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Unformatted text preview: equals the world
interest rate (rw). (Why?)
A small economy takes the world interest rate as
given • How is the world interest rate determined?
Is the US a “small economy”?
economy” 44 Capital Market (cnt.)
cnt.) • The Cap.A (and therefore CA) is determined by the
difference between saving and investment at the
world interest rate
world Depending on the domestic S and I curves and the
prevailing world interest rate, an economy can have a
zero, positive, or negative trade balance • Some applications: Is a larger trade deficit necessarily bad? Suppose the
investment opportunities in an economy expand. The
investment curve shifts outward and the deficit worsens.
(A leftward shift in S has the same effect) 45 Capital Markets (cnt.)
cnt.) • More applications: Does a budget deficit lead to a trade deficit? In the 80s
both deficits were high leading to theories that the twin
deficits were connected. In the traditional view, a
budget deficit financed by tax cut decreases saving,
which in turn worsens the trade deficit Note, the Ricardian argument against this view – there, the
national saving is unchanged and so is the trade deficit An increase in the world interest rate (say due to a
decrease in funds supplied to the market by some large
economies) will cause a decrease in the trade deficit of a
small open economy 46 10
Government expenditures (purchases)
Net interest & dividend payments
received from abroad
47 THE END 48 11
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