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ECON1000 CH. 13.docx

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Carleton University
ECON 1000
Nick Rowe

The Macroeconomic Theory of the Open Economy: Chapter 13 Continued • In an open economy: o National saving o Domestic investment o Net foreign investment (NCO) o The exchange rate o Net exports (NX) • Are determined in the market for loanable funds and the market for foreign currency exchange Net Capital Outflow: The Link between the two markets • In the market for loanable funds o Supply comes from national saving (s) o Demand comes from domestic investment (i) and net capital outflow (NCO) • In the market for Foreign-Currency Exchange o Supply comes from net capital outflow (NCO) o Demand comes from net exports (NX) • The link between the two markets is: o Net capital outflows or NCO Trade Policy •Trade policy is government policy that directly influences the quantity of goods and services that a country imports or exports •Some trade policies to affect quantity of imports: o Tariff: a tax on an imported good o Import Quota: a limit on the quantity of a good produced abroad and sold domestically •Lets assume the government imposes an import quota o What is the initial impact of the measure? • On net exports (exports - imports): because imports decline at every exchange rate and therefore, net exports rise at every exchange rate • On foreign exchange market: since net exports are source of demand for dollars and therefore the demand for dollars rises o What is the impact on the Market for Loanable Funds? • That is, on national saving, domestic investment and NCO • There is no impact on the market for loanable funds o What is the impact on the Market for Foreign Currency Exchange Surprise Ending: Trade policies do not affect the trade balance The Effect of An Import Quota • Because foreigners need dollars to buy Canadian net exports (which intitially increase) • There is an increased demand for dollars in the market for foreign currency • Leads to an appreciation of the real exchange rate because the supply of dollars is unchanged • An appreciation of the dollar encourages imports and discourages exports • In the end, trade policies do not affect the trade ba;ance There are Winners and Losers Import Quota: • Reduces imports of commodity under quota--beneficial to that industry • Leads to appreciation of Canadian dollar which harms all other export industries by increasing export prices--not beneficial to export industries • As well, it encourages imports by reducing the prices for imported goods--beneficial to importers Question: "Buy Canadian" Campaign • Suppose the Canadian government institutes a Buy Canadian campaign, in order to encourage spending on domestic goods • What effect will this have on the Canadian trade balance? Answer: • Campaign will increase the demand for domestically produced goods and hence decrease the demand for imports: initially NX (exports - imports) will tend to rise • This will increase the demand for dollars in the market for foreign currency, hence the real exchange rate will appreciate, exports will fall and imports will rise. NX will return to its former level • In the end, net effect will be no change in the trade balance • But there are winners and losers Poitical Instability and Capital Flight Capital Flight • Large and sudden reduction in the demand for assets located in a country • Usually
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