Economics Chapter: Market for Loanable Funds

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Questions and Answers

What effect does an increase in the world interest rate have on the supply of Canadian dollars in the foreign-currency exchange market?

  • It increases the supply of Canadian dollars. (correct)
  • It causes the supply to fluctuate unpredictably.
  • It has no effect on the supply.
  • It decreases the supply of Canadian dollars.

How does an import quota affect net exports at any given real exchange rate?

  • Net exports decrease due to increased imports.
  • Net exports remain unchanged.
  • Net exports increase due to decreased imports. (correct)
  • Net exports are unaffected by changes in imports.

What happens to the real exchange rate when there is a government deficit?

  • It increases, leading to a decrease in net exports. (correct)
  • It fluctuates randomly without a clear pattern.
  • It remains constant regardless of the deficit.
  • It decreases, leading to an increase in net exports.

Which factor primarily determines the supply of Canadian dollars in the foreign-currency exchange market?

<p>Net capital outflow. (D)</p> Signup and view all the answers

What is the effect of capital flight on the peso?

<p>It causes the peso to depreciate. (D)</p> Signup and view all the answers

What does an increase in savings in an economy lead to?

<p>An increase in net capital outflow. (D)</p> Signup and view all the answers

What is the primary purpose of a tariff?

<p>To impose a tax on imported goods. (C)</p> Signup and view all the answers

What is the relationship between net capital outflow (NCO) and net exports (NX)?

<p>NCO is equal to NX. (B)</p> Signup and view all the answers

How does political instability affect the demand for a country's assets?

<p>It leads to capital flight and reduces demand for local assets. (D)</p> Signup and view all the answers

What is the effect of a higher real exchange rate on exports?

<p>Exports decrease. (B)</p> Signup and view all the answers

How is the interest rate determined in an open economy?

<p>By world financial markets (A)</p> Signup and view all the answers

What does it indicate when borrowing exceeds national savings in the context of loanable funds?

<p>Excess demand for loanable funds (C)</p> Signup and view all the answers

If net capital outflow (NCO) is negative, what does this imply?

<p>Foreign investments in the domestic economy exceed domestic investments abroad (A)</p> Signup and view all the answers

What is the relationship between NCO and net exports (NX) in an economy?

<p>NCO is equal to NX (C)</p> Signup and view all the answers

What happens in the foreign-currency exchange market when a Canadian purchases Japanese goods?

<p>The supply of Canadian dollars increases (B)</p> Signup and view all the answers

What is required to purchase goods from foreign sellers?

<p>Foreign currency (D)</p> Signup and view all the answers

Which equation reflects the relationship between savings (S), investment (I), and net exports (NX)?

<p>S - I = NX (C)</p> Signup and view all the answers

What balances the supply and demand for Canadian dollars in the foreign exchange market?

<p>Net exports (NX) and net capital outflow (NCO) (B)</p> Signup and view all the answers

Flashcards

Interest rate in an open economy

In an open economy, the interest rate is set by global financial markets, not just domestic supply and demand.

What is net capital outflow?

The difference between the quantity of loanable funds supplied (savings) and the quantity demanded (investment) is the net capital outflow (NCO).

What happens when investment exceeds savings in an open economy?

When a country's investment exceeds its savings, foreigners provide the extra funds, resulting in a negative NCO.

Relationship between NCO and NX

Net capital outflow (NCO) equals net exports (NX). This means the amount a country lends to the rest of the world equals the value of its net exports.

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What happens when a Canadian buys goods or assets from abroad?

When a Canadian buys goods or assets from abroad, they supply Canadian dollars to the market for foreign currency exchange.

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What happens when a foreign resident buys Canadian goods or assets?

When a foreign resident buys Canadian goods or assets, they demand Canadian dollars from the market for foreign currency exchange.

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How does net exports (NX) impact the market for foreign currency?

The value of net exports (NX) represents the net demand for Canadian dollars due to international trade.

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How does net capital outflow (NCO) impact the market for foreign currency?

The value of net capital outflow (NCO) represents the net supply of Canadian dollars resulting from purchases of foreign assets by Canadians and domestic assets by foreigners.

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Real Exchange Rate (E)

The price of one currency in terms of another.

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Net Exports (NX)

The difference between a country's exports and imports.

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Net Capital Outflow (NCO)

The net flow of funds from a country to the rest of the world.

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Increase in World Interest Rate

An increase in the world interest rate leads to an increase in NCO, which in turn increases the supply of Canadian dollars in the foreign-currency exchange market. This causes the real exchange rate to fall (depreciation of the Canadian dollar), making Canadian goods cheaper to foreigners, leading to increased exports and decreased imports, ultimately increasing NX.

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Increase in Government Deficit

A decrease in national savings leads to a decrease in NCO, which decreases the supply of Canadian dollars in the foreign-currency exchange market. This causes the real exchange rate to rise (appreciation of the Canadian dollar), making Canadian goods more expensive to foreigners, leading to decreased exports and increased imports, ultimately decreasing NX.

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Binding Import Quota

A binding import quota decreases imports (at all real exchange rates), which increases the demand for Canadian dollars, leading to an appreciation of the Canadian dollar. However, since NCO (determined by the world real interest rate) doesn't change, the supply of Canadian dollars remains unchanged.

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Capital Flight

A large and sudden reduction in demand for assets located in a country, often due to a loss of confidence in the economy.

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Political Instability and Higher Interest Rates

An increase in the country's real interest rate caused by a risk premium (increased risk of defaulting on loans) during periods of political instability.

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Capital Flight and Currency Depreciation

Capital flight increases NCO, which increases the supply of Canadian dollars in the foreign-currency exchange market, leading to a depreciation of the Canadian dollar (making Canadian goods cheaper for foreigners).

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Increase in Savings and Currency Depreciation

An increase in savings leads to an increase in NCO, which increases the supply of Canadian dollars in the foreign-currency exchange market, causing the real exchange rate to fall (depreciation of the Canadian dollar). This makes Canadian goods less expensive for foreigners, leading to increased exports and increased net exports.

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Study Notes

Market for Loanable Funds (Open Economy)

  • Supply of loanable funds equals investment plus net capital outflow (S = I + NCO)
  • Domestic interest rate equals world interest rate (r = rw) in an open economy.
  • Market equilibrium is determined by global financial markets, not domestic supply and demand.
  • The difference between saving and investment (I – S) equals net capital outflow (NCO).

Equilibrium in the Market for Loanable Funds (Open Economy)

  • In an open economy, if investment exceeds saving (I > S), the extra borrowing is filled by foreign saving.
  • This results in a negative net capital outflow (NCO), where foreigners buy more domestic assets than domestic residents buy foreign assets.
  • Canada has typically had a negative NCO position over the last 60 years.

Net Foreign Investment and the Trade Balance

  • Net capital outflow (NCO) equals net exports (NX).
  • The market for loanable funds determines the trade balance.

Market for Foreign-Currency Exchange

  • Purchasing foreign goods requires exchanging domestic currency for foreign currency.

  • Savings equal investment plus net exports (S = I + NX).

  • Canadian buying Japanese goods requires supplying Canadian dollars and demanding Japanese yen.

  • Japanese buying Canadian goods requires demanding Canadian dollars and supplying Japanese yen.

  • Net exports determine the net demand for domestic currency.

  • Net capital outflow determines the net supply of domestic currency.

  • The real exchange rate (E) balances supply and demand for the domestic currency in the foreign-currency exchange market.

Equilibrium in the Open Economy

  • Equilibrium requires balance in both loanable funds and foreign-currency exchange markets.
  • Net capital outflow (NCO) is determined by the supply and demand for loanable funds and affects the real exchange rate.
    • NCO can be negative.

Policies and Events in an Open Economy

  • Examples include changes in world interest rates and government deficits.

An Increase in the World Interest Rate

  • Increased NCO leads to a fall in the real exchange rate (depreciation of the domestic currency).
  • Cheaper domestic goods lead to higher exports and lower imports, increasing net exports (NX).

Increase in Government Deficit

  • Reduced national saving.
  • Lower NCO results in an appreciation of the domestic currency and reduced net exports (NX).
  • Government deficits do not crowd out investment in an open economy; instead they crowd out net exports.

Trade Policy

  • Trade policy (e.g., tariffs, quotas) directly affects imports and exports.

How Does an Import Quota Affect the Trade Balance?

  • A binding import quota reduces imports.
  • At any real exchange rate, net exports rise; demand for currency rises as well.
  • No change in supply of currency, only higher real exchange rate leading to reduced exports, offsetting increased imports. Trade volume decreases. The trade balance is unchanged.

Political Instability and Capital Flight

  • Capital flight is a sudden reduction in demand for a country's assets.
  • This leads to higher domestic interest rates to compensate for the greater risk of default.
  • NCO increases, domestic currency depreciates.

Further Effects of an Increase in Saving

  • An increase in savings leads to higher NCO, which decreases the real exchange rate and increases net exports.

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