Macroeconomics 4: Long run models for the small and large open economy

Question 1

Describe & explain the development of a model for the small open economy that operates an open Capital Account

Answer 1

We will develop a model for the small open economy that operates an open Capital Account (is fully
integrated into global financial markets). For the small open economy its financial markets are very
small compared to the global financial markets.
If the (real) income paid on a bond is B and the (real) price of the bond is PB then r=B/PB
Suppose r<r*
International investors will sell domestic bonds and buy foreign bonds. This will cause PB to fall and r
to rise until r=r*
What if r>r*
International investors will want to buy domestic financial assets and PB will rise until r=r*
Hence r=r* is the long run equilibrium condition