Graph Assignment 1- CH32 OPEN ECONOMY

a. The demand for dollars in the foreign-currency market will be affected.

Explanation: Since the tariffs are imposed on imported goods, it will definitely impact imports. As net exports are equal to ‘exports – imports,’ net exports will also be affected. Finally, as net exports are the source of demand for dollars in the foreign-currency exchange market, we can predict that the demand curve in the foreign-currency exchange market will be affected.

 

 

b. The tariff makes imported goods more expensive. As a result, Americans will import less; the imports will decrease at any given real exchange rate. Consequently, net exports will (temporarily) increase for any given real exchange rate. Since foreigners need dollars to buy U.S. American net exports, the increase in net exports will lead to the increase of demand for dollars in the foreign-currency exchange market. This increase is represented as the shift from D₁ to D₂ in the graph below.

 

 

c. The loanable fund market and the net capital outflow will not have any changes. In the foreign exchange market, the demand for dollars will rise (D₁ to D2), leading to the appreciation of the dollar (E₁ to E₂). Since the initial increase in net exports becomes offset, the increase of the real exchange rate will be the only difference in the new equilibrium.

Explanation: Since no event has occurred in the loanable fund market, the real interest rate will not change. Since the real interest rate has not changed, the net capital outflow will also be the same. Finally, since the net capital outflow stays the same and since the net capital outflow should equal net exports, there will be no changes in net exports. The initial increase in net exports, explained in the answer of question b, will be offset as the appreciation of the real exchange rate will encourage imports and discourage exports. Thus, the only difference in the equilibrium is the increase of the real exchange rate.

(Graph below.)