Econ- Chap 13

Econ- Chap 13 - February exam February Answers and grades...

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Unformatted text preview: February exam February Answers and grades are on WebCT Problems: e-mail me. ECON 1002- e-mail me. US budget US Macroeconomics in an Open Economy CH 13 Economy The important macroeconomic variables The of an open economy include: National Saving, Domestic Investment, Net Capital Outflow and Net Exports. The values of these variables are determined The through the interaction of: the Loanable Funds Market and the Market for Foreign-Currency Exchange. –FX--The market where people exchange the domestic currency for the currency of other countries. 2 markets. of Objectives-ch. 13 Objectives-ch. Develop SOE model to explain: Trade Develop balance and exchange rates exchange Use the model to analyze a series of Use related variables. related The model takes as given-real GDP and The the price level. the The Market For Loanable Funds The Financial markets co-ordinate the economy’s Financial saving and investment in saving The Loanable Funds Market The Supply of Loanable Funds comes from The national saving (S) and from net capital outflow (NCO) (NCO) The Demand for Loanable Funds comes from The domestic investment (I). domestic In an open economy the amount that a nation saves In does not have to equal the amount it spends to purchase domestic capital. purchase Market for Loanable Funds Market If the amount of national saving exceeds the If amount needed to finance the purchase of domestic capital, net capital outflow (NCO) is positive. is If the national saving is insufficient to If finance the purchase of domestic capital, the NCO is negative. the The Market for Loanable Funds The The supply and demand for loanable funds The depend on the real interest rate. A higher real interest rate encourages people to higher save and raises the quantity of loanable funds supplied. supplied. The interest rate adjusts to bring the supply and The demand for loanable funds into balance. demand At the equilibrium interest rate, the amount that At people want to save exactly balances the desired quantities of domestic investment and net foreign investment. investment. Loanable Funds –closed Loanable economy-domestic interest rate is 5% Loanable Funds-SOE Loanable In a small open economy with perfect capital In mobility, like Canada, the domestic interest rate will equal the world interest rate. will As a result, the quantity of loanable funds made As available by the savings of Canadians does not have to equal the quantity of loanable funds demanded for domestic investment. demanded The difference between these two amounts is net The capital outflow (NCO) capital RealPositive Interest Rate Net Capital Outflow Net Capital Outflow Supply World Interest Rate Demand--I 100 150 Loanable Funds Negative Net Capital Real Interest Rate Outflow: Inflow Supply World Interest Rate Net Capital Outflow 90 Demand 130 Loanable Funds The Market For Loanable Funds The In a small, open economy with perfect In capital mobility, the Canadian interest rate is equal to the world interest rate. equal National Saving represents the supply of loanable funds, while domestic investment represents demand. demand The Market For Loanable Funds The x Recall the identity: Domestic Saving = Investment + Net Capital Outflow At the equilibrium interest rate, the amount At that people want to save, exactly balances the desired quantities of investment and net capital outflow. capital NCO can be positive or negative. The Market for Foreign-Currency Exchange Exchange The market for foreign-currency exchange exists The because people want to trade with people in other countries, but they want to be paid in their own currency. currency. – The two sides of the foreign-currency exchange The market are represented by NCO and NX. NCO NX – NCO represents the imbalance between the purchases and sales of capital assets. purchases – NX represents the imbalance between exports and imports of goods and services. and The Equality of Net Exports and Net Capital Outflow Net Net exports (NX) and net capital outflow (NCO) are Net net closely linked. For an economy as a whole, NX and NCO balance each other out so that: NX = NCO NX NCO represents the quantity of dollars supplied for the purpose of buying assets abroad. NX determines NX the quantity of dollars demanded for the purpose of buying foreign goods. buying The Market for Foreign-Currency Exchange Exchange The identity, NX = NCO represents the The NX two sides of the foreign-exchange market in which Canadian dollars are traded for foreign currencies. The price that balances the supply and The demand is the “real exchange rate”, i.e. the relative price of domestic and foreign goods. relative Market for Foreign-Currency Exchange Market Real Exchange Rate Supply of Dollars (NCO) Demand for Dollars (NX) Quantity of Dollars Exchanged into Foreign Currency The Market for Foreign-Currency Exchange Exchange The demand curve is negatively related to The the real exchange rate. A higher exchange rate makes domestic goods more expensive. expensive. The supply curve is vertical because the The quantity of dollars supplied for net capital outflow is unrelated to the real exchange unrelated rate. The Market for Foreign-Currency Exchange Exchange The real exchange rate adjusts to balance the supply and demand for dollars. At the equilibrium exchange rate, the demand for dollars to buy net exports exactly balances the supply of dollars to be exchanged into foreign currency to buy assets abroad. foreign Market for Foreign-Currency Exchange Market Real Exchange Rate Equilibrium Real Exchange Rate Supply of Dollars (NCO) Demand for Dollars (NX) Equilibrium Quantity Quantity Equilibrium in the Open Economy Equilibrium Net capital outflow (NCO) links the loanable Net funds market with the foreign-currency with exchange market. The key determinant of NCO is the world interest rate. NCO In the market for loanable funds, NCO is a In portion of demand. In the market for foreignportion currency exchange, NCO is the source of currency supply. TUTORIAL GROUP B09 TUTORIAL Tutorial was cancelled today due to TA Tutorial illness. Apologies. illness. Hand in Assignments to me today. Next meeting is March 17 Equilibrium in the Open Economy Equilibrium The market for loanable funds and the The foreign-currency exchange market determine the real exchange rate, national saving, domestic investment, net exports and the size of net capital outflow. and LF: S, I, NCO FX: RER and NX--------Using NCO 2 Markets—LF and FX Markets—LF FX market-NCO from LF FX Figure 1 3 .2 LF AND FX MARKETS LF 1The real interest rate (r) is determined in the market for 1The loanable funds by rw. loanable 2This real interest rate determines the level of NCO. 2This 3NCO must be paid for with foreign currency so the 3NCO quantity of NCO determines the supply of dollars. quantity 4The equilibrium real exchange rate brings into balance the 4The quantity of dollars supplied and the quantity of dollars demanded. demanded. 5The real interest rate and the real exchange rate adjust 5The simultaneously to balance supply and demand in the two markets. As they do so, they determine the levels of national S, domestic I, NCO and NX. national How Policy and Events Affect an Open Economy Open The magnitude and variation in important The macroeconomic variables may be illustrated by these specific events: by – – – – Increase in world interest rates Government Budget Deficits Government Trade Policies Political and Economic Stability-Greece, Egypt-- Assessing Policies and Events Assessing Three steps in using the model to analyze Three these events these – Determine which of the supply and Determine demand curves each event affects demand – Determine which way the curves shift – Examine how these shifts alter the Examine economy’s equilibrium. economy’s – Like Micro Increase in World Interest Rates In an open economy with perfect capital mobility, an increase in world interest rates crowds out domestic investment, causes the dollar to depreciate, and increases net exports. exports. World Interest Rates Go Up13.4 World G Budget deficits Budget Because a government budget deficit Because represents negative public saving, it negative reduces national saving, and therefore reduces. . . – the supply of loanable funds, – net capital outflow – the supply of Canadian dollars in the the market for foreign-currency exchange market Government Budget Deficits Government In a small open economy, - an increase in government budget deficits causes the dollar to appreciate and causes net exports to fall. - a decrease in government budget deficits causes the dollar to depreciate and causes net exports to rise. Principles of Macroeconomics: Ch. 18 First Canadian Edition Government Budget Deficits: Specific Market Effects Specific Loanable Funds Market Effect: Loanable – Reduces national saving which... shifts the supply curve for loanable funds to the left, which reduces NCO. funds Government Budget Deficits: Specific Market Effects Specific Foreign-Currency Exchange Market: – The decrease in NCO reduces the supply of The dollars to be exchanged into foreign currency, which causes the real exchange rate to appreciate. appreciate. G deficits deficits Government Trade Policy Government Government Trade Policy Effect: – Does not alter the trade balance because it does Does not alter national saving or domestic investment. For given levels of national saving and domestic For investment, the real exchange rate adjusts to keep the balance the same, regardless of the trade policies the government puts in place. trade Trade policies are more microeconomic than Trade macroeconomic. macroeconomic. Government Trade Policies: Government Specific Market Effects Foreign-Currency Exchange Market: – – Nothing happens in the loanable funds market Nothing or to the supply of dollars in the market for foreign-currency exchange. The only effect is a rise in net exports for any The given exchange rate. This increases the demand for dollars, which causes the value of the dollar to appreciate. Government Trade Policies: Government Specific Market Effects NCO Market: – – Because there is no change in NCO, there will Because be no change in net exports. An appreciation of the dollar in the foreign An exchange market encourages imports and discourages exports which... discourages ... offsets the direct increase in net exports due to import quota. exports Political Instability and Capital Flight Political Capital Flight is a situation in which a large and Capital sudden movement of funds out of a country occurs due to political instability (e.g. 1994 Mexico, 2011 Egypt: government instability.) Egypt: When investors around the world observe political When problems in one country (e.g. Mexico) they decide to sell some of their Mexican assets and use the proceeds to buy other countries’ assets. proceeds Interest rates increase in Mexico and the domestic Interest currency depreciates. currency Political Instability and Capital Flight Specific Market Effects NCO Market: – – – – Observed political problems in Mexico in 1994 Observed increased Mexican interest rates (r+risk). increased To save the same amount Mexican savers must To get r+risk so Slf shifts upwards. NCO gets bigger. This increase in NCO increases the supply of This pesos in the foreign-currency exchange market. pesos The peso depreciates. Due to instability. Principles of Macroeconomics: Capital flight Capital Summary Summary To analyze the macroeconomics of open economies, two To markets are central—the market for loanable funds and the market for foreign-currency exchange. SOE market LF market: the interest rate adjusts to balance supply for LF loanable funds (from national saving) and demand for loanable funds (from domestic investment and net capital outflow). outflow). In the market for foreign-currency exchange, In – the real exchange rate adjusts to balance the supply of the dollars (for net capital outflow) and the demand for dollars (for net exports). dollars NCO is the variable that connects the two markets. ...
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