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Countries spend these foreign currencies by importing goods and services or purchasing assets abroad. In an open economy, the proportion of country’s foreign currency earned and spent for purchasing…
These transactions may involve multiple investors and banks.
Purchasing power parity states that a unit of any given currency should be able to buy the same amount of goods in all countries. The monetary policies practiced in countries are different. Therefore, different inflation rates are experienced by the countries. Price levels reflect the country’s rate of inflation. In case if the amount of goods that can be bought by spending a unit of dollar in country A is higher than the amount that can be bought in country B, selling such goods from country A to B is profitable. Ideally, arbitrage process occurs until the purchasing power of the currency is equal in both countries.
Quantity or quality of the goods and services produced by the country is not changed. Only the amount of money circulating in the economy is increased. The real value of a dollar is now low while the amount of goods and services it can buy is now less. Similarly, the units of yen a dollar can buy in market for foreign currency exchange are also decreased.
Supply of market for loanable funds is generated from domestic savings while demand is generated from domestic investments and net capital out flaw. The cost of borrowing from market for loanable funds is denoted by real interest rate (i). Market for loanable funds can be graphically illustrated as below.
Supply of market for foreign-currency exchange is generated from net capital out flaw while the demand is generated from net exports. NCO is determined by real interest rate. The cost of purchasing foreign currencies is denoted by real exchange rate (r) as illustrated bellow.
These are called twin deficits because the first can trigger the latter. As the government draws money from national savings to fund its expenditures, the cost of borrowing by public is increasing. Therefore, investing in domestic businesses becomes more profitable. Capital is now flowing into the country while decreasing the NCO. Low capital ...