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lnc14prime4 - We know of course that this will cause the...

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Notes 14’’’’. Crowding out through the foreign exchange market Recall from domestic loanable funds market crowding out that {G without T } {budget deficit} {government borrowing } D LF r Now—note from Interest Rate Parity theory (exchange rates will adjust to equalize rates of return in different countries with different interest rates): If r US then e $ , as holders of foreign currencies will seek to invest in US dollar-denominated bonds to earn the higher interest rates here. But first, they have to acquire US dollars, so the demand for US dollars will rise.
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Unformatted text preview: We know, of course, that this will cause the dollar to appreciate. And recall from way back in Chapter 23 that an appreciating currency reduces exports and sucks in imports and hence causes AD to fall. In symbols, picking up where I left off above, . . . → D $ ↑ → e $ ↑ → {X ↓ and M ↑ } → AD ↓ And since AD = C + I + G + (X – M), the contractionary effect of the fall in net exports (X – M) offsets the expansionary effect of G ↑ , and so AD remains unchanged. Of course, Y remains unchanged, too....
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