Supply and Demand for Loanable Funds

and for Foreign-Currency Exchange

The Market for

Loanable Fund

Supply of loanable Demand for loanable

funds funds

From national saving (S) From domestic investment (I) and

Net capital outflow (NCO)

At the equilibrium interest rate, the amount that people want to save exactly balances the desired
quantities of domestic investment and net capital outflow.

The Market for Foreign-

Currency Exchange

Supply of foreign-currency Demand for foreign -

exchange currency exchange

Net capital outflow Net exports

Equilibrium in the Open Economy

Net Capital Outflow: The Link

between the Two Markets
 Simultaneous Equilibrium in
Two Markets

How Policies and Events Affect an Open

Economy

Government Budget
Deficits

When government spending exceeds government revenue.

A government budget deficit represents negative public saving, it reduces national saving (the sum
of public and private saving). Thus, a government budget deficit reduces the supply of loanable
funds, drives up the interest rate, and crowds out investment.

In an open economy, government budget deficits raise real interest rates, crowd out domestic
investment, cause the currency to appreciate, and push the trade balance toward deficit.
 Trade Policy

A government policy that directly influences the quantity of

goods and services that a country imports or exports

Trade policy takes various forms: -

1) One common trade policy is a tariff, a tax on imported goods.

2) Another is an import quota, a limit on the quantity of a good produced abroad that can be sold
domestically.

- Trade policies do not affect the trade balance.

 Political Instability and
Capital Flight

- Political instability leads to Capital Flight

- Capital Flight is large and sudden reduction in the demand for assets
located in a country