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How does European Debt Crisis influence the interest rate in Euro Zone? How does European Debt Crisis influence the value of Euro dollar?
Important identities
Assume a closed economy one that does not engage in international trade: Y=C+I+G Now, subtract C and G from both sides of the equation: Y C G =I The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).
Meaning of Saving
National Saving National saving is the total income in the economy that remains after paying for consumption and government purchases. Private Saving Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y T C)
Budget
Surplus and Deficit
If T > G, the government runs a budget surplus because it receives more money than it spends. The surplus of T - G represents public saving. If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue.
Saving = Investment?
For the economy as a whole, saving must be equal to investment. S=I
Equilibrium
Financial markets work much like other markets in the economy.
The equilibrium of the supply and demand for loanable funds determines the real interest rate.
Interest Rate
Supply
5%
Demand
$1,200
Government Policies
Government Policies That Affect Saving and Investment
Taxes and saving Taxes and investment Government budget deficits
Interest Rate
Supply, S1
S2
1. Tax incentives for saving increase the supply of loanable funds . . . Demand
$1,200
$1,600
Interest Rate
Supply 1. An investment tax credit increases the demand for loanable funds . . .
D2 Demand, D1
$1,200
$1,400
Crowding Out
Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. This fall in investment is referred to as crowding out.
The deficit borrowing crowds out private borrowers who are trying to finance investments.
Budget Deficit
A budget deficit decreases the supply of loanable funds.
Shifts the supply curve to the left. Increases the equilibrium interest rate. Reduces the equilibrium quantity of loanable funds.
Interest Rate
S2
Supply, S1
Demand
$800
$1,200
Outflow The real interest rates being paid on foreign assets. The real interest rates being paid on domestic assets. The perceived economic and political risks of holding assets abroad. The government policies that affect foreign
NX=NCO
Net exports (NX) and net capital outflow (NCO) are closely linked. For an economy as a whole, NX and NCO must balance each other so that: NCO = NX This holds true because every transaction that affects one side must also affect the other side by the same amount.
S=I + NCO
National saving is the income of the nation that is left after paying for current consumption and government purchases: S=Y - C - G = I + NX S=I + NCO National Saving = Investment + Net Capital Outflow
Formula
Nominal exchange rate v Domestic price Real exchange rate = Foreign price
Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity Quantity of Loanable Funds
Copyright2003 Southwestern/Thomson Learning
Equilibrium real exchange rate Demand for dollars (for net exports)
Equilibrium quantity
Supply
Policies
The magnitude and variation in important macroeconomic variables depend on the following: Government budget deficits Trade policies Political and economic stability
S 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency . . .
Trade Policy
trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports. Tariff: A tax on an imported good. Import quota: A limit on the quantity of a good produced abroad and sold domestically.
A
r 3. Net exports, however, remain the same. NCO Quantity of Loanable Funds Net Capital Outflow
Demand
Capital Flight
Capital
flight is a large and sudden reduction in the demand for assets located in a country. Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries. If investors become concerned about the safety of their investments, capital can quickly leave an economy. Interest rates increase and the domestic currency depreciates.
r1 3. . . . which increases the interest rate. 2. . . . increases the demand for loanable funds . . . D2 D1 Quantity of Loanable Funds
r1
NCO1
S2 4. At the same time, the increase in net capital outflow increases the supply of pesos . . .
Demand