THE MACROECONOMICS OF OPEN ECONOMIES

open economy an economy that interacts freely with other economies around the world

factors that might influence a country’s exports, imports, and net exports
• The tastes of consumers for domestic and foreign goods
• The prices of goods at home and abroad
• The exchange rates at which people can use domestic currency to buy foreign currencies
• The incomes of consumers at home and abroad
• The cost of transporting goods from country to country
• Government policies toward international trade

net capital outflow: the purchase of foreign assets by domestic residents - the purchase of domestic
assets by foreigners

important variables that influence net capital outflow:

• The real interest rates paid on foreign assets
• The real interest rates paid on domestic assets
• The perceived economic and political risks of holding assets abroad
• The government policies that affect foreign ownership of domestic assets

net capital outflow (NCO) must always equal net exports (NX)

NCO = NX

When a nation is running a trade surplus (NX . 0), it is selling more goods and services to foreigners than
it is buying from them. It must be using it to buy foreign assets. Capital is flowing out of the country
(NCO . 0).

• When a nation is running a trade deficit (NX , 0), it is buying more goods and services from foreigners
than it is selling to them. It must be selling assets abroad. Capital is flowing into the country (NCO , 0).

Spending = C+I+G
Savings= Y-C-G

Savings= domestic investment(I) +net capital outflow(NCO)

nominal exchange rate the rate at which a person can trade the currency of one country for the currency
of another

real exchange rate the rate at which a person can trade the goods and services of one country for the
goods and services of another

real exchange rate = (Nominal exchange rate x Domestic price)/Foreign price

purchasing power parity: a unit of any given currency should be able to buy the same quantity of goods
in all countries

the law of one price. This law asserts that a good must sell for the same price in all locations.
if the purchasing power of the dollar is always the same at home and abroad, then the real exchange
rate—the relative price of domestic and foreign goods—cannot change.

According to the theory of purchasing-power parity, the nominal exchange rate between the currencies
of two countries must reflect the price levels in those countries

nominal exchange rates change when price levels change.

when the central bank prints large quantities of money, that money loses value both in terms of the
goods and services it can buy and in terms of the amount of other currencies it can buy

Yet the theory of purchasing-power parity is not completely accurate.

1. many goods are not easily traded
2. even tradable goods are not always perfect substitutes when they are produced in different countries.

Chapter 32 A Macroeconomic Theory of the Open Economy

the quantity of loanable funds supplied and the quantity of loanable funds demanded depend on the
real interest rate. A higher real interest rate encourages people to save and, therefore, raises the
quantity of loanable funds supplied. A higher interest rate also makes borrowing to finance capital
projects more costly; thus, it discourages investment and reduces the quantity of loanable funds
demanded.

at the equilibrium interest rate, the amount that people want to save exactly balances the desired
quantities of domestic investment and net capital outflow.
if the interest rate were above the equilibrium level, the quantity of loanable funds supplied would
exceed the quantity demanded. The surplus of loanable funds would drive the interest rate downward

A higher real exchange rate makes U.S. goods more expensive and reduces the quantity of dollars
demanded to buy those goods. The supply curve is vertical because the quantity of dollars supplied for
net capital outflow does not depend on the real exchange rate

changes in the exchange rate influence both the cost of buying foreign assets and the benefit of owning
them, and these two effects offset each other.

The real exchange rate moves to ensure equilibrium in this market. It adjusts to balance the supply and
demand for dollars just as the price of any good adjusts to balance supply and demand for that good.

if the real exchange rate were above the equilibrium level, the quantity of dollars supplied would exceed
the quantity demanded. The surplus of dollars would drive the value of the dollar downward

32-2 Equilibrium in the Open Economy

In the market for loanable funds, supply comes from national saving (S), demand comes from domestic
investment (I) and net capital outflow (NCO), and the real interest rate balances supply and demand.
In the market for foreign-currency exchange, supply comes from net capital outflow (NCO), demand
comes from net exports (NX), and the real exchange rate balances supply and demand.

How Net Capital Outflow Depends on the Interest Rate:

Because a higher domestic real interest rate makes domestic assets more attractive, it reduces net
capital outflow. Note the position of zero on the horizontal axis: Net capital outflow can be positive or
negative. A negative value of net capital outflow means that the economy is experiencing a net inflow of
capital.

A higher interest rate at home makes domestic assets more attractive, and this in turn reduces net
capital outflow

The real exchange rate does not affect net capital outflow, so the supply curve is vertical. The demand for
dollars comes from net exports. Because a depreciation of the real exchange rate increases net exports,
the demand curve for foreign-currency exchange slopes downward.

a government budget deficit reduces the supply of loanable funds, drives up the interest rate, and
crowds out investment.

Hence, 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

In the end, an import quota reduces both imports and exports, but net exports (exports minus imports)
are unchanged. This is due to a decrease in imports leading to an increase in the real exchange rate
casusing domestic goods to be priced higher than foreign so imports increase and exports dec causing no
change.

Trade policies do not affect the trade balance

NX = NCO = S - I.
Trade policies do not alter the trade balance because they do not alter national saving or domestic
investment. For given levels of national saving and domestic investment, the real exchange rate adjusts
to keep the trade balance the same

capital flight: a large and sudden reduction in the demand for assets located in a country