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Chapter 21: Q 6. (page 566)

Why do increases in the real interest rate lead to decreases in net exports, and vice versa?

Short Answer

Expert verified

Change in real interest rate is directly related to demand of domestic currency. So, it is inversely related to exchange rate & net exports.

Step by step solution

01

Step 1. Introduction

Net exports is net amount earned through - difference between receipts from exports value & expenditure on imports value.

Real Interest rate effects the demand of a country's currency, which further impact currency's exchange rate.

Exchange rate have implication on exports & imports, as former shows the value of domestic currency in terms of other currency.

02

Detail Explanation 

Increase in real interest rate leads to more demand of country's currency. It implies that the currency appreciates, & its exports become expensive & imports become cheaper. Hence, the exports decrease & imports increase, finally reducing net exports.

Decrease in real interest rate leads to less demand of country's currency. It implies that the currency depreciates, & its exports become cheap & imports become expensive. Hence, the exports increase & imports decrease, finally increasing net exports.

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Most popular questions from this chapter

Go to the St. Louis Federal Reserve FRED database, and find data on Real Private Domestic Investment (GPDIC1), a measure of the real interest rate; the 10-year Treasury Inflation-Indexed Security, TIIS (FII10); and the spread between Baa corporate bonds and the 10-year U.S. treasury (BAA10YM), a measure of financial frictions. For (FII10) and (BAA10YM), convert the frequency setting to “quarterly,” and download the data into a spreadsheet. For each quarter, add the (FII10) and (BAA10YM) series to create ri , the real interest rate for investments for that quarter. Then calculate the change in both investment and ri as the change in each variable from the previous quarter.

a. For the eight most recent quarters of data available, calculate the change in investment from the previous quarter, and then calculate the average change over the eight most recent quarters.

b. Assume there is a one-quarter lag between movements in ri and changes in investment; in other words, if ri changes in the current quarter, it will affect investment in the next quarter. For the eight most recent lagged quarters of data available, calculate the onequarter-lagged average change in ri .

c. Take the ratio of your answer from part (a) divided by your answer from part (b). What does this value represent? Briefly explain.

d. Repeat parts (a) through (c) for the period 2008:Q3 to 2009:Q2. How do financial frictions help explain the behavior of investment during the financial crisis? How do the coefficients on investment compare between the current period and the financial crisis period? Briefly explain.

During and in the aftermath of the financial crisis of 2007–2009, planned investment fell substantially despite significant decreases in the real interest rate.

What factors related to the planned investment function could explain this?

Why do companies cut production when they find that their unplanned inventory investment is greater than zero? If they didn’t cut production, what effect would

this have on their profits? Why?

When the Federal Reserve reduces its policy interest rate, how, if at all, is the IS curve affected? Briefly explain.

Consider an economy described by the following data:

C=\(4trillionI=\)1.5trillionG=\(3.0trillionT=\)3.0trillionNX=\(1.0trillionf=0

mpc = 0.8

d = 0.35

x = 0.15

a. Derive an expression for the IS curve.

b. Assume that the Federal Reserve controls the interest rate and sets the interest rate at r = 4. What is the equilibrium level of output?

c. Suppose that a financial crisis begins and f increases to f = 3. What will happen to equilibrium output? If the Federal Reserve can set the interest rate, then at what level should the interest rate be set to keep output from changing?

d. Suppose the financial crisis causes f to increase as indicated in part (c) and also causes planned autonomous investment to decrease to I = \)1.1 trillion. Will the change in the interest rate implemented by the Federal Reserve in part (c) be effective in stabilizing output? If not, what additional monetary or fiscal policy changes could be implemented to stabilize output at the original equilibrium output level given in part (b)?
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