Problem Set 14 Solutions

EC201: Intermediate Macroeconomics

1. (Small Open Economy and Real Exchange Rate) Consider a small open economy
(the domestic country) with perfect capital mobility. Perfect capital mobility
means that there are no restrictions on international trade on assets. This implies
that the domestic real interest rate r is equal to the international real interest rate
r∗ . A small open economy is one that is too small to affect international prices
and in particular it cannot affect the international interest rate. The assumptions
of perfect capital mobility and small open economy imply that domestic country
takes r∗ as exogenously given and r = r∗ .
(a) Assume that investments in the domestic country are a decreasing function
of r, called I(r). National saving is given by S = Y − C − G and it does
not depend on r. In a graph with r on the vertical axis and S and I on the
horizontal axis, show how the real interest rate is determined in a closed
economy.
Answer: In a closed economy, our equilibrium is given Y = C + I + G or
S = I (the two equations are equivalent). In this case we have S = I(r).
Since S does not depend on r, we graph the savings as a vertical line at some
level S. The investment function is decreasing in r and therefore, the graph
of that is a downward sloping line.

1
 In a closed economy, the real interest rate would adjust in order to guarantee
the equality between investments and national saving. We will represent the
resulting interest rate as rC .
(b) In an open economy we have N X = S − I, where N X is the net exports
or Trade Balance. Since we have assumed perfect capital mobility, the real
interest rate in the domestic economy is always equal to the world real interest
rate r∗ . In the same graph as in (a), show how N X can be determined.
Answer: In an open economy, national saving may be different from domestic
investment. In particular we have that N X = S − I. Furthermore, in a small
open economy the domestic interest rate r must be equal to r∗ , the world
interest rate which is unaffected by the domestic economy. Therefore, the
domestic interest rate cannot adjust to equalise S and I. At a given interest
rate r = r∗ , if there is a difference between S and I, that difference must be
equal to N X.

Here the exogenous world interest rate determines investment through the
function I(r), and the difference between S and I will be equal to N X. In
this graph we consider the case where the world interest rate is greater than
the interest rate would be in the closed economy, r∗ > rC . At this interest
rate, people are saving more domestically than the demand for domestic
investment. Therefore, there is an excess of domestic saving that can be
invested abroad.
The increase in S-I means that the global supply of domestic currency is
increasing. The excess saving is used to buy investment outside the domestic
economy, so savers convert their domestic currency into foreign currency to
buy foreign investment. This increases the global supply of the domestic
currency.

Page 2
 If the supply of domestic currency (S) is larger than the demand for domestic
currency (from foreigners that want to invest in the domestic country), the
value of the currency must decrease. In this particular case, the real value of
the currency that is decreasing, what we call the real exchange rate (with the
same amount of domestic currency we can buy less now since the currency has
lower value). However, if the currency has a lower value in real terms, then
exports become cheaper while imports become more expensive. Therefore,
N X increases. We will see this clearly when we introduce the real exchange
rate into the analysis later.
(c) Suppose that there is an increase in government expenditure in the domestic
country. Since the interest rate does not change (it is r∗ ) an increase in G
will not affect investment. Show in the same graph as in (b) the effect of an
increase in G. Show what happens to the level of N X.
Answer: Here an increase in G simply decreases national saving since it
increases national expenditure: S = Y − C − G.
Since I(r) does not change, what will move in the graph is the vertical line
given by S. This vertical line will shift to the left:

This shift in S decreases the trade balance N X, from N X( b) to N X( c). The

Page 3
Answer: Now we explicitly introduce the real exchange rate into the analysis
by assuming that N X is a decreasing function of the real exchange rate,
N X(). An increase in the real exchange rate means an appreciation of the
real exchange rate. Therefore we use the definition of the real exchange rate
given by:  = e PP∗
We can think of a domestic country that is trading with another single country
which we call the rest of the world. So the real exchange rate measures the
relative price of domestic goods in terms of the goods produced in the foreign
country (the rest of the world).
In the graph defined in part (d) of the exercise, the function S − I(r) does
not depend on  and therefore it will be a vertical line, while N X() will be
a decreasing function.

As we can see the real exchange rate adjusts to create the equilibrium between
S − I and N X(). We know that S − I is the net capital outflow. In practice,
S − I is the net global supply of domestic currency: the supply of domestic
currency from domestic residents investing abroad minus the demand for
domestic currency from foreigners buying domestic assets.
The trade balance N X can be considered as the net demand for domestic
currency: foreign demand for domestic currency to purchase our exports
minus our supply of domestic currency to purchase imports.
The real exchange rate in equilibrium is determined by the equality between
the net supply of domestic currency and the net demand of domestic currency,
or N X() = S − I(r).
One important thing about the graph: the vertical axis is not necessarily
cutting the horizontal axis at N X = 0. We know that N X() = S − I(r),
but if I(r) > S, then N X < 0. Suppose that at (d) , I(r) > S. Then the
value N X(d) is negative. So in that graph the zero for N X is somewhere on
the horizontal axis to the right of the vertical axis.

Page 4
(e) Suppose that there is an increase in G in the domestic country. Using the
same graph as in (d) show how the increase in G will affect the real exchange
rate.
Answer:
Suppose that there is an increase in G. The only variable that is affected by
this increase in G is the national saving S. In particular, if G increases then
S must decrease. This implies that S − I(r) will decrease. This implies that
the function S − I(r) shifts to the left. A decrease in S decreases the net
supply of domestic currency compared to the net demand.
At the real exchange rate (d) there is now an excess of demand (net) for the
domestic currency compared to the supply (net). To remove the excess of
demand, the domestic currency must increase its value, meaning it appreciates.
This means that the domestic prices are now higher than foreign prices. Since
the real exchange rate increases, N X decrease since exports are now more
expensive and imports are cheaper. So it is cheaper to buy goods from the
foreign country (more imports) while it is more expensive for the foreign
country to buy the domestic goods (less exports).

(f) Now suppose that the domestic government introduces a protectionist trade
policy by restricting the amount of imports. Using the same graph as in (d)
show the effects of this trade policy.
Answer: A trade policy that reduces the amount of imports will affect the
N X function. In particular, now, at any level of the real exchange rate
imports must be lower. This implies that N X will shift up.

Page 5
Given that S − I(r) does not change, the primary effect of this policy is to
increase the real exchange rate. The shift of the N X schedule means that
demand for the domestic currency increases while the supply (S − I) does
not change. Therefore, at the original real exchange rate (the equilibrium
before the introduction of the policy) there is now an excess of demand for
the domestic currency.
This excess of demand increases the value of the domestic currency. Notice
that the trade policy does not change the value of NX. The reason is that
S − I(r) remains the same after the policy and we know that N X = S − I(r).
Notice another effect of this policy. Imports are reduced by the policy,
however the real exchange rate increases and this decreases exports in such a
way that N X does not change.
Suppose that in the domestic country there are some firms that mainly sell
their product abroad (we call it the export sector) and some other firms that
sell their product only domestically (the internal sector). This trade policy
makes the export sector worse off (they sell less product abroad because
now their products are more expensive) while it makes the internal sector
better-off. This is because the internal sector now faces less competition
(fewer foreign firms are selling their products in the internal market).

Page 6