Question

In an open economy, why is the supply curve in the foreign-currency exchange market vertical?

• Net capital outflow is determined by real GDP, not the real exchange rate.
• Net capital outflow is extremely sensitive to small changes in the real exchange rate.
• Net capital outflow is determined by the real interest rate, not the real exchange rate.
• Net capital outflow equals net exports.

Answer 1

The supply curve is vertical because Net capital outflow is determined by the real interest rate not the real exchange rate. Real exchange rate is determined by the supply & demand for foreign currency exchange . The supply of dollars to be exchanged into foreign currency comes from net capital outflow because net capita outflow doesnot depend on the exchange rate.

Answer 2

Answer: 3^rd option

Net capital outflow (NCO) is the net amount of money invested abroad, means the supply of dollar in foreign countries. Such outflow doesn’t depend on real exchange rate but depends on real interest rate (domestically) – if the domestic real interest rate is high, saving money at home would be more profitable than in abroad.

Therefore, NCO is inversely related with domestic real interest rate – the NCO curve becomes downward slopped from left to right. But, this curve is perfectly inelastic or vertical in relation to real exchange rate, establishing a non-relation.