N. Gregory Mankiw & Mohamed H.

Rashwan

Principles of
Economics Arab World Edition

Chapter 33
- A Macroeconomic Theory of
the Open Economy
To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3rd edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
In this chapter, look for the answers to these
questions:

 In an open economy, what determines:

 the real interest rate?
 the real exchange rate?
 How are the markets for loanable funds and
foreign-currency exchange connected?

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To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3 edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
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INTRODUCTION
 The previous chapter explained the basic concepts
and vocabulary of the open economy:
net exports (NX), net capital outflow (NCO),
and exchange rates.
 This chapter ties these concepts together into a
theory of the open economy.
 We will use this theory to see how government
policies and various events affect the trade balance,
exchange rate, and capital flows.
 We start with the loanable funds market…

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To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3 edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
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SUPPLY & DEMAND FOR LOANABLE
FUNDS AND FOR FOREIGN CURRENCY
EXCHANGE
 To understand the forces at work in an open
economy we need to focus on the supply and
demand in two markets.
 The market for loanable funds.
 Is the market that coordinates the economy’s
savings, investment and net capital outflow.
 The market for foreign currency exchange.
 This coordinates those who wish to exchange
domestic for foreign currencies.

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To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3 edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
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The Market for Loanable Funds
 An identity from the preceding chapter:
S = I + NCO
Saving Net capital
Domestic
outflow
investment
 Supply of loanable funds = saving.
 A dollar of saving can be used to finance
 the purchase of domestic capital.
 the purchase of a foreign asset.
 So, demand for loanable funds = I + NCO
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To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3 edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
rd
The Market for Loanable Funds
 Recall:
 S depends positively on the real interest rate, r.
 I depends negatively on r.
 What about NCO?

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To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3 edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
rd
 How NCO Depends on the Real Interest Rate

The real interest rate, r,

is the real return on
Net capital outflow
domestic assets. r
A fall in r makes domestic
assets less attractive
r1
relative to foreign assets.
 People purchase more r2
foreign assets.
 People abroad purchase NCO
fewer of your country’s
NCO
assets. NCO1 NCO2
 NCO rises.
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To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3 edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
rd
The Loanable Funds Market
Diagram
r adjusts to balance supply
and demand in the LF market.
Loanable funds
r
S = saving
Both I and NCO
depend negatively on r,
r1
so the D curve is
D = I + NCO downward-sloping.

LF

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To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3 edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
rd