Written Assignment 4

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Written Assignment 4

Answer all of the following questions. Title your assignment "Written Assignment 4," unless your mentor directs otherwise. This assignment covers text chapters 18 through 23.

1. Explain the relationship among savings, investment, and net capital outflow.

Answer: S = I + NCO (Savings = Domestic Investment + Net Capital Outflow)

Savings equals domestic investment plus net capital outflow; therefore, when U.S. citizens save a dollar of their income for the future, that dollar can be used to finance accumulation of domestic capital or it can be used to finance the purchase of capital abroad.

2. Describe the economic logic behind the theory of purchasing-power parity (PPP). What factors might prevent PPP from holding true?

Answer: The theory of purchasing-power parity (PPP) is based on a principle called the law of one price. According to the law of one price, a good must sell for the same price in all locations. Otherwise, there would be opportunities for profit left unexploited. The process of taking advantage of price differences for the same item in different markets is called arbitrage.

What factors might prevent PPP from holding true?

Answer: There are two factors that might prevent PPP from holding true:

a. Many goods are not easily traded (haircuts in Paris versus haircuts in New York). Thus, arbitrage would be too limited to eliminate the difference in prices between the locations.

b. Tradable goods are not always perfect substitutes when they are produced in different countries (American cars versus German cars). There is no opportunity for arbitrage here, because the price difference reflects the different values the consumer places on the two products.

3. Describe supply and demand in the market for loanable funds and the market for foreign currency exchange. How are these markets linked?

Answer: Two markets are central to the macroeconomics of open economies: the market for loanable funds and the market for...