Eco 111 Macroeconomics Written Assignment 4 Questions

Eco 111 Macroeconomicswritten Assignment 4 Questions

Explain the difference between foreign direct investment and portfolio investment. Describe what the purchasing power parity exchange rate is. Discuss the impact of expected exchange rate appreciation on the interest rates paid on government bonds. Analyze whether specific groups would benefit or suffer if the U.S. dollar appreciated, providing explanations. Calculate and interpret the change in the value of the British pound relative to the U.S. dollar between 2010 and 2020, including the cost of the U.S. dollar in British pounds in 2020. Define budget deficit and national debt, and explain their differences. Explain Arthur Laffer’s concept that tax revenue can increase when tax rates decrease. Clarify whether a country can have a falling debt/GDP ratio despite running budget deficits, and vice versa. Suggest whether expansionary or contractionary fiscal policies are appropriate in various economic scenarios, including recession, market collapse, rapid export growth, rising inflation, equilibrium at natural rates, and rising oil prices.

Paper For Above instruction

The distinction between foreign direct investment (FDI) and portfolio investment is fundamental in understanding international capital flows. FDI involves a firm or individual establishing a lasting interest in a foreign enterprise, usually by acquiring a substantial ownership stake that provides significant influence over the company's operations. Conversely, portfolio investment refers to purchasing financial assets such as stocks and bonds in a foreign country without seeking control; it is more liquid and less involved than FDI (Borensztein, 1990). The differences have implications for economic stability, technology transfer, and financial integration, as FDI often leads to knowledge transfer and employment, while portfolio investment is primarily driven by short-term returns and market speculation (Caves, 1997).

The purchasing power parity (PPP) exchange rate is a theoretical rate that equates the price levels of a basket of goods between two countries, allowing for meaningful comparisons of living costs and economic productivity (Krugman & Obstfeld, 2009). Specifically, the PPP exchange rate is calculated as the ratio of price levels in two countries, assuming that goods should cost the same when expressed in a common currency, in the absence of transportation and transaction costs. PPP is often used to assess whether a currency is undervalued or overvalued and can forecast long-term exchange rate movements (Rogoff, 1996).

Expected exchange rate appreciation influences the interest rates on government bonds through the interest parity condition. If investors anticipate that a currency will strengthen, they will demand a higher interest rate to offset the expected future depreciation of the bond’s real value when converted back into the domestic currency. Conversely, if a currency is expected to appreciate, the interest rates on bonds denominated in that currency tend to be lower, reflecting decreased risk premiums (Mishkin, 2007). Hence, expectations about currency movements are integral to international financial markets and influence the cost of borrowing for governments.

When the U.S. dollar appreciates, different groups experience varying impacts. Dutch pension funds holding U.S. government bonds would generally benefit because the appreciation increases the dollar value of their holdings, boosting their returns when converted back to euros (Lane & Milesi-Ferretti, 2007). U.S. manufacturing industries, reliant on exporting goods, would be disadvantaged as a stronger dollar makes their products more expensive abroad, reducing competitiveness. Australian tourists planning a trip to the United States would benefit since the stronger dollar would allow them to purchase more goods and services at a lower relative cost. An American firm seeking to purchase property overseas would face higher costs due to increased prices in foreign currency, making investments more expensive (Obstfeld & Rogoff, 1996).

In 2010, the British pound cost $1.56, and in 2020, it cost $1.66. To evaluate currency strength, observe that in 2010, the pound was weaker than the dollar because fewer dollars could buy one pound. The appreciation of the pound relative to the dollar indicates a stronger pound in 2020. Specifically, the U.S. dollar depreciated against the pound over this period, as now more dollars are needed to buy the same amount of pounds (Svensson, 2000). Calculating the cost of one U.S. dollar in British pounds in 2020 involves taking the reciprocal of the exchange rate: 1 / 1.66 ≈ 0.6024 pounds per dollar, meaning each dollar now converts to approximately 0.6024 pounds.

A budget deficit occurs when a government’s expenditures exceed its revenues within a fiscal year, requiring borrowing to cover the gap. The national debt represents the accumulated total of past deficits minus surpluses—an ongoing liability the government must service over time (Selway, 2018). While deficits are short-term flows, debt is a stock variable representing the total amount owed. The key distinction is that deficits measure annual fiscal imbalance, whereas debt reflects the overall accumulation of past deficits and surpluses (Auerbach, 2002).

Arthur Laffer’s insight suggests that lowering income tax rates can sometimes increase total tax revenue through economic growth stimulation. The rationale is that high tax rates can discourage work, investment, and entrepreneurship, thereby shrinking the tax base. Reducing rates might incentivize increased economic activity, broadening the tax base and, paradoxically, increasing overall revenue—a concept famously illustrated by the Laffer Curve (Laffer, 2004).

A nation can run budget deficits and still see its debt-to-GDP ratio fall if economic growth outpaces the increase in debt. In other words, if GDP expands rapidly, the relative size of debt compared to the economy diminishes despite annual deficits. Conversely, a country can run surpluses but still experience an increasing debt-to-GDP ratio if the economy contracts or the debt level rises faster than GDP (Cavaliere & Shankar, 2019). Thus, fiscal policy effectiveness must be evaluated within the context of economic growth and debt dynamics.

Regarding fiscal policy responses, expansionary measures are appropriate during a recession to stimulate aggregate demand and promote growth (Blanchard & Johnson, 2013). During a stock market collapse that affects confidence, similar policies might help stabilize the economy. Conversely, contractionary policies are warranted amid rising inflation to cool down overheated demand. When the economy is at its natural rate of unemployment and at potential GDP, it is typically best to maintain a neutral stance to avoid destabilizing cyclical fluctuations. Finally, a massive increase in government expenditure is usually suitable when addressing recession or high unemployment, while rising oil prices, which can induce cost-push inflation, might necessitate tightening fiscal measures or monetary policy (Friedman, 1968).

In conclusion, macroeconomic policies and exchange rate phenomena significantly influence international economic relations and domestic economic stability. Understanding the interplay of investment types, exchange rate theories, fiscal discipline, and policy tools is essential for policymakers aiming to foster sustainable growth and stability (Mankiw, 2014).

References

• Auerbach, A. J. (2002). Fiscal policy and the debt-to-GDP ratio. Journal of Economic Perspectives, 16(3), 3-28.
• Blanchard, O., & Johnson, D. R. (2013). Macroeconomics (6th ed.). Pearson.
• Borensztein, E. (1990). How does foreign direct investment affect economic growth? Journal of International Economics, 464-474.
• Caves, R. E. (1997). International Investment and International Trade. Harvard University Press.
• Cavaliere, V., & Shankar, R. (2019). Debt Dynamics and Economic Growth: Investigating the Role of Fiscal Policy. Journal of Policy Modeling, 41(4), 668-688.
• Friedman, M. (1968). The Role of Monetary Policy. The American Economic Review, 58(1), 1-17.
• Krugman, P. R., & Obstfeld, M. (2009). International Economics: Theory and Policy. Pearson.
• Laffer, A. B. (2004). The Laffer Curve: Past, Present, and Future. The Heritage Foundation.
• Lane, P. R., & Milesi-Ferretti, G. M. (2007). The External Wealth of Nations: Measures of Foreign Assets and Liabilities. Journal of International Economics, 73(2), 223-250.
• Mankiw, N. G. (2014). Principles of Economics (7th ed.). Cengage Learning.
• Mishkin, F. S. (2007). The Economics of Money, Banking, and Financial Markets (8th ed.). Pearson.
• Obstfeld, M., & Rogoff, K. (1996). Foundations of International Macroeconomics. MIT Press.
• Rogoff, K. (1996). The Purchasing Power Parity Puzzle. Journal of Economic Literature, 34(2), 647-668.
• Selway, J. (2018). The Budget Deficit and Public Debt. Congressional Research Service.
• Svensson, L. E. (2000). Open-Economy Inflation Targeting. Journal of International Economics, 50(1), 155-183.