Macro.Week4.2008 - II-4/1What we were doing at the end of...

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Unformatted text preview: II-4/1What we were doing at the end of the lectures last week was to complicate the model:We inserted governmentWe inserted the foreign sectorWe ended up with a much more detailed model:C = 20 + (7/8)DIT = (2/7)Y - 20TR = 220 - (1/7)YI = 100 - 5(r - .05); r = .05G = 250X = 120 - 3(EC/US- 0.85); EC/US= 0.85IM = (1/8)Y + 2.5(EC/US- 0.85); EC/US= 0.85What’s new?C function out of DI(7/8 is marginal propensity to consume out of DI)T, TR functionsGX and IMII-4/2We now have a much more complicated model, but for now we keep it RELATIVELY simple by holding the interest rate (r) and the exchange rate (EC/US) constantWe have already explained why the level of investment depends inversely on the interest rate:The simplest explanation is that firms borrow to finance investment. The interest rate is the cost of borrowing.So the higher r rises, the less firms want to borrow and invest.Another explanation is that firms with cash lying around can choose either to buy investment goods, or to buy bonds that pay interest. At higher rates of interest, bonds look more attractive, so firms invest less in capital and equipment.Now we need to explain why we have shown exports falling when the exchange rate rises, and imports rising when the exchange rate rises.Again, we will do this in more detail later.For now, it is enough to do this roughly. A rise in the exchange rate makes our exports more expensive for foreigners, so they buy less of them and exports fall. A rise in our exchange rate makes our imports look cheaper so we buy more of them and imports rise.Exchange rate = EC/US= value of 1 Canadian dollar in U.S. funds (eg. now about 0.99: we will use 0.85 in model)II - 4/3First consider our imports.Suppose an American product costs $200 in the U.S. in U.S. currencyWhen EC/US= 0.85, that product will sell for $200/0.85 = $235.29 in Canada in Canadian dollarsIf EC/USrises to 0.90, that same product will sell for $200/0.90= $222.22 in CanadaSo imports are cheaper, so we buy more of them....
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This note was uploaded on 06/13/2011 for the course ECON A06 taught by Professor Mk during the Spring '11 term at University of Toronto.

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Macro.Week4.2008 - II-4/1What we were doing at the end of...

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