1
Open Economy
(a) Goods and Service Market: Supply of domestic output = Demand for domestic output
Ys=Yd=Y, ⇒ Y=C+I+G+NX
Trade Balance (NX)
-- represents the flow of goods and services (royalty payments, interest payments, freight, etc), and
transfer payments (grants, gifts). It is the net amount we receive from abroad in exchange for our
net export of goods and services.
-- This is also called the current account. If there is a current account deficit (NX<0), the U.S.
consumes more than it produces.
-- If there is a trade deficit (NX<0), the country’s sales of goods and services to foreigners are not
sufficient to pay for its imports. The country must therefore be paying for the excess by selling
assets to foreigners (i.e., a negative NFI). The converse also holds. See below for the NFI.
(b) Financial Market (Loanable fund market)
In a closed economy, national savings S is used to finance the domestic investment I, and the
equilibrium condition of the G&S market is the same as
S=I=(Y-C-G)=I
In an open economy, national savings is used to finance domestic investment as well as foreign
investment. Foreign country may also invest in the domestic market.
Supply of funds = national saving + reverse foreign investment
Demand for funds = domestic investment + foreign investment
reverse foreign investment = inflow of funds from the rest of the world
foreign investment = outflow of funds (investment) to the ROW
Equilibrium
supply=demand ⇒ S+reverse foreign investment = I + foreign investment ⇒ S=I+NFI
The Net Foreign Investment (NFI)
-- represents the flow of funds. If it is negative, it is a net inflow of funds.
-- records borrowing and lending by banks, purchases and sales of assets, such as stocks, bonds
and land
-- The negative of NFI is also called the capital account
(c) Balance of Payment (BOP)
BOP = Current account + Capital account = NX-NFI
-- If the balance of payments is not zero, then Official Reserve Transactions occur. If the U.S. has a
BP deficit, then it has to pay for it with gold or by drawing down the international reserve at the
IMF (International Monetary Fund).
-- In the long run equilibrium, BOP must be zero: that is,
BOP=0 ⇒ NX=NFI
2
Determinants of C, I, G, NX and NFI
Consumption:
C = C(Y-T)
Investment:
I = I(r)
̅ ....Exogenous
Government:
G= G
̅
Net Taxes:
T=T .... Exogenous
Net export:
NFI:
NX=NX()
NFI=NFI(r-r*)
 = real exchange rate
r*= interest rate of foreign countries
Exchange Rate -- A Determinant of Trade Balance (Current Account) NX
Nominal Exchange Rate
Relative price of two currencies.
This can be expressed as the amount of foreign currency that can be bought with $1. (Or the amount
of dollars that can be bought with one German Mark or one British Pound.)
-- Depreciation or Appreciation of the dollar: Decrease or increase in the exchange rate
-- Exchange Rate System: Floating, or Fixed, or Managed (or Dirty) Floating
-- Spot or Forward Exchange Rate
Real Exchange Rate (Terms of Trade)
Relative price of goods in two countries. This is expressed as the number of bottles of French wine that
can be bought with one bottle of U.S. wine.
-- Real exchange rate depends on the nominal exchange rate and the prices of goods measured in
domestic currencies.
-- Let P dollars and P* Francs be the prices of the good measured in domestic currencies in each country.
Let e be the nominal exchange rate (number of Francs per dollar). If you give up one unit of the good
in the U.S., you get $P, which can be converted into eP Francs in the foreign exchange market. Then
you can buy eP/P* units of French good. Therefore, the real exchange rate (terms of trade) is
eP
 *
P
-- If the nominal exchange rate is fixed, an increase in the domestic price (P) increases the real
exchange rate, and an increase in the foreign price decreases the real exchange rate.
-- If the nominal exchange rate falls (dollar depreciates, dollar becomes weak), the real exchange
rate also falls.
Real Exchange Rate and Net Exports: NX = NX()
If the real exchange rate falls, foreign goods become relatively more expensive compared to the
domestic goods. This tends to reduce imports and increase exports, and hence the net exports increase.
If  rises, the converse holds. Thus, the net export (current account) has a negative relationship with .
Net Foreign Investment (NFI)
The NFI depends on the difference in returns of domestic asset and foreign asset.
If the difference r-r* rises, the NFI falls as domestic investors invest more on the domestic asset and
foreign investors also invest in the domestic country. Therefore, the NFI has a negative relation
with r-r*
The sensitivity of the NFI to a change in r-r* depends on how freely funds can flow from a country to
another country. We will consider two cases:
3
Perfect capital mobility: capital can flow freely from one country to another (no restrictions on
foreign investments)
Imperfect capital mobility: there are restrictions on foreign investment, or differences in the risk
(a) Perfect Capital Mobility -- If the rate of return from foreign assets is higher than the rate of return
from the domestic asset, risk neutral investors will put all their wealth into foreign asset. This will reduce
the yield of foreign asset. This process will continue until the rates of return from domestic and foreign
assets are equal, i.e., r=r*, where risk neutral investors become indifferent between the two assets.
-- Consider a small country that has a negligible effect on the world equilibrium interest rate r* at which
world savings equals world investment. For such a small country domestic interest rate will adjust to the
world interest rate. This can be considered as a perfectly elastic NFI(r-r*) function with respect to the
domestic interest rate r, given r*.
(b) Imperfect Capital Mobility -- Transactions cost, risk averseness of investors, government regulations
and other factors impede perfect capital mobility. The net foreign investment can be considered as a
decreasing function of the difference in the interest rates r-r*.
Equilibrium in Loanable fund market and foreign Exchange market
Equilibrium conditions:
Loanable fund market: S(Y,G,T)-I(r)=NX(

S(Y,G,T)=Y-C(Y-T)-G
Balance of Payment (foreign exchange market): NX(=NFI(r-r*)
Assumptions
(a) G, T, r* are exogenous.
(b) To simplify the analysis and to focus on the determination of r and , we will assume that Y is
predetermined, i.e., Y = ̅
Y. This assumption is usually justified by considering the production
sector, in which the output is determined by factor market equilibrium: equilibrium inputs of
labor and physical capital.
Under these assumptions, we find the equilibrium r and  Once these equilibrium values are found, other
endogenous variables I, NX and NFI are determined.
Since we assume that total output is predetermined, we are looking for how this total output is divided
among consumption, domestic investment, net export and foreign investment.
Under assumption (b), the national saving S is also predetermined, that is, it does not depend on r nor on

̅ = S̅
̅−T
̅) − G
Y=̅
Y ⇒ S=̅
Y − C(Y
4
Small Open Economy with perfect capital mobility and risk neutrality
We have argued that, under perfect capital mobility, r=r* and NFI(r-r*) is perfectly elastic with respect to
the domestic interest rate r, given world interest rate r*. Therefore,
NFI = S̅ − I(r ∗ )
The real exchange rate is then determined in the foreign exchange market
𝑁𝑋(𝜖) = 𝑁𝐹𝐼 = 𝑆̅ − 𝐼(𝑟 ∗ )
Following graphs illustrate these processes.
S
r

NFI
NFI
r0 = r*

0
A

NFI 
I(r)
0
I0
S0
NX(
)
I, S,NFI
0
NX 0
NX,,NFI
Notes:
(i) In a closed economy without international capital flow, the domestic interest rate will be
determined at point A, where savings equal investment. The domestic interest rate at point A is
below world interest rate, which will cause the outflow of capital and raises the interest rate to
world interest rate.
(ii) At the equilibrium, this economy has a trade surplus (NX>0), which is matched by the equal
amount of NFI.
(iii) If NX()>NFI at any exchange rate  , the demand for dollars is greater than the supply of dollars
in the exchange market, and this pushes  down, and vice versa. The real exchange rate  can
change if either the nominal exchange rate e, or domestic price P, or foreign price P* changes.
Typically, it is the nominal exchange rate that changes in a clean floating system.
Policy Effects - Small Open Economy
Consider a small open economy whose current equilibrium is at r0=r*, I0, S0, NFI0 and 0 in the figures
above. We analyze the effects of changes in G, T, and other exogenous variables on the endogenous
variables.
[A] The Effect of an Increase in Government Purchase G
An increase in G by G reduces the public saving by the same amount, while private saving is
unchanged in the current model. This shifts the savings curve S̅ to the left by G.
5
r
Effect of an Increase in G


S
S
Effect of an Increase in G

0
1
NFI1
NFI0
G
——
G
——

1
NFI
r1=r0=r*

0
I(r)
0
I0=I1 S1
S0
NX(
)
I, S,NFI
0
NX 1 NX 0
NX,,NFI
In a small open economy, interest rate does not change r1=r0=r*, and hence investment is not
affected (I1=I0). The trade surplus is reduced from NX0 to NX1, and capital outflow is also reduced from
NFI0 to NFI1, and the real exchange rate has increased from 0 to 1.
An increase in G reduces S ⇒ excess demand for loanable fund ⇒ pushes domestic interest rate r up ⇒
⇒ reduce foreign investment and/or increase reverse foreign investment, and I decreases
⇒ domestic interest rate falls back to the initial rate which is r * and I rises back to the initial level.
⇒ the net effect is a decrease in NFI
⇒ a lower NFI reduces demand for foreign currency ⇒ value of foreign currency drops
⇒ nominal exchange rate rises ⇒ real exchange rate rises
[B] The Effect of an Increase in Tax T
An increase in tax by T reduces the disposable income (Y-T) by T, which reduces the consumption
C by C=MPCxT. This increases the national saving S by S=MPCxT, which shifts the S curve to the
right by S=MPCxT. In a closed economy this reduces the equilibrium interest rate and increases
investment by S. In a small open economy, the equilibrium interest rate stays the same at r* and hence
investment is not affected. There is an increase in trade surplus (current account surplus) and an increase
in capital outflow (NFI) to other countries. The real exchange rate  decreases.
[C] The Effects of Increases in G and T by the same amounts (G=T): Balanced Budget Effect
An increase in G by G reduces the national saving: S = -G.
An increase in T by T increases the national saving: S = MPCxT.
Net effect on the national saving: S = -G + MPCxT = -(1-MPC)G.
Since MPC<1, net national saving is lower. The net effect is similar to the case of an increase in G, except
that magnitudes of the effects are smaller in this case.
[D] The Effects of an Increase in Autonomous Investment: Shift-Out of the Investment Curve
In a closed economy, this increases the interest rate and reduces the non-autonomous investment;
these two effects exactly offset each other. At the new equilibrium in a closed economy, the interest rate
is higher and the investment is the same as before. This is because the supply of loanable funds is fixed at
𝑆̅
6
In a small open economy, a shift out of the investment schedule does not affect the equilibrium
interest rate, reduces trade surplus and NFI. The real exchange rate  increases.
[E] A Fiscal Expansion Abroad
When foreign governments increase their government purchases, it reduces world saving and hence
increases world interest rate r*. This reduces domestic investment, increases trade surplus and NFI. The
real exchange rate  decreases. Show this in the graphs.
[F] Protectionist Trade Policies (Import Tariffs and/or Import Quotas)
They initially increase NX by reducing imports and/or increasing exports at any exchange rate, which
implies a right-ward shift of the NX curve. But this raises  until NX=NFI again. A higher  means a
smaller export and hence, the international trade volume falls. There is a loss in the benefits from trade,
although a certain group benefits from the trade restrictions.
As long as the trade policies do not affect the capital account, the current account is not affected
under the floating exchange rate system.
̅
[G] The Effect of an Increase in income 𝒀
̅
An increase in income by 𝑌 increases the national saving S by S=(1-MPC)x𝑌̅, which shifts the S
curve to the right. In a closed economy this reduces the equilibrium interest rate and increases investment
by S. In a small open economy, the equilibrium interest rate stays the same at r* and hence investment is
not affected. There is an increase in trade surplus (current account surplus) and an increase in capital
outflow (NFI) to other countries. The real exchange rate  decreases.
Remarks on Determinants of the Nominal Exchange Rate
𝑒𝑃
𝑃∗
𝜖𝑃∗
𝑃
Real Exchange Rate:
𝜖=
Nominal Exchange Rate:
e=
-- Given the real exchange rate, the nominal exchange rate falls as domestic price rises and/or foreign
price falls.
-- Changes in over time: %∆𝑒 ≈ %∆𝜀 + %∆𝑃∗ − %∆𝑃
-- If the foreign country has a higher inflation rate than the U.S., then the nominal exchange rate rises
at the rate of the difference in the inflation rates. That is, dollar becomes more valuable.
Purchasing Power Parity -- International arbitrage
-- Prices of traded goods should be the same everywhere, after adjusting for customs duties and
transportation costs. That is, the real exchange rate must be equal to 1.
𝜖=
𝑒𝑃
𝑃∗
=1
-- If <1, then P < P*/e. Arbitragers will buy in the U.S. paying price P and sell it in France at P*
Francs, which will converted into P*/e dollars in the exchange market. This gives per unit profit
of (P*/e - P) dollars, assuming no other costs involved.
-- Is PPP valid? Issues of non-traded goods and services and heterogeneity of goods and services.
7
Imperfect Capital Mobility
The net foreign investment function NFI(r-r*) is not perfectly elastic at the world interest rate r*. The
figure on the left hand side below shows the downward sloping NFI curve, passing through r* point, and
the horizontal sum of I and NFI curves (I+NFI).
S
r

NFI
r*

0
r0
I+NFI
NFI(r-r*)
I(r)
0
I0
NX(
)
I, S,NFI
S0
0
NX 0
NX,,NFI
The domestic equilibrium interest rate is determined at r0 where 𝑆̅ = 𝐼 + 𝑁𝐹𝐼. At r=r0, I=I0 and
𝑁𝐹𝐼 = 𝑆̅ − 𝐼. Given this NFI, the real exchange rate is determined at 0 where NX(0)=NFI.
Comparative Statics -- Analyze the effects of changes of exogenous variables as above for this case.
(a) Effects of an Expansionary Domestic Fiscal Policy: increase in G
𝑆̅ line shifts to the left  r  I and NFI   and NX
(b) Effects of an Increase in Autonomous Investment
As I curve shifts to the right, I+NFI line also shifts to the right by the same distance. The new I curve
and the new I+NFI curve cross each other at r=r*. The equilibrium domestic interest rate rises to r1,
which reduces NFI. The shift of NFI in the right hand side figure (see below) shows an increase in 
to 1 and a decrease in NX to NX1. An increase in autonomous investment will increase I if r does not
change. An increase in the equilibrium r partially offsets the initial increase in I. The net effect is an
increase in I to I1. To summarize:
S
r

NFI


1
r*
r1
r0

0


I+NFI
NFI(r-r*)
I(r)
0
I 0 I 1 S0
r, I, NFI,  and NX
NX(
)
I, S,NFI
0
NX 1 NX 0
NX,,NFI
8
(c) Effects of a Fiscal Expansion Abroad: An increase in world interest rate r*
S
r

NFI
r1*

r0*

0
c
r1
r0
a
b


1

I+NFI
NFI(r-r*)
I(r)
0
I1 I0
S0
NX(
)
I, S,NFI
0
NX 0 NX 1
NX,,NFI
An increase in the world interest rate r* from 𝑟0∗ to 𝑟1∗ shifts the NFI(r-r*) curve to the right. The
new NFI curve crosses the vertical axis at 𝑟1∗ . The shift of the NFI line also shifts the I+NFI line
to the right by the same horizontal distance as the shift of the NFI line. The new equilibrium
domestic interest rate is r1 where 𝑆̅ is equal to the new I+NFI. The increase in r reduces the
domestic investment I to I1. The decrease in I implies an increase in NFI because 𝑁𝐹𝐼 = 𝑆̅ − 𝐼.
This can also be seen from the left figure. A shift of NFI line indicates that the NFI increases
from point a to b if r stays the same at r0. However, an increase in r to r1 reduces the NFI to point c,
partially offseting the initial increase of the NFI. This increase in NFI reduces the real exchange rate 
to 1. To summarize,
r, I, NFI,   and NX.
(d) Effects of Protectionist Trade Policies:
This simply shifts the NX line to the right, and hence the real exchange rate  rises. There are no
other effects on the endogenous variables.
9
Alternative Approach
The analysis above requires two graphs to determine the equilibrium and the effects of changes in
exogenous variables. It could be useful if we can construct one graph to do the same.
The equilibrium conditions in goods and service market and foreign exchange market are
̅ + NX(ϵ)
̅
̅−T
̅) + I(r) + G
G&S market:
Y = C(Y
*
FX market:
NX(𝜖=NFI(r-r )
We need to find the interest rate r and the exchange rate  that satisfy the equilibrium conditions in
both markets for given exogenous variables.
We will first find all possible pairs of r and  that satisfy the equilibrium condition in the G&S market.
Suppose that (r1, 1) at point A in the figure below satisfies the G&S market equilibrium condition. If the
interest falls to r2<r1 and the exchange rate stays at 1 (i.e., point B), there will be an excess demand for
goods and services because the investment demand is higher. What must happen to  to restore the
equilibrium? Should it be higher or lower than 1? Since NX is negatively related to , the exchange rate
must increase to reduce the demand and thereby restore the equilibrium. That is, the new equilibrium
exchange rate 2 at interest rate r2 must be higher than 1. This line of reasoning indicates that the
collection of all pairs of interest rate and exchange rate that will clear the G&S market will form a
negatively sloped line as shown by the line GSE in the figure below.
r
r
GSE
GSE
FXE
r1
•A
r2
•B
ESG EDF


EDG EDF
r0


FXE
ES


G
ESF
r4
r3
•F


•H
EDG ESF


1 
3
2 
4
0


The same type of logics indicates that the collection of all pairs of r and  that will clear the FX market
will form a positively sloped line. An increase in  from 3 to 4 reduces NX (demand for dollars by foreign
importers). To restore the equilibrium in the FX market, NFI must also fall (i.e., supply of dollars through
NFI must fall). This requires an increase in domestic interest rate r so that domestic investors' foreign
investment falls and/or foreign investors' investment in the U.S. rises.
The equilibrium interest rate r0 and exchange rate 0 are determined where the two equilibrium lines
intersect each other. The right hand side figure indicates the market conditions when the economy is not
at equilibrium. The arrows indicate the adjustments of r and : if the G&S market is out of equilibrium the
interest rate adjusts, and if FX market is out of equilibrium the exchange rate adjusts.
10
Comparative Statics
(a) Effects of an Expansionary Domestic Fiscal Policy
An increase in G or a decrease in T shifts the GSE line to the right/upward. This is because an increase in
G creates an excess demand and interest rate must increase to offset the excess demand by reducing the
investment (or the exchange rate must increase to reduce NX). Thus, the equilibrium r and  increase and
thereby reduce I and NX. An increase in r also reduces NFI. The change in I and NX must sum to the
change in G.
To trace the responses of r and  to an increase in G, we will assume that
any disequilibrium (either excess demand or excess supply) in the G&S market will make r to change
to restore the equilibrium
any disequilibrium (either excess demand or excess supply) in the FX market will make  to change to
restore the equilibrium
EDGS and ESGS: Excess demand for and excess supply of goods and services
EDFX and ESFX: Excess demand for and excess supply of dollars in foreign exchange market
Starting from an initial equilibrium
G↑ EDGS r↑  I↓ EQGS
NFI ↓ EDFX 𝜖 ↑  NX↓ EQFX
ESGS
ESGS r↓  I↑ EQGS
NFI ↑ ESFX 𝜖 ↓ NX↑ EQFX
EDGS
This process continues until both markets reach a new equilibrium.
r
GSE 1
FXE
GSE 0
r1
r0


 



0
1

(b) Effects of an Increase in Autonomous Investment
This also shifts the GSE line upward, causing an increase in r and , and reducing NX and NFI. What
about the investment? An increase in r offsets the initial increase in autonomous investment, but the net
11
effect is an increase in I. This is because the net change in I and the change in NX must sum to zero to
maintain the GS market equilibrium.
(c) Effects of a Fiscal Expansion Abroad: An increase in world interest rate r*
This increases the NFI which creates an excess supply of dollars in the FX market. To restore the
equilibrium in the FX market, the exchange rate must decrease which will increase NX and thereby the
demand for dollars. Or the domestic interest rate must increase to match the increase in foreign interest
rate. This indicates that the FXE line must shift to the left/upward. The equilibrium r increases and the
equilibrium  falls. Hence, NX rises, investment falls, and NFI increases. The increase in NFI indicates
that the domestic interest rate does not rise as much as the foreign interest.
(d) Effects of Protectionist Trade Policies
This shifts both GSE and FXE lines to the right. The horizontal distances of the shifts are identical.
(Why?) Therefore, there is no change in r and  rises. The increase in  reduces NX back to the initial level.
Magnitude of the Effects
Consider two countries which are identical except for the interest elasticity of investment. What is the
difference in the effect of an expansionary fiscal policy between the two countries?
To answer this question, we need to know the difference in the GSE line and the difference in its shift in
response to an increase in G between the two countries. Let the interest elasticity of investment be
denoted by 𝜃.
𝜃= interest elasticity of investment
Difference in the slope of the GSE line
A decrease in r by ∆r increase in I by ∆I
∆I is greater if 𝜃 is higher: ∆IH > ∆IL
The excess demand for G&S caused by falling r is greater in a country with a higher 𝜃
To restore the equilibrium in the G&S market, the exchange rate 𝜖 must increase more in a country
with a higher 𝜃.
Therefore, the GSE line is flatter in a country with a higher 𝜃.
Difference in the shift of the GSE line as G increases
We can consider the shift as a horizontal shift or a vertical shift. A horizontal shift means an increase in
the exchange rate while holding the interest rate r constant, and the vertical shift means an increase in the
interest rate while holding the exchange rate ∈ constant.
Consider first the horizontal shift
Does an increase in G shift the GSE line horizontally by the same distance or by different distances
between the two countries of different interest elasticity of investment?
Answer: An increase in G by ∆G creates excess demand in the G&S market by that much. To restore
the equilibrium while holding the interest rate constant, the exchange rate must rise by a sufficient
amount to reduce NX by ∆G. Since the exchange rate elasticity of NX is the same between the
two countries, the exchange rage must rise by the same amount. That is, an increase in G shifts
the GSE line horizontally by the same distance in both countries.
Consider the vertical shift
12
An increase in G by ∆G creates excess demand in GS market by that much. To restore the equilibrium
while holding the exchange rate constant, r must rise by a sufficient amount to reduce I by ∆G.
Which country will have to raise r more to restore the GS market equilibrium without changing
exchange rate?
A high interest elasticity of investment means that investment falls (rises) a lot when interest rate rises
(falls). If the elasticity is high, we don't have to raise r a lot to reduce I by ∆G. Therefore, the
interest rate must rise more in a country with a lower interest elasticity of investment. That is, the
GSE line shifts more in a country with a lower interest elasticity when G increases.
Note: A similar reasoning leads to the conclusion that an increase in G shifts the GSE line to the right by
a larger amount when the exchange rate elasticity of net export is lower.
The figure below shows two GSE lines of high and low interest elasticity of demand and their shifts when
G increases. It shows that GSE lines shift to the right by the same distance, which leads to different
effects on the equilibrium r and . Interest rate and exchange rate rise more in a county of a lower 𝜃.
Therefore, Investment falls more and NX falls more in a country of a lower 𝜃.
r
GSE L
FXE
GSE H
r1L
r1H
r0
•

0

13
The role of the exchange rate elasticity of NX
Suppose that two countries are identical except for the exchange rate elasticity of net export. This
difference affects both the GSE and the FXE lines. Let this elasticity be denoted by 𝛿.
𝛿= exchange rate elasticity of net export
Using the same line of thought as before, it is straightforward to show
GSE line: steeper for the country with a higher 𝛿
FXE line: steeper for the country with a higher 𝛿
The figure below shows different effects of an increase in G between two countries of nonidentical
exchange rate elasticity of NX. Note that the vertical shifts of GSE lines are identical because we assume
here that the interest elasticity of investment is the same between two countries.
The equilibrium exchange rate rises less in the country with a higher 𝛿. But the effect on the equilibrium
interest rate is uncertain though the figure below shows a little higher r in the country with a higher 𝛿.
r
GSE 1H
GSE 0H
FXE H
•
FXE L
r1H
r0
GSE 1L
GSE 0L

0 
1H 
1L

Exercises
Conduct various comparative static analyses when two countries are identical except for
(1) interest elasticity of investment
(2) exchange rate elasticity of net export
(3) interest elasticity of net foreign investment
14
A special case - perfectly elastic NFI
The slope of the FXE line depends on the elasticity of NFI with respect to r. If NFI is very sensitive to a
change in r, the slope of FXE line becomes flatter. In the extreme case of perfectly elastic NFI, the FXE
line becomes flat at r=r*. This is the case of perfect capital market. Any factor that shifts the GSE
line upward (to right) will increase the exchange rate and reduce NX, but has no effect on
domestic interest rate.
r
Perfectly elastic NFI
GSE0
GSE1
r*
FXE

0

1

15
Alternative Consumption Function: C=C(Y-T, r)
The equilibrium conditions in goods and service market and foreign exchange market are
̅ + NX(ϵ)
̅ = C(Y
̅−T
̅, 𝑟) + I(r) + G
G&S market:
Y
*
FX market:
NX(𝜖=NFI(r-r )
Case 1. Perfect capital mobility and risk neutrality
NFI(r-r*) is perfectly elastic with respect to the domestic interest rate r, given world interest rate r* and
hence, r=r*. Therefore, the only remaining variable is the exchange rate. This is determined in the G&S
market equilibrium condition.

r
NFI
S
NFI
r0 = r*

0
A

NFI 
NX(
)
I(r)
0
I0
S0
I, S,NFI
0
NX0
NX, NFI
Case 2. Imperfect capital mobility
The equilibrium line FXE is the same as the line we discussed earlier.
The equilibrium line GSE is essentially the same as the line we discussed earlier. The difference is the
slope of GSE. The GSE line is flatter when the consumption is negatively related with r than when C
is not related with r. This can be explained by following the same line of thought.
Suppose that (r1, 1) satisfies the G&S market equilibrium condition. If the interest falls to r2<r1 and the
exchange rate stays at 1 (i.e., point B), there will be an excess demand for goods and services. The size of
the excess demand is greater when C depends on r than when C does not depend on r. This is because not
only the investment demand is higher, but also the consumption demand is higher as r falls. Therefore, 
 must increase more now than when C does not depend on r. This leads to a flatter GSE line.