AP Macro Unit 6

Front

If the US increases exports, what will happen to the US current account?

Back

It will increase

Answer explanation

An account is in surplus if money is flowing into it. If the US is exporting, then money is flowing into the US, so the current account is in surplus.

Front

If the US increases exports, what will happen to the value of the dollar?

Back

It will increase

Answer explanation

If we are exporting, then foreigners need dollars in order to buy our stuff. This increases the demand for the dollar (and increases the supply of pesos, since they have to supply pesos in order to buy dollars), thus appreciating the dollar.

Front

If incomes in Mexico increase, what will happen to the value of the dollar?

Back

It will increase

Answer explanation

With their higher income, Mexicans will buy more American stuff, and they need dollars to do that. This increases the demand for the dollar (and increases the supply of pesos, since they have to supply pesos in order to buy dollars), thus appreciating the dollar.

Front

If interest rates are higher in the US than in Mexico, what will happen to the value of the dollar?

Back

It will increase

Answer explanation

Higher interest rates here will attract foreign savers to put their savings here (buying bonds, stocks, etc.). Thus our financial account will increase until interest rates normalize between the two countries. In order to buy our stocks and bonds, foreigners will need dollars, so the demand for the dollar will increase.

Front

If interest rates are higher in the US than in Mexico, what will happen to US exports?

Back

They will decrease.

Answer explanation

Higher interest rates here will attract foreign savers to put their savings here (buying bonds, stocks, etc.). Thus our financial account will increase until interest rates normalize between the two countries. In order to buy our stocks and bonds, foreigners will need dollars, so the demand for the dollar will increase.

Since the dollar is now more expensive, it is harder for foreigners to buy our stuff, so our NX will decrease. Notice also how the current account and financial account always move in opposite directions.

Front

If the peso suddenly appreciates, what will happen to the US financial account?

Back

It will increase

Answer explanation

A more expensive peso will make it harder for Americans to buy Mexican products, so Mexican exports (and US imports) will decrease. This moves their current account toward deficit and our current account toward surplus.

The current and financial accounts always move in opposite directions, so if our current account is in surplus, our financial account must be in deficit.

Front

If incomes rise in the US, what will happen to the US financial account?

Back

It will decrease.

Answer explanation

Higher US income means we will buy more Mexican stuff, so their NX will increase and ours will decrease. Since the current and financial accounts move in opposite directions, that means the US financial account will move toward surplus.

Front

In an effort to fight inflation, the Federal Reserve has increased interest rates. What will happen to the US current account?

Back

It will decrease

Answer explanation

Higher interest rates in the US will attract Mexican savers to buy our assets (bonds, stocks, etc.). This puts our financial account into surplus and their financial account into deficit.

There are two ways to think about what happens next:

1) In order to buy our assets, Mexicans need dollars, so the demand for the dollar increases, and the dollar appreciates. A more expensive dollar makes it harder for foreigners to buy our stuff, so our net exports decrease, and our current account moves toward deficit.

2) Alternatively, you can just memorize that the financial and current accounts always move in opposite directions, so if our financial account is in surplus, our current account must be in deficit.

Front

US residents suddenly increase their demand for Mexican assets. What will happen to the value of the US dollar?

Back

It will decrease

Answer explanation

In order to buy Mexican assets, US residents will supply dollars in international exchange markets and demand pesos, causing the dollar to depreciate and the peso to appreciate. This will put the Mexican financial account into surplus.

Front

The US budget deficit suddenly increases. What will be the effect on Mexico's current account?

Back

It will increase (move toward surplus)

Answer explanation

In the Market for Loanable Funds, the supply curve is made up of public, private, and international savings. If the US gov't runs a deficit, that decreases the public savings rate, thus decreasing the supply of loanable funds (thus increasing real interest rates in the US).

When real interest rates are higher here, foreigners want to put their savings here by buying US assets, so they demand dollars / supply pesos, while simultaneously increasing our supply of loanable funds (remember, S(LF) is made up of public, private, and international savers), all the way until the interest rates between the two countries even out.

This more expensive US dollar will make it harder for foreigners to buy our exports, since everything is so expensive now, so our NX drops, leading to a deficit in the current account.