Class Slides for EC 204 Spring 2006 To Accompany Chapter 5 Relative Importance of Trade, Various Countries, 2000 The International Flow of Capital and Goods Role of Net Exports: Y = C d + I d + G d + EX C = C f + C d, I = I f + I d, G = G f + G d Y = (C - C f ) + (I - I f ) + (G - G f ) + EX Y = C + I + G + EX - (C f + I f + G f ) Y = C + I + G + EX - IM Y = C + I + G + NX NX = Y - (C + I + G) Net Exports = Output - Domestic Spending Net Capital Outflow and the Trade Balance: Y = C + I + G + NX Y - C - G = I + NX S = I + NX S - I = NX Net Capital Outflow = Trade Balance Saving and Investment in a Small Open Economy Capital Mobility and the World Rate of Interest: r = r* The Model: Exchange Rates Nominal versus Real Exchange Rate: Real Exchange = Nominal Exchange X Ratio of RateRate Price Levels eX(P/P*) The Real Exchange Rate and the Trade Balance: NX = NX( ) Determinants of the Real Exchange Rate Real exchange rate is related to net exports Lower real exchange rate makes domestic goods less expensive relative to foreign goods, so net exports are greater. Trade balance (net exports) must equal net capital outflow Net capital outflow equals saving minus investment The Determinants of the Nominal Exchange Rate Rewrite the earlier equation for the real exchange rate: e= x (P*/P) %Change in e = %Change in + %Change in P* -%Change in P %Change in e = %Change in + ( * - ) Inflation and the Depreciation of the Nominal Exchange Rate (Average rates for Various Countries over ) Special Case of Purchasing-Power Parity Large Open Economy Model