EC 111 1st Edition Lecture 19PREVIOUS LECTUREI. Case Study: The US Trade DeficitII. The Nominal Exchange RateIII. Appreciation and DepreciationIV. The Real Exchange RateV. Interpreting the Real Exchange RateVI. Purchasing Power ParityVII. Purchasing Power Parity and its ImplicationsVIII. Limitations of the Purchasing Power Parity TheoryCURRENT LECTUREI. The Market for Loanable FundsII. How Net Capital Outflow Depends on the Real Interest RateIII. The Loanable Funds Market DiagramIV. The Market for Foreign-Currency ExchangeV. The Connection Between Interest Rates and Exchange RatesTHE MARKET FOR LOANABLE FUNDS- An identity from the preceding chaptero S=I+NCO- A supply of loanable funds=saving- A dollar of saving can be used to financeo The purchase of domestic capital o The purchase of foreign asset- So demand for loanable funds=I+NCO- Recall:o S depends positively on the real interest rate ro I depends negatively on r- What about NCO?HOW NET CAPITAL OUTFLOW DEPENDS ON THE REALINTEREST RATE- The real interest rate, r, is the real return on domestic assets- A fall in r makes domestic assets less attractive relative to foreign assetso People in the US purchase more foreign assetso People abroad purchase fewer US assetso NCO rises- NCO negatively related to the interest rateThe loanable funds market diagram- r adjusts to balance supply and demand in the loanable funds market- Both I and NCO depend negatively on r so the demand curve is downward sloping- A budget deficit reduces saving and the supply of loanable funds causing r to rise- The loanable funds market determines r then this value of r determines NCOTHE MARKET FOR FOREIGN-CURRENCY EXCHANGE- Another identity from the preceding chaptero NCO=NX- What goes abroad comes back-what comes here goes back abroad- In the market for foreign-currency exchange:o NX is the demand for dollars: Foreigners need dollars to buy US net exportso NCO is the supply of dollars: US residents sell dollars to obtain foreign currency they need tobuy foreign assets- Recall: the US real exchange rate E measures the quantity of foreign goods and services that trade for 1 unit of goods and serviceso E is the real value of a dollar in the market for foreign-currency exchange- An increase in E makes US goods more expensive to foreigners, reduces foreign demand for US goods and US dollars- An increase in E has no effect on saving or investment, so it does not effect NCO or the supply of dollars- E adjusts to balance supply and demand for dollars in the market for foreign-currency exchangeTHE CONNECTION BETWEEN INTEREST RATES ANDEXCHANGE RATES- Anything that increases r will reduce NCO and the supply of dollars in the foreign market - Result: the real exchange rate appreciates- Keep in mind: the loanable funds market determines r. This value of r then determines NCO. This values of NCO then determines supply of dollars in foreign exchange