Answer to Question 1:

Under full-employment conditions, an upward shift of domestic savings at given levels of income and world interest rates will lead to an increase in the trade balance, while an upward shift of exports at given levels of income and the real exchange rate will leave the trade balance unaffected.

True or False?

The correct answer is True. When there is full employment, the real exchange rate adjusts to bring the trade balance into line with the excess of savings over investment. Any shift of savings or investment will thus lead to an equivalent change in the trade balance. A shift of exports, on the other hand, will not involve any change in savings or investment, so the capital flow will be unchanged. The real exchange rate must adjust in this case to keep the trade balance at its initial level.

Consider again Equation 1

1. S − I = B_T + DSB

and its extension, Equation 10

10. Φ_S-I + s Y + μ r* = Φ_BT − m Y + m* Y* − σ Q + DSB .

An upward shift of savings represents an increase in Φ_S-I which raises the left side of the two equations. Equilibrium requires that Q fall to raise the right side by the same amount. An upward shift of exports represents an increase in Φ_BT which raises the right side of the two equations, leaving the left side unchanged. Given full employment, all of the adjustment must fall on the real exchange rate Q . It must therefore rise to reduce the right side back to equal the unchanged left side.

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