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Lecture 11

ECON 1BB3 Lecture Notes - Lecture 11: Interest Rate Parity, Real Interest Rate, Open Economy

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Bridget O' Shaughnessy

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What is a small open economy?
Interest rates in a small open economy
- Open economy
oAllows goods, services and capital to flow across borders freely
- Small open economy (SOE)
oNot large enough to affect world interest rates or world prices
- Perfect capital mobility
oFull access to world financial markets
-Example : Canada
- Interest rate parity
oIn theory, the real interest rate (in Canada) should equal real interest in world financial markets
or = rw
-interest rate parity is not always perfect for 2 reasons:
otax treatment
Model of a small open economy
-2 markets
oMarket for loanable funds
oMarket for foreign currency
-Loanable funds
oS – I = NCO (open economy)
oS = I (closed economy)
-in a closed economy, the interest rate adjusts to bring S into line with I
-in an SOE, we take the world interest rate as given
Market for foreign currency
-supply, demand of $CAD on foreign currency market
-artificially divide foreign exchange transactions
-trying to determine RER (eP/P*)
- supply
ofrom NCO, a Canadian purchase of foreign assets (we are supplying $CAD, demanding for
- demand
ofor NX, foreigners wanting to buy $CAD (because they want to buy Canadian goods)
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