CHAPTER 20

EQUILIBRIUM IN THE GOODS MARKET

- Consumption (disposable income): positive
- Investment (Output, real interest rate): positive, negative
- Government Spending
- Imports (output, real exchange rate): positive, positive
NOTE: imports of domestic good = quantity of imports divided by the real exchang
e rate
- Exports (foreign output, real exchange rate): positive, negative
- NET EXPORTS: directly related, foreign output; inversely related, domestic goo
ds; inversely related, real exchange rate
- INCREASE IN REAL INTEREST RATE: decrease investment, decrease in domestic good
s, decrease output
- INCREASE IN REAL EXCHANGE RATE: shift in foreign goods, decrease net exports,
decrease output
- Goods market equilibrium - output depends negatively on real interest rate and
real exchange rate
EQUILIBRIUM IN THE FINANCIAL MARKET
- real money = real output (nominal interest rate) - opportunity cost of holding
money rather than bonds
- money supply: inversely related kay interest rate
- money demand: directly related kay interest rate
DOMESTIC BONDS VERSUS FOREIGN BONDS
- dapat, same expected returns for both foreign and domestic bonds. kasi kung hi
ndi, isa lang ang pipiliin
- equation: (INTEREST PARITY CONDITION)
* left side: rate of returns kapag nag-hold ng domestic bonds
* right side: rate of returns kapag nag-hold ng foreign bonds. may E (exchange
rate) kasi for you to hold the bond, dapat yung currency mo e ipapalit sa curren
cy ng other. kaya naman may expected E (t+1) dahil para bumalik sayo yung fund f
or the next period, yung currency ng other e ipapalit sa currency mo.
- CURRENT EXCHANGE RATE: directly related, domestic interest rate; inversely rel
ated, foreign interest rate; directly related, expected future change
- an appreciation today leads to a depreciation in the future
- An increase in domestic interest rate relative to the foreign interest rate le
ads to an appreciation.
- increasing domestic interest rate, increasing exchange rate
- if domestic interest rate = foreign interest rate, exchange rate is equal to e
xpected exchange rate
PUTTING GOODS AND FINANCIAL MARKET TOGETHER
- First effect (directly): increase interest rate, decrease investment, decrease
demand for domestic goods, decrease output (present in closed and open economy)
- Second effect (indirectly): increase in domestic interest rate, increase in ex
change rate (appreciation), decrease in demand for domestic goods, decrease outp
ut (present in open economy only)
- IS CURVE: downward sloping due to the effects
- LM CURVE: upward sloping; increase income, increase money demand, increase equ
ilibrium interest rate
- equilibrium interest rate determines the equilibrium exchange rate
EFFECTS OF FISCAL POLICY IN OPEN ECONOMY
- increase government spending, shift right IS curve

- increase output, increase money demand, increase interest rate, increase deman
d for domestic bonds, increase exchange rate (appreciation)
- increase in consumption (due to income) and government spending
- investment remains ambiguous (kasi parehas tumaas output at interest rate, di
alam kung sino nag-dominate)
- both the output and appreciation negtively affects the net exports, which lead
s to trade deficit
EFFECTS OF MONETARY POLICY IN OPEN ECONOMY
- only shifts the LM curve. IS curve and interest parity doesn't shift
- decrease output, increase interest rate, increase demand in domestic bonds, in
crease exchange rate (appreciation)
FIXED EXCHANGE RATES
- peg - ina-adjust yung exchange rate (applicable sa fixed exchange rates)
- devaluations and revaluations
- crawling peg - countries that have inflation rates that exceeds US dollars kay
a mabagal ang pag-adjust nila to make their products competitive
- under a FIXED EXCHANGE RATE and CAPITAL MOBILITY, domestic interest rate must
be equal to foreign interest rate (interest parity condition)
- kapag nagbago ang demand for money, sa isang country with fixed exchange rate,
dapat baguhin din niya yung money supply para ma-satisfy yung interest parity c
ondition
- under FIXED EXCHANGE RATE, central bank gives up monetary policy as a policy i
nstrument
- under FIXED EXCHANGE RATE, fiscal policy is more powerful than it is under fle
xible exchange rates. fiscal policy triggers monetary accomodation (pangpa-neutr
alize kumbaga)
- in a fixed exchange rate, you are free from correcting trade imbalances and co
ntrolling interest rates