ECN204 Chapter 13.doc

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22 Apr 2012
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ECN204 – Chapter 13
The Market for Loanable Funds
oAn identity from the preceding chapter:
S = I + NCO
oSupply of loanable funds = saving
oA dollar of saving can be used to finance
The purchase of domestic capital
The purchase of a foreign asset
So, the demand for loanable funds = I + NCO
oRecall:
S depends positively on the real interest rate, r
I depends negatively on r
What about NCO
oThe supply and demand for loanable funds depend on the real interest
rate
oA higher real interest rate encourages people to save and raises the
quantity of loanable funds supplied
oThe interest rate adjusts to bring the supply and demand for loanable
funds into balance
oAt the equilibrium interest rate, the amount that people want to save
exactly balances the desired quantities of domestic investment and net
foreign investment.
oIn a small open economy with perfect capital mobility, like Canada, the
domestic interest rate will equal the world interest rate
oAs a result, the quantity of loanable funds made available by the savings
of Canadians does not have to equal the quantity of loanable funds
demanded for domestic investment
oThe difference between these two amounts is NCO.
How NCO Depends on the Real Interest Rate
oThe real interest rate, r, is the real return on domestic assets
oA fall in r makes domestic assets less attractive relative to foreign assets
Canadians purchase more foreign assets
Canadians purchase fewer domestic assets
NCO rises
The Market for Foreign-Currency Exchange
oThe market for foreign-currency exchange exists because people want
to trade with people in other countries, but they want to be paid in their
own currency
The two sides of the foreign-currency exchange market are
represented by NCO and NX
NCO represents the imbalance between the purchases and sales
of capital assets
NX represents the imbalance between exports and imports of
goods and services
oAnother identity from the preceding chapter:
NCO = NX
oIn the market for foreign-currency exchange,
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