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Lecture 13

ECON 102 Lecture 13: ECON 102 - Chapter 13 Notes

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ECON 102
Karl Pinno

Wednesday, November 23, 2016 ECON 102 Chapter 13: A Macroeconomic Theory of the Small Open Economy The goal of the model in this chapter is to highlight the forces that determine the economys trade balance and exchange rate. To understand what factors determine a countrys trade balance and how government policies can affect it, we need a macroeconomic theory of the small open economy. Assumptions for our small open economy model: 1. The level of GDP is a given 2. The price level is xed 3. The real interest rate is equal to the world interest rate and is taken as given Supply and Demand for Loanable Funds and for ForeignCurrency Exchange The focus is on supply and demand on two markets to understand the forces at work in an open economy: Market for loanable funds coordinates the economys saving, investment, and ow of loanable funds abroad (called NCO). Market for foreign currency exchange The Market for Loanable Funds The place to start to understand the market for loanable funds in a small open economy is with this identity: S = I + NCO Saving = Domestic investment + Net capital outow Recall that in a small open economy with perfect capital mobility (e.g. Canada), the domestic interest rate will equal the world interest rate. The market for loanable funds in a small open economy with perfect capital mobility is different from that in a closed economy The interest rate is now longer determined by the demand and supply of loanable funds. 1
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