Written Assignment 4 1. Savings equals domestic investment plus capital outflow; so when I save a dollar of income, that dollar can be used for finance in domestic capital or capital abroad. 2. Purchasing power parity (PPP) can be described as the ability to buy a product anywhere in the world for the same price. According to the law of one price, a good must have equal monetary value anywhere in the world. Without this theory opportunistic individuals would use to opportunity to profit through exploitation, which would be arbitrage. For example, if DVDs cost $20 in Portland, Oregon and $10 in Philly, what would stop me from buying the DVDs locally and shipping them to Oregon? I would make a great profit.
There are two factors that would prevent PPP from being true. The first is that many goods are not easily traded, such as a lawn mowing business. The other is that substitutes are not always perfect when manufactured in different countries, such as automobiles made in the US and Japan, because of the value consumers place on the products. 3. The market for loanable funds and the foreign money exchange are both central to macroeconomics of open economies. First, the real interest rate adjusts to equilibrium between the supply and demand for loanable funds. The supply of loanable funds comes from national savings, and the demand comes from domestic investments and net capital outflow.
Second, the balance between the supply and demand of dollars happens when the real exchange rate adjusts. In the exchange rate the supply of dollars comes from the net capital outflow and the demand for dollars are represented by net exports. These markets are linked by net capital outflow because this variable represents the demand of loanable funds and the supply for dollars in for the money exchange. 4. Capital flight happens when a large amount of funds