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Banks make these transfers on a net basis by writing

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Unformatted text preview: causing capital flows out of the economy. This outflow prevents the domestic interest rate from falling below r*. The fall in the exchange rate stimulates net exports, thereby increasing income. Trade policy: suppose the government reduces demand for imported goods by imposing an import quota or tariff. This increases net exports, which shifts the IS* curve to the right, thus raising the exchange rate but not affecting income. Because net exports are part of GDP, an increase in NX puts upward pressure in Y; which increases money demand and puts upward pressure on the interest rate r; foreign capital responds by flowing into the domestic economy, pushing r back down to r* and causing the currency to appreciate in value. This appreciation reduces exports, reducing NX and returning Y to its original level. The overall effect of this is simply less trade. The domestic economy imports and exports less than it did before. Consider an increase in the general level of world interest rates. The higher world interest rates causes LM* to shift to the right. The higher interest rate depresses investment and shifts IS* to the left. The domestic currency depreciates. The model shows that the depreciation in the Canadian dollar must be so large that aggregate demand rises. New exports are stimulated more than investment is reduced. Small open economy under fixed exchange rates Under a system of fixed exchange rates, the central bank announces a value for the exchange rate and stands ready to buy and sell the domestic currency to keep the exchange rate at its announced level. The euro is an example of countries instating a system of fixed exchange rates among European countries. How it works: the central bank stands ready to buy or sell the domestic currency for foreign currencies at a predetermined price. For example, it this rate is $0.90 U.S. per dollar, then to carry out this policy, the Bank of Canada would need a reserve of Canadian dollars (which it can print) and a reserve of U.S. dollars (which it must have accumulated in past transactions). It involves dedicating a country’s monetary policy to the single goal of keeping the exchange rate at the announced level. In other words, the essence of...
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