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Nov 27 note - What can the government of a small open economy do about business cycles.docx

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Department
Economics
Course
ECON 1B03
Professor
Hannah Holmes
Semester
Fall

Description
What can the government of a small open economy do about business cycles? (Ch 15) 26/11/2008 SOE: R= Rw - Government can use only one policy, they cannot use both - Fiscal policy or monetary depending on exchange rate regime - Whether we have flexible or fix exchange rates Monetary policy: flexible exchange rates Ms r P Md AD M Y - Increase in the money supply (expansionary monetary policy) - That cause interest rate to down which cause investment to go up - AD curve shift to the right - Aincrease in theAD will increase in people’s income since more investment equals more spending which will ultimately lead to a increase in people’s income - Aincrease in income will cause people to want to spend more so the demand for money increases - Ms up, R down, I up, AD shift right, Y up, Md shift right But in a small open economy where the Canadian interest rate is less than the world interest rate If we assume perfect capital mobility that people are free to buy and sell anywhere in the world then this difference in this interest rate will make have a effect in people’s behaviour since now people would want to buy foreign assets or foreign bonds because they are paying a higher interest. When people want to buy foreign assets and bonds they need to buy foreign currency which they will need to sell Canadian currency in order to 1 What can the government of a small open economy do about business cycles? (Ch 15) 26/11/2008 buy the foreign ones. This would have a downward pressure on the value of the Canadian dollar. (Real exchange rate)Nobody wants to buy Canadian dollar because they want to buy foreign currency in order to buy these attractive foreign assets. When we have downward pressure on Canadian dollar, then Canadian dollar becomes relatively cheap to buy, that means Canadian goods becomes cheap. - Net Export up - AD shift further to the right - Income goes up - Demand for money goes up - All the pressure of the interest rate stops when the Canadian interest rate equal to the world interest rate Fiscal policy, flexible exchange rates Ms r P Md AD M Y - Government spending goes up -
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