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In the book 'Economics' by Mankiw and Taylor the demand and supply curves on the foreign-currency exchange market are shown as follows:

the foreign-currency exchange market

The supply equals the Net Capital Outflow (NCO). I would have assumed that the exchange rate influences NCO in the same way it influences imports and exports, for example a higher exchange rate makes it more profitable to invest abroad than domestically, leading to an increased NCO. However, the supply isn't influenced at all by the exchange rate according to Mankiw and Taylor and that's what I don't understand.

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Because the supply of pounds in the model is controlled and fixed by the central bank. The central bank does not have to change (increase) the supply of pounds when the exchange rate changes. So the supply of pounds will be just a flat vertical line because no matter what the exchange rate is the supply of pounds will not respond to exchange rate as it is given by the central bank's monetary policy.

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  • $\begingroup$ So the supply of currency in the foreign-currency exchange market is the same as the supply on the domestic money market? How does the Net Capital Outflow enter the picture then? $\endgroup$ – Jocka G Jan 4 at 13:10
  • $\begingroup$ @JockaG what do you mean? Central bank is the sole supplier of money in the economy some of it ends up on forex market. $\endgroup$ – csilvia Jan 4 at 13:23
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    $\begingroup$ Ok, I think I am a bit confused... I thought there were different money markets, one domestic one where the price is determined by an interest rate, and the other being the foreign-currency exchange market with the exchange rate as a price. Otherwise I am not sure what Mankiw and Taylor mean by saying that NCO determines the supply on the forex. $\endgroup$ – Jocka G Jan 4 at 14:41
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The authors assume that the capital outflow is exogenous, i.e. not affected by the current exchange rate. Here's why (from a U.S. point of view):
If I want to invest money in Mexico, then I want to know how much money I get back after one year. That is determined by: the rate of return in Mexico (in pesos); and how much the peso/$ rate changes. Regarding the latter, it doesn't matter what the current exchange rate is; what matters is how much it will change in the coming year.

Of course, no one can predict exchange rate changes (similarly a rate of return usually can't be predicted, except for safe bonds). But those aren't relevant, because your chart simply shows that capital flows are not a function of the current exchange rate.

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