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Tastes are converging (i.e., more and more people all over the world
generally like the same things) and many goods we consume are
either made abroad or have many imported parts and components.
Many of the services we use are increasingly provided by foreigners.
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When goods markets are open, domestic consumers must
decide not only how much to consume and save, but also
whether to buy domestic goods or to buy foreign goods.
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Closed economy
Y = C + I +G
Where
C = (Y-T) is consumption which is a direct function of
disposable income
I = I (Y, r) is investment which is a direct function of
income/production Y and indirect function of real interest
rate ‘r’
G = autonomous
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Open economy
Y = C + I +G + X - M
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Y = C (Y – T) + I (Y, r)+ G + X (Y*, E) – M (Y, E)
Where E → exchange rate; Y* → foreign income
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Openness in financial markets allows:
◦ Financial investors to diversify—to hold both domestic and
foreign assets and speculate on foreign interest rate
movements.
◦ Allows countries to run trade surpluses and deficits. A
country that buys more than it sells must pay for the difference
by borrowing from the rest of the world.
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The decision whether to invest abroad or at home depends
not only on interest rate differences, but also on your
expectation of what will happen to the nominal exchange rate.
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Closed economy: People have demand for two financial
assets: money & bond
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Open Economy
An additional consideration is: Now people have a choice
between domestic bonds & foreign bonds
Due to this ne dimension a new equation in the system is the
interest parity equation as shown in the text box below:
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