Intl 1210 Assignment 2

Question 1:

a) The private sector balance is savings minus investment.

The private sector balance in the U.K. in 2003:

S - I

= 162 - 181

= - 19

The private sector is running a deficit.

b) The government sector balance is equal to net taxes minus government expenditure on goods and services. The government sector balance in the U.K in 2003:

T - G

= 217 - 230

= - 13

The government sector is running a deficit.

c) The Net exports are the exports of goods and services minus imports of goods and services.

(X - M) = (T - G) + (S - I)

(X - M) = −19 + − 13

= − 32

The United Kingdom imported more in 2003 than it exported.

d) Net exports are somewhat correlated with the government balance and these two components are sometimes referred to as "twins". The increase and decrease of government sector balance will affect net exports positively. For example, when the government is running a deficit (and cannot be covered by the private sector) net exports will be negative as the government must borrow from the rest of the world to finance the deficit. When the government is running a surplus (and can at least cover the private sector) net exports will be positive as the government will lend to the rest of the world.

Question 2:

a) The Federal Reserve's policy of decreasing interest rates had a dramatic effect on the exchange rate. People buy financial assets in order to make a return. The higher the return that people earn on American assets (compared to foreign assets), the more American assets they buy. If the American rate falls and the foreign exchange remains constant, the American interest rate differential (the American interest rate minus the foreign interest) decreases. This will lead to decrease in demand on American assets and the dollar. In addition, the supply of American dollars increases as the demand for foreign currency increases. The decrease in demand and increase in supply will reduce exchange rates and the quantity is ambiguous. It depends on the amount of change in demand and supply.

b) This has a great impact on The United States Balance of Payments. The current account will increase due to the increase in exports and decrease in imports. The falling exchange rate makes American goods and services less expensive relative to foreign county goods and services which increases foreign imports and decreases American imports. The capital account will decrease due to the depreciation of the interest rate. People would save less in America and more in foreign market. Foreign investment in America would fall and foreign investment abroad would increase. The magnitude of the increase of the current account and decrease of the capital account would determine the magnitude of the change in the official reserves. If they change in equal proportions the official reserve will remain static. The official reserve will increase if the increase in the current account is greater than the decrease in the capital account. It will decrease if the increase in the current account is less than the decrease in the capital account. The change in the official settlements account will be determined by change in official reserves.

Question 3:

a) The world economy goes into an expansion:

This means an increase in foreign income which will increase Canadian aggregate demand and exports. This leads to an expansionary gap. Therefore, there will be an upward pressure on costs (since workers demand higher wages, more capital is used, and raw materials are sold for higher prices). When costs are increasing and profit is decreasing, firms have a less incentive to produce. This decreases the short run aggregate supply. The long run aggregate supply stays the same (because labour productivity is not mentioned here).

Canadian businesses expect a higher future profit:

They will increase investment today and which will increase aggregate demand. There will be an expansionary gap. When in an expansionary gap there us an upward pressure on costs for the firm. This decreases the short run aggregate supply. Since there is no mention of an increase in labor productivity the long run aggregate supply stays the same.

Government increases its expenditure on goods and services in a time of war or increased international tensions:

This leads to an increase in government spending which will increase aggregate demand. This will again put the economy into an expansionary gap. When in an expansionary gap there will be an upward pressure on the firm's costs of production. This will decrease the short run aggregate supply. The long run aggregate supply stays static. However, if the country's spending on exports is greater than government expenditure on goods and services in a time of war or increased international tensions, there will be a decrease in overall spending and a decrease in aggregate demand. This will lead to a recessionary gap which puts downward pressure on the firm's costs of production. This will increase the short run aggregate supply.

In general, for three cases above, the shift in AD is small if the money supply grows slower than the growth rate of the economy. If the