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* * PPP implies that the cost of a basket of goods (even a basket with just one good, like a Big Mac or a latte) should be the same across countries. e P = the foreign-currency cost of a basket of goods in the U.S., while P* the cost of a basket of foreign goods. PPP implies that the baskets cost the same in both countries: eP = P*, which implies that e = P*/P. * Revisiting our model, this implies that the NX curve should be horizontal at ? = 1. Intuition for the horizontal NX curve: Under PPP, different countries’ goods are perfect substitutes, and international arbitrage is possible. If the relative price of U.S. goods falls even a tiny bit below 1, then there’s a profit opportunity: buy U.S. goods and sell them abroad. Hence, the tiniest drop in the U.S. real exchange rate causes a massive increase in NX. Similarly, if the relative price of U.S. goods rises even a tiny amount above 1, then it is profitable to buy foreign goods and sell them in the U.S., so this arbitrage causes a massive increase increase in imports---and decrease in NX. Thus, under PPP, the real exchange rate equals 1 regardless of net capital outflows S-I. Changes in S or I have no impact on the real exchange rate. * * * This is a continuation of the case study begun in Chapter 3 (both the textbook and slides 49-51 of the PowerPoint presentation). It is placed here to motivate the last topic of the text: the U.S. as a large open economy. As we saw in chapter 3, the closed economy model correctly predicted that national saving would fall and the interest rate would rise. But, the closed economy model predicted that investment would fall as much as saving; actually, investment fell by much less than saving. Also, the closed economy model by definition could not have predicted the effects on the trade balance or exchange rate. The small open economy model correctly predicted what would happen to NX and the real exchange rate, but incorrectly predicted that the inte
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