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Unformatted text preview: Answers to Spread Sheet # 13 1. We know that the I+NCO curve in the open economy (The demand for loanable funds) is flatter than the I curve in the closed economy (as it is the horizontal summation of the I and NCO curves). Cutting the deficit will shift the S curve by the same amount to the right in both the closed and open economies. But with a flatter I+NCO curve, the interest rate will not fall by as much in open case as in the closed case. (r will fall by less than 2). Therefore equilibrium level of S will be higher than the closed case. Similarly, the smaller fall in r will also lead to a smaller increase in investment. The falling r affects not only the S and I, but also the NCO. NCO will increase as a result of the fall in the interest rate because foreign assets will become relatively more desirable with a lower domestic interest rate. Since it is I+NCO that is equal to S, and since NCO has increased, the I will increase by less than the full amount that S increases. Running the experiment, we see the expected changes. r falls only by 1.5. S increases by 22.5, the increase in NCO = 7.5. Increase in I = 15. Change in S = Change in I + Change in NCO. With a positive NCO, NX has to increase to keep NCO=NX. So, we move down along the NX curve to a lower exchange rate. Increased net capital outflow increases the supply of domestic currency in the foreign exchange market, decreasing the exchange rate. Goods Market Equilibrium 2 4 6 8 10 12 14 16 18 20 50 100 150 200 250 300 I+NCO, S r (I+NCO)' S' Base Case I+NCO Base Case S req Seq Net Capital Outflow 2 4 6 8 10 12 14 16 18 20-60-40-20 20 40 60 NCO r NCO' Base Case NCO eq1 NCO1 Exchange Rate Determination 16 17 18 19 20 21 22 23-60-40-20 20 40 60 NX,NCO E NCO' NCO NX' NX Eeq A little trial and error shows that cutting the deficit by 40 will the interest rate by 40. To get the same reduction in the interest rate, you have to increase national saving by more because the demand for loanable funds is more interest elastic in the open economy. The determinants of investment, however, are the same in the closed and open economy, the domestic interest rate. Therefore, when the interest rate falls by 2, Investment rises by 20 (when the interest sensitivity of investment in cell D10 = 10). Another way to see this is that not all of the increase in saving is going to finance domestic investment. Some of it is and increase in NCO, which reflects the accumulation of foreign financial assets. Go o d s M arket Eq uilib rium...
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- Spring '08