current account?
CA + CFA = 0, so a larger capital and financial account surplus goes with a larger current account deficit. The two always have opposite signs.
What does contractionary monetary policy do to capital flows and net exports?
The real interest rate rises, capital flows in, the currency appreciates and net exports fall.

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