Chapter 5 The Open Economy In this chapter we revisit the loanable funds model in the context of an open economy. If there is a trade surplus what does this mean? Make note of the definitions in table 5-1 of your text. The international investor: • A person, firm, government with funds to save • Funds seek the highest rate of return • Perfect capital mobility results in one world interest rate What is a small open economy? • A price taker in the loanable funds market: takes the world interest rate as given • Changes in saving and investment do not result in permanent changes in the interest rate • Capital flows adjust to maintain the interest rate at the world level • The exchange rate adjusts What is the difference between the nominal and the real exchange rate? • The nominal exchange rate is the relative price of the currencies of two countries • The real exchange rate is the relative price of the goods of two countries • See the formula in the text • If prices are not changing then changes in the nominal exchange rate cause
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