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Static LR Open

Economy Model &


Analysis
Small Open Economy Solution
The workings of a small open economy involve solving the 2 markets in proper
order.
Market for Loanable Funds
1. Draw market for loanable funds with S and I(r)
2. Set real interest rate equal to ROW real rate, r*
3. Solve for NCO(r*) at ROW real interest rate.
Market for Foreign Exchange
1. Take NCO(r*) as Supply of domestic currency.
2. Draw NX(e) as Demand for domestic currency.
3. Find real exchange rate, e*, where NCO(r*) = NX(e).
2
Small Open Economy
Rest of World

r*
Market for S - I(r*) = NCO(r*)
Loanable Funds

Market for
Foreign Exchange

NX(e)
Real Exchange Rate, e

3
Small Open Economy

Real NCO(r*)
Interest Real
Rate S(r) Exchange NCO(r*)
Rate

r*

e*
NX(e)

I(r)

0Foreign Exchange
Loanable Funds

4
Policy 1: Domestic Govt Deficit
Increase in Domestic Govt Budget Deficit of a small open economy.
Govt Budget Deficit reduces Loanable Funds Supply.
Results:
1. Real interest rate fixed at ROW level, r*.
2. NCO falls, reducing Supply of Foreign Exchange.
3. NX(e) does not shift, thus real exchange rate, e*, appreciates.
Changes in gov't deficit thus do not affect real interest rate or investment
but do affect the real exchange rate and Net Exports.

5
Domestic Deficit Diagrams
Real
Interest NCO1(r*)
Real NCO0(r*)
Rate S1 S0 Exchange
Rate 2
1

r* e1
3
e0
NX(e)
I(r)

Loanable Funds Foreign Exchange

6
Policy 2: Foreign Govt Deficits

Increases in foreign govt budget deficits and small open economy.


Foreign govts Budget Deficits increase ROW real interest rate r* as
world-wide supply of savings falls.
Results:
1. Lowers Domestic Investment and increases NCO.
2. Rise in NCO increases Supply of Foreign Exchange.
3. Given NX(e), Real Exchange Rate depreciates.
Changes in ROW govt budget deficits affect domestic real interest rate,
investment, net exports, and the real exchange rate.
Chapter 5 - Open Economy 7
ROW Deficit Diagrams
Real
Interest NCO0(r*)
Real NCO1(r*)
Rate S0 Exchange
Rate 2

r*1
1 e0
r*0 3
e1
NX(e)
I(r)

Loanable Funds Foreign Exchange

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