Problem Set 6 Key

The open market is curve is includes net exports and

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Unformatted text preview: the economic interpretation of this result? We want to understand why (under the Mundell ­Flemming model), an open economy has a steeper IS curve. The IS curve links the real discount rate on the y ­axis with output on the x ­axis. The closed market IS curve is plotted as the dotted line on the plot below. The open market IS curve (IS$) includes net exports, and is flatter than the closed market IS curve. We’ve seen in section why mathematically this is the case, but here we’ll present an economic argument. Suppose we start at the intersection point of the two curves. If the real domestic interest rate rd were to drop, then we know the IS curve would increase because investments would increase. But it’s not yet clear what would happen to Net Exports. If real discount rates increase, then we know Net Capital Outflows CF(r) would increase. That is, with a lower domestic rate of return, investors will want to invest more abroad because the rate of return is relatively higher. This means that when faced with a lower domestic interest rate, US citizens sell USD in exchange for foreign currency and purchase foreign assets. This selling pressure on the dollar depreciates the currency, and the nominal (e)...
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