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Lecture 27.docx

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Hannah Holmes

Lecture 27 (Small Open Economy) In an open economy, theAggregate Demand equation is Y = C + I + G + NX In a closed economy, theAggregate Demand equation is Y = C + I + G • SOE: r = r^w (perfect capital mobility)  all this means is Canadian can purchase their own capitals and capitals abroad. Foreigners can purchases Canadian capitals or their own capitals. • Government can use only one policy • Fiscal policy or monetary depending on exchange rate regime (flexible or fixed) Flexible exchange rate = “e” is determined by market forces of supply and demand - People buy foreign currency (sell $CAD) Exchange rate goes down = Real Exchange Rate goes down - People (buy $CAD) Exchange rate goes up = Real Exchange Rate goes up Fixed exchange rate – central bank must buy or sell $CAD to keep exchange rate fixed - The bank do that through open-market operation (so Bank of Canada alters the Money Supply) “e” – how much foreign currency can you purchase with $1 CAD Expansionary – Monetary policy, flexible exchange rates Y = C + I + G + NX 1) Aggregate Demand increases, because it is Expansionary 2) Output increases because Aggregate Demand increases 3) More Output means more people in the economy 4) If there is more income in the economy, the assumption is people will consume more 5) If people consume more, they will demand more money (so money demand curves shifts to the right) 6) Interest Rates therefore below the World’s interest rate. The world’s assets are more attractive because it provides us with a higher return (higher r). Therefore people will buy foreign assets, and in order to buy that they have to buy foreign currency (sell $CAD) 7) Exporting more goods to foreigners, they are buying more of our goods. If NX increases, it means theAggregate Demand curve shifts further to the right. That means we are producing more goods and services thanAD2. That means we are employing more people, and there are more income in the economy. And people will consume more, and the money demand curve will shift to the right again. TheAggregate Demand Curve stops shifting out when the Real Exchange Rate stops falling. It stops falling when the pressure on the Canadian dollar stops. The pressure stops when our interest rate is equal to the world interest rate again (equilibrium). Expansionary – Fiscal policy, flexible exchange rates Y = C + I + G + NX 1) Fiscal policy is the change in government spending or change in taxes 2) Aggregate Demand shifts to right because (G) increases 3) Output increases when shift to the right. More output means more people employed. More income in the economy will be consuming more. When consuming more, the money demand (Md) curve shifts to the right because we are demanding more money 4) Will see that our interest rate is greater than the world interest rate. This means our asset is more attractive than the world’s assets 5) People will want to buy Canadian assets. In order to buy Canadian assets, they will need to buy Canadian currency 6) It will put upward pressure on exchange rate because everyone is demanding Canadian assets 7) Exchange rate increases = Real Exchange Rat
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