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Chapter 32 -- Carlos Pitta

Chapter 32 -- Carlos Pitta - Chapter 32 A Macroeconomic...

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CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 1 Chapter 32 A Macroeconomic Theory of the Open Economy Instructor: Carlos Pitta
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CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 2 In this chapter, look for the answers to these questions: In an open economy, what determines the real interest rate? The real exchange rate? How are the markets for loanable funds and foreign-currency exchange connected? How do government budget deficits affect the exchange rate and trade balance? How do other policies or events affect the interest rate, exchange rate, and trade balance? 0
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CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 3 Introduction The previous chapter explained the basic concepts and vocabulary of the open economy: net exports ( NX ), net capital outflow ( NCO ), and exchange rates. This chapter ties these concepts together into a theory of the open economy. We will use this theory to see how govt policies and various events affect the trade balance, exchange rate, and capital flows. We start with the loanable funds market… 0
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CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 4 The Market for Loanable Funds An identity from the preceding chapter: S = I + NCO Saving Domestic investment Net capital outflow Supply of loanable funds = saving. A dollar of saving can be used to finance the purchase of domestic capital the purchase of a foreign asset So, demand for loanable funds = I + NCO 0
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CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 5 The Market for Loanable Funds Recall: S depends positively on the real interest rate, r . I depends negatively on r . What about NCO ? 0
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CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 6 How NCO Depends on the Real Interest Rate The real interest rate, r , is the real return on domestic assets. A fall in r makes domestic assets less attractive relative to foreign assets. People in the U.S. purchase more foreign assets. People abroad purchase fewer U.S. assets. NCO rises. r NCO NCO r 2 Net capital outflow r 1 NCO 1 NCO 2 0
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CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 7 D = I + NCO r adjusts to balance supply and demand in the LF market. The Loanable Funds Market Diagram r LF S = saving Loanable funds r 1 Both I and NCO depend negatively on r , so the D curve is downward-sloping. 0
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Think! Think!     Budget deficits and capital flows Budget deficits and capital flows Suppose the government runs a budget deficit (previously, the budget was balanced). Use the appropriate diagrams to determine the effects on the real interest rate and net capital outflow. 8 0
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The higher r makes U.S. bonds more attractive relative to foreign bonds, reduces NCO . A budget deficit reduces saving and the supply of LF , causing r to rise.
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