ECON103 Chapter Notes - Chapter ECON103: Exchange Rate, Real Interest Rate, Capital Flight
How Policies and Events Affect an Open Economy
o In an open economy, the rise in the interest rate also reduces net capital outflow
o This makes the crowding out effect on investment smaller than it would have been in
a closed economy
o A trade policy is a government policy that directly influences the quantity of goods
and services that a country imports or exports.
o One common trade policy is a tariff, a tax on imported goods. Another is an import
quota, a limit on the quantity of a good produced abroad that can be sold
domestically.
o The real exchange rate is determined by the demand and supply of dollars in the
market for dollars to exchange for foreign currency
o The increase in the interest rate reduces net capital outflow (increases inflow). This
reduces the supply of dollars to exchange for foreign currency. The shift in supply
leads to an increase in the real exchange rate. The higher exchange rate reduces the
trade balance.
o Capital flight: a large and sudden reduction in the demand for assets located in a
country
Example-1:
If the nominal exchange rate is .70 euro per dollar, the price of an MP3 player in Paris is 150 euros
and the price of an MP3 player in the U.S. is $150, then what is the real exchange rate?
a. 1/.70 French MP3 players per U.S. MP3 player
b. .70 French MP3 players per U.S. MP3 player.
c. 1 French MP3 players per U.S. MP3 player
d. None of the above are correct.
Answer:
= (0.70 * $ 150) = 0.70 (Option B)
150 Euros
Example-2:
Suppose the world had only two countries and domestic residents of country A purchased $50
billion of assets from country B and country B purchased $30 billion of assets from country A.
What would the net capital outflows of both countries be?
a. $50 billion for country A and $30 billion for country B
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