Figure 13.4 shows the effect of an increase in the world interest rate on a small open economy with perfect capital mobility. We assumed there that the Net Capital Outflow (NCO) was positive. For most of the past 40 years, however, Canada's NCO has been negative.

a.Redraw the two panels of figure 13.4, but this time assume that NCO is negative at the world interest rate. Now suppose that the world interest rate increases. What happens to national saving (S)? What happens to domestic Investment (I)? What happens to NCO and the real exchange rate? Carefully label both diagrams and explain step by step what happens starting from the initial equilibrium in both markets. Make sure to include all the relevant details step by step or you will lose marks.

b.Does the conclusion we reached in figure 13.4 (that an increase in world interest rates causes the Canadian dollar to depreciate and net exports to increase) still hold? Explain why or why not.

FIGURE 13.4 (a) The Market for Loanable Funds The Effects of an Increase Real in the World Interest Rate Interest Supply of loanable funds When the world interest rate Rate Net capital outflow (S - 1) from national saving (S) increases, it increases the supply of loanable funds 1. An 2. . . . causes net capital made available by Canadians increase in outflow to increase. and reduces the quantity of loanable funds demanded the world for domestic investment. For interest both of these reasons, net rate . . . capital outflow increases. An increase in the supply of dol- Demand for loanable lars in the market for foreign- funds for domestic currency exchange causes investment (1) the Canadian dollar to depre- ciate. The depreciation of the Quantity of dollar causes net exports to Loanable Funds rise. (b) The Market for Foreign-Currency Exchange Real Exchange Supply of dollars Rate (S - M1 (S-12 3. The increase in net capital outflow increases the supply of 4. . . . which E1 dollars to be exchanged causes the into foreign currency . . . real exchange rate to depreciate. Demand for dollars (NX) Quantity of Dollars NEL