Chapter 13 Flashcards
What is the primary goal of the model developed in Chapter 13?
To explain the trade balance and exchange rate in a small open economy, and how government policies affect these variables.
What are the key assumptions in the small open economy model?
GDP is given
Price level is fixed
The real interest rate equals the world interest rate
In a small open economy, what two markets are linked?
The market for loanable funds and the market for foreign-currency exchange, linked by net capital outflow (NCO).
What determines the supply and demand in the market for loanable funds?
Supply: National saving
Demand: Domestic investment and net capital outflow
What determines the supply and demand in the foreign-currency exchange market?
Supply of dollars: Net capital outflow
Demand for dollars: Net exports
What is the formula that links saving, investment, and net capital outflow?
π = πΌ + ππΆπ
S=I+NCO
What identity links the foreign exchange market to saving and investment?
ππ = ππΆπ
NX=NCO and therefore ππ = π β πΌ
NX=SβI
What does an increase in the world interest rate do in a small open economy?
It increases national saving, increases NCO, causes the currency to depreciate, and increases net exports.
How does a government budget deficit affect the trade balance?
A budget deficit reduces national saving, decreases NCO, appreciates the currency, and reduces net exports.
What is the effect of an investment tax credit on the open economy?
It increases investment, reduces NCO, appreciates the currency, and reduces net exports.
How does a trade policy like an import quota affect the real exchange rate and trade balance?
It increases demand for dollars, appreciates the currency, but leaves net exports unchanged.
What is the macroeconomic result of capital flight from a country?
Capital flight increases interest rates, causes the currency to depreciate, and raises net exports.
What is the definition of capital flight?
A large and sudden reduction in the demand for assets located in a country.
What happens to NCO and the exchange rate when foreigners invest heavily in Canada?
NCO decreases, the dollar appreciates, and net exports decrease.
How do budget deficits and trade deficits relate in an open economy?
Increases in government budget deficits reduce net capital outflow, causing the currency to appreciate and the trade deficit to grow.
What does the real exchange rate represent in this model?
The price that balances the supply and demand of dollars in the market for foreign-currency exchange.
What effect does a fall in the world interest rate have on Canadaβs net exports?
It reduces NCO, appreciates the dollar, and decreases net exports.
What happens to domestic investment and net exports if the government raises taxes on corporate profits?
Investment decreases, NCO increases, the dollar depreciates, and net exports increase.
What happens if national saving increases?
The supply of loanable funds increases, real interest rate falls, NCO rises, currency depreciates, and net exports rise.
Why is NCO the key link between the loanable funds and foreign exchange markets?
Because NCO appears in both markets: itβs the difference between saving and investment and determines the supply of dollars in the foreign exchange market.
What is a small open economy?
An economy that engages in international trade and finance but is too small to affect world interest rates.
What is net capital outflow (NCO)?
The net flow of funds being invested abroad by a countryβs residents minus the inflow of foreign investment into the country.
What is the real exchange rate?
The rate at which goods and services of one country trade for goods and services of another country.
What is national saving?
The total income in the economy that remains after paying for consumption and government purchases:
π = π β πΆ β πΊ
S=YβCβG
What is the market for loanable funds?
The market where savers supply funds for borrowers to invest.
What is the market for foreign-currency exchange?
The market where domestic currency is exchanged for foreign currency to pay for net exports.
What is the world interest rate (r*)?
The real interest rate that prevails in the world financial markets and which a small open economy takes as given.
What is a trade policy?
A government policy that directly influences the quantity of goods and services a country imports or exports.
What is a budget deficit?
When a governmentβs spending exceeds its revenue, leading to a reduction in national saving.
What is capital flight?
A large and sudden movement of funds out of a country due to economic or political instability.
