The interest rate in a small open economy can differ from the world interest rate because of:country risk and expectations of future exchange-rate changes.perfect capital mobility and purchasing power parity.currency boards and monetary unions.dollarization and speculative attacks.

Exchange rates and the open economy

Chapter 14 showed how the exchange rate between currencies depends ontwo factors, the interest that can be earned on deposits of those currenciesand the expected future exchange rate. To understand fully thedetermination of exchange rates, however, we have to learn how interest ratesthemselves are determined and how expectations of future exchange rates areformed. In this and the next two chapters we examine these topics by building aneconomic model that links exchange rates, interest rates, and other importantmacroeconomic variables such as the inflation rate and output.The first step in building the model is to explain the effects of a country’smoney supply and of the demand for its money on its interest rate and exchangerate. Because exchange rates are the relative prices of national monies, factorsthat affect a country’s money supply or demand are among the most powerfuldeterminants of its currency’s exchange rate against foreign currencies. It istherefore natural to begin a deeper study of exchange rate determination with adiscussion of money supply and money demand.Monetary developments influence the exchange rate by changing both inter-est rates and people’s expectations about future exchange rates. Expectationsabout future exchange rates are closely connected with expectations about thefuture money prices of countries’ products; these price movements, in turn,depend on changes in money supply and demand. In examining monetaryinfluences on the exchange rate, we therefore look at how monetary factorsinfluence output prices along with interest rates. Expectations of future ex-change rates depend on many factors other than money, however, and thesenonmonetary factors are taken up in the next chapter.Once the theories and determinants of money supply and demand are laidout, we use them to examine how equilibrium interest rates are determined bythe equality of money supply and money demand. Then we combine our modelof interest rate determination with the interest parity condition to study theeffects of monetary shifts on the exchange rate, given the prices of goods andservices, the level of output, and market expectations about the future. Finally,we take a first look at the long-term effects of monetary changes on outputprices and expected future exchange rates.

Consider a small open economy that takes the world real interest rate as given. Suppose the world real interest rate is less than the country’s autarky real interest rate. Which of the following is TRUE?  Domestic saving exceeds domestic investment   There is capital outflow   There is excess demand for capital   None of the other options

Evidence from the United States from 1973 to 2016 shows there is a correlation between nominal interest rates and changes in exchange rates.a.not even close to the relationship between changes in exchange rates and government spending.b.not at all similar to the relationship between governmental deficits and changes in exchange rates.c.a lot closer than the relationship between changes in real interest rates and exchange rates.d.not even close to the relationship between changes in real interest rates and exchange rates.

In a small open economy with a floating exchange rate, how does the exchange rate respond to various fiscal and monetary policies?A.The exchange rate will depreciate if the government implements a contractionary fiscal policyB.The exchange rate will depreciate if the government implements an expansionary fiscal policyC.The exchange rate will depreciate if the central bank implements a contractionary monetary policyD.The exchange rate will depreciate if the central bank implements no monetary policy