26 The Open Economy, Part 2 - 1 26-1 Exchange Rates,...

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Unformatted text preview: 1 26-1 Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy, Part 2 26-2 Agenda How Exchange Rates are Determined (again) The IS-LM Model for an Open Economy Macroeconomic Policy in an Open Economy with Flexible Exchange Rates 26-3 How exchange rates are determined In a flexible exchange-rate system, exchange rates are determined in the foreign exchange market where the demand for the currency equals the supply of the currency. 26-4 The supply of and demand for the dollar Q $ P $ or e nom 2 26-5 How exchange rates are determined The supply of dollars come from domestic residents who want to buy: Foreign made goods and services (imports), and/or Foreign real and financial assets. 26-6 How exchange rates are determined The demand for dollars comes from foreign residents who want to buy: Domestic made goods and services (exports), and/or Domestic real and financial assets. 26-7 How exchange rates are determined The exchange rate will change whenever there is a change in the supply of, or demand for, the currency. The supply of the currency will increase if domestic residents want to buy more foreign goods, services, or assets. The demand for the currency will increase if foreign residents want to buy more domestic goods, services, or assets. 26-8 How exchange rates are determined Factors that increase the supply of the currency: An increase in domestic output, Y. A decrease in the domestic real interest rate, r. An increase in the foreign real interest rate, r FOR . A shift in domestic demand toward foreign goods, services, or assets. 3 26-9 How exchange rates are determined Factors that increase the demand for the currency: An increase in foreign output, Y FOR . A decrease in the foreign real interest rate, r FOR . An increase in the domestic real interest rate, r. A shift in rest of world demand towards domestic goods, services, or assets. 26-10 An increase in the domestic real interest rate Q $ P $ or e nom S $ D $ P $ 26-11 An increase in the foreign real interest rate Q $ P $ or e nom S $ D $ P $ 26-12 The IS-LM Model for an Open Economy Only the IS curve is affected by having an open economy instead of a closed economy; the LM curve and FE line are the same. The IS curve is affected because net exports are part of the demand for goods. The IS curve remains downward sloping. 4 26-13 The IS-LM Model for an Open Economy The goods-market equilibrium condition in an open economy is: S d I d = NX Desired foreign lending MUST equal foreign borrowing. 26-14 The IS-LM Model for an Open Economy Goods market equili brium, open economy : The S d I d curve slopes upward because a rise in the real interest rate increases desired national saving and reduces desired investment....
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This note was uploaded on 07/29/2010 for the course UGBA 100b taught by Professor Wood during the Summer '10 term at University of California, Berkeley.

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26 The Open Economy, Part 2 - 1 26-1 Exchange Rates,...

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