1. Credit items in the current account are exports of goods and services and income receipts from abroad. Debit items in the current account are imports of goods and services, income payments to foreigners, and net unilateral transfers. Adding all of the credit items and subtracting all of the debit items gives the current account balance. The current account balance equals net exports plus net income from abroad plus net unilateral transfers.

4. In any period, the net amount of new foreign assets that a country acquires equals its current account surplus, which in turn must equal its capital and financial account deficit. A country with greater net foreign assets than another is not necessarily better off. What really counts is total national wealth, which consists of both net foreign assets and net domestic assets. For example, the United States has lower net foreign assets than other countries, but has one of the world’s highest levels of total national wealth per citizen.

5. In a small open economy, saving does not have to be equal to investment. Saving can be used to finance domestic investment or it can be lent abroad. So saving equals investment plus net exports.

Similarly, output need not equal absorption. Absorption is a country’s total spending on consumption, investment, and government purchases. Absorption may be different from output because some output may be exported. The difference between output and absorption is net exports.

 

1.

 

Current Account	Credit (+)			Debits (-)
Goods	100			125
Services	90			80
Income from/to foreigners	110			150
Total		300			355

Current account balance (CA) = 300 – 355 = –55.

Net exports (NX) = (100 + 90) – (125 + 80) = –15.

 

Current and Financial Account	Credit (+)			Debits (-)
Increase in home country assets abroad				160
Increase in foreign assets in home country	200
Total		200			160

Notice that the increase in home reserve assets is just a subcategory of the increase in home country assets, so it is not included separately. Similarly, the increase in foreign reserve assets is just a subcategory of the increase in foreign assets in the home country. The information about the changes in home and foreign reserve assets is included for calculation of the official settlements balance only; it does not affect the capital and financial account.

Capital and financial account balance (KFA) = 200 – 160 = 40.

Statistical discrepancy (SD):

CA + KFA + SD = 0

–55 + 40 + SD = 0

SD = 15

Official settlements balance = increase in home official reserve assets minus increase in foreign official reserve assets = 30 – 35 = –5.

3. All variables but interest rates are in billions of dollars.

(a) S = 10 + (100 ´ 0.03) = 13

A = C + I + G

= 27 + 12 + 10

= 49

(b) S = 13, as before.

4. (a) To find the equilibrium interest rate (r^w), we must first calculate the current account for each country as a function of r^w. Then we can find the value of r^w that clears the goods market, that is, where CA + CA_For = 0.

Home:

C^d = 320 + 0.4(1000 – 200) – 200r^w

= 320 + 320 – 200 r^w

= 640 – 200 r^w

CA = NX = S^d – I^d = Y – (C^d + I^d + G)

= 1000 – (640 – 200 r^w + 150 – 200r^w + 275)

= –65 + 400 r^w

Foreign:

= 480 + 0.4(1500 - 300) - 300r^w

= 480 + 480 – 300r^w

= 960 – 300r^w

CA_For = NX_For = S^d_For – I^d_For = Y_For – (C^d_For + I^d_For + G_For)

= 1500 – (960 – 300r^w + 225 – 300r^w + 300)

= 15 + 600 r^w

At equilibrium, CA + CA_For = 0, so:

–65 + 400 r^w + 15 + 600 r^w = 0

–50 + 1000 r^w = 0

r^w = .05

C = 640 – 200 r^w = 630

C_For = 960 – 300 r^w = 945

S = Y – C – G = 1000 – 630 – 275 = 95

S_For = Y_For – C_For – G_For = 1500 – 945 – 300 = 255

I = 150 – 200 r^w = 140

I_For = 225 – 300 r^w = 210

CA = S – I = 95 – 140 = –45

CA_For = S_For – I_For = 255 – 210 = 45

(b) C^d = 320 + 0.4(1000 – 250) – 200 r^w

= 320 + 300 – 200 r^w

= 620 – 200 r^w

CA = NX = S^d – I^d = Y – (C^d + I^d + G)

= 1000 – (620 – 200 r^w + 150 – 200 r^w + 325)

= –95 + 400 r^w

At equilibrium, CA + CA_For = 0, so:

–95 + 400 r^w + 15 + 600 r^w = 0

–80 + 1000 r^w = 0

r^w = 0.08

C = 620 – 200 r^w = 604

C_For = 960 – 300 r^w = 936

S = Y – C – G = 1000 – 604 – 325 = 71

S_For = Y_For – C_For – G_For = 1500 – 936 – 300 = 264

I = 150 – 200 r^w = 134

I_For = 225 – 300 r^w = 201

CA = S – I = 71 – 134 = –63

CA_For = S_For – I_For = 264 – 201 = 63

So a balanced-budget increase in government spending increases the home country’s current account deficit.

 

1. (a) Export of merchandise: + entry in current account.

(b) No entry: just changes the type of foreigner holding U.S. assets.

(c) Decrease in U.S. official reserve assets: + entry in capital and financial account.

(d) Income receipt from abroad: + entry in current account.

(e) Import of assets: – entry in capital and financial account.

(f) Import of services: – entry in current account.

(g) Increase in foreign ownership of U.S. assets: + entry in capital and financial account.