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Topic 10: A Macroeconomic Theory

of the Open Economy

PowerPoint Slides prepared by:


Andreea CHIRITESCU
Eastern Illinois University

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Macroeconomic Theory
of the Open Economy
Open Economies

An open economy is one that interacts


freely with other economies around
the world.

Key Macroeconomic Variables


in an Open Economy

The important macroeconomic variables


of an open economy include:
Net exports
Net capital outflow
Nominal exchange rate
Real exchange rate

What forces determine them and how are


they related to each other?

A Macroeconomic Theory
of the Open Economy
Basic Assumptions of a Macroeconomic
Model of an Open Economy
The model takes the economys GDP as
given.
The model takes the economys price
level as given.
The goal is to explain the trade balance and
exchange rates and how government
policies can affect them

The Market for Loanable Funds


and Foreign Currency Exchange

The model focuses on only two markets:


Supply and demand in the market for
loanable funds; coordinates saving,
investment, and the flow of loanable funds
abroad (NCO)
Supply and demand in the market for
foreign exchange

Market for Loanable Funds


In an open economy
S = I + NCO
Saving = Domestic investment + Net capital
outflow

Supply of loanable funds


From national saving (S)

Demand for loanable funds


From domestic investment (I)
And net capital outflow (NCO)
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Market for Loanable Funds


When NCO > 0
Net outflow of capital
Net purchase of capital overseas
Adds to the demand for domestically generated

loanable funds

When NCO < 0


Net inflow of capital
Capital resources coming from abroad
Reduce the demand for domestically generated

loanable funds
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Market for Loanable Funds


Loanable funds - interpreted as
Domestically generated flow of resources
available for capital accumulation

Purchase of a capital asset


Adds to the demand for loanable funds
Asset located at home: I
Asset located abroad: NCO

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Market for Loanable Funds


Higher real interest rate
Encourages people to save
Increases quantity of loanable funds supplied

Lower real interest rate


Discourages people from saving
Decreases quantity of loanable funds supplied

Supply curve for loanable funds slopes


upwards
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Market for Loanable Funds


Higher real interest rate
Discourages investment
Discourages Philippine residents from buying
foreign assets
Reduces Philippine net capital outflow

Encourages foreigners to buy Philippine assets


Reduces Philippine net capital outflow
Decreases quantity of loanable funds demanded

Demand curve for loanable funds slopes


downwards
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Market for Loanable Funds


Supply of loanable funds
Slopes upward

Demand of loanable funds


Slopes downward

At equilibrium interest rate


Amount that people want to save
Exactly balances the desired quantities of
domestic investment and net capital
outflow
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Figure 1
The Market for Loanable Funds
Real
Interest
Rate

Supply of loanable funds


(from national saving)

Equilibrium
real interest
rate

Equilibrium
quantity

Demand for loanable


funds (for domestic
investment and net
capital outflow)
Quantity of
Loanable Funds

The interest rate in an open economy, as in a closed economy, is determined by the


supply and demand for loanable funds. National saving is the source of the supply of
loanable funds. Domestic investment and net capital outflow are the sources of the
demand for loanable funds. At the equilibrium interest rate, the amount that people
want to save exactly balances the amount that people want to borrow for the purpose
of buying domestic capital and foreign assets.
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Foreign-Currency Exchange
The market for foreign-currency exchange
Identity: NCO = NX
Net capital outflow = Net exports

If trade surplus, NX > 0


Exports > Imports
Net sale of goods and services abroad
Philippine residents are holding foreign
currency or using it to buy foreign assets
Capital is flowing abroad, NCO > 0
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Foreign-Currency Exchange
If trade deficit, NX < 0
Imports > Exports
Foreigners are holding Philippine currency
Or using pesos to buy Philippine assets
Foreign capital is flowing into the Philippines

meaning Philippines is borrowing from


foreigners abroad
NCO < 0

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The Market for Foreign Exchange

Horizontal axis
Quantity of pesos exchanged into foreign
currency

Vertical axis
Real exchange rate

NCO = NX
Represents the two sides of the market for
foreign exchange
Supply and demand

The Market for Foreign Exchange

Supply of pesos for foreign exchange


Net capital outflow
Quantity of pesos supplied to buy foreign

assets
Need to exchange pesos for foreign currency
to buy foreign assets

Supply curve is vertical


Quantity of pesos supplied for net capital

outflow
Does not depend on the real exchange rate;
depends on real interest rate
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Foreign-Currency Exchange
Demand for pesos for foreign exchange
Net exports
Quantity of pesos demanded to buy Philippine net

exports of goods and services

Demand curve is downward sloping


A higher real exchange rate
Makes Philippine goods more expensive
Reduces the quantity of pesos demanded to buy

those goods

A lower real exchange rate


Makes Philippine goods cheaper
Reduces pesos demanded to buy those goods
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The Foreign Exchange Market


Equilibrium real exchange rate
Demand for pesos
By foreigners
Arising from Philippine net exports of goods &

services

Exactly balances supply of pesos


From Philippine residents
Arising from Philippine net capital outflow

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Figure 2
The Market for Foreign-Currency Exchange
Real
Exchange
Rate

Supply of pesos
(from net capital outflow)

Equilibrium real
exchange rate
Demand for pesos
(for net exports)
Equilibrium
quantity

Quantity of Pesos Exchanged


into Foreign Currency

The real exchange rate is determined by the supply and demand for foreign-currency exchange.
The supply of pesos to be exchanged into foreign currency comes from net capital outflow.
Because net capital outflow does not depend on the real exchange rate, the supply curve is
vertical. The demand for pesos comes from net exports. Because a lower real exchange rate
stimulates net exports (and thus increases the quantity of pesos demanded to pay for these net
exports), the demand curve is downward sloping. At the equilibrium real exchange rate, the
number of pesos people supply to buy foreign assets exactly balances the number of pesos
people demand to buy net exports.
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Equilibrium in the Open Economy


Recap
Identities
Market for loanable funds: S = I + NCO
Market for foreign-currency exchange:
NCO=NX

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Equilibrium in the Open Economy


Market for loanable funds
Supply comes from national saving
Demand comes from domestic investment
& net capital outflow
Equilibrium real interest rate, r, balances
demand and supply

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Equilibrium in the Open Economy


Market for foreign exchange
Supply comes from net capital outflow
Demand comes from net exports
Equilibrium real exchange rate, E,
balances supply and demand

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Equilibrium in the Open Economy


Net-capital-outflow curve
Link between
Market for loanable funds
Market for foreign-currency exchange

In the market for loanable funds


NCO is part of demand

In the foreign exchange market


NCO is a source of the supply of domestic

currency

Equilibrium in the Open Economy


Net-capital-outflow curve
Determined by the real interest rate
If domestic interest rates are high, owning

Philippine assets is attractive so NCO is low


If domestic interest rates are low, owning
foreign assets is attractive so NCO is high

Downward sloping with respect to


domestic real interest rates

Exhibit 3
How Net Capital Outflow Depends on the Interest Rate
Real
Interest
Rate

Net capital outflow 0 Net capital outflow Net Capital


Outflow
is negative
is positive

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.
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Figure 4
The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds
Real
Interest
Rate

Supply

(b) Net Capital Outflow


Real
Interest
Rate
r1

r1

Net capital
outflow, NCO

Demand
Quantity of
Loanable Funds
In panel (a), the supply and demand for
loanable funds determine the real interest
rate. In panel (b), the interest rate
determines net capital outflow, which
provides the supply of pesos in the market
for foreign-currency exchange. In panel (c),
the supply and demand for pesos in the
market for foreign-currency exchange
determine the real exchange rate.

Net capital outflow


Real
Exchange
Rate

Supply

E1
Demand
Quantity of Pesos
(c) The Market for Foreign-Currency Exchange

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Equilibrium in the Open Economy


Equilibrium real exchange rate, E
Price of domestic goods and services
Relative to foreign goods and services

E and r adjust simultaneously


To balance supply and demand
In both markets
Loanable funds
Foreign-currency exchange

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Equilibrium in the Open Economy


E and r adjust simultaneously
Determine
National saving
Domestic investment
Net capital outflow
Net exports

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Government Budget Deficits


Government budget deficits
When government spending exceeds
government revenue
Negative public saving
Reduces national saving
Reduces supply of loanable funds
Increase in interest rate
Reduces net capital outflow

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Government Budget Deficits


Government budget deficits
Crowd-out domestic investment
Decrease in supply of foreign-currency
exchange
Currency appreciates
Net exports fall
Push the trade balance toward deficit

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Exhibit 5

The Effects of a Government Budget Deficit


(b) Net Capital Outflow

(a) The Market for Loanable Funds


Real
Interest
Rate

r2
r1
2. . . . which
increases the
real interest
rate . . .

1. A budget deficit reduces the


supply of loanable funds . . .

S2
B

S1
A

Real
Interest
Rate

r2

3. . . . which in
turn reduces net
capital outflow.

r1
Demand

Quantity of Loanable Funds


When the government runs a budget deficit, it
reduces the supply of loanable funds from S1 to S2
in panel (a). The interest rate rises from r1 to r2 to
balance the supply and demand for loanable funds.
In panel (b), the higher interest rate reduces net
capital outflow. Reduced net capital outflow, in turn,
reduces the supply of pesos in the market for
foreign-currency exchange from S1 to S2 in panel
(c). This fall in the supply of pesos causes the real
exchange rate to appreciate from E1 to E2. The
appreciation of the exchange rate pushes the trade
balance toward deficit.

NCO
Real Exchange
Rate

E2
E1
5. . . . Which
causes the real
exchange rate
to appreciate.

Net capital outflow

S2 S1

4. The decrease in net


capital outflow reduces
the supply of pesos to
be exchanged into
foreign currency . . .

Demand

Quantity of Dollars
(c) The Market for Foreign-Currency Exchange

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Trade Policy
Trade policy
Government policy
Directly influences the quantity of goods
and services
That a country imports or exports

Tariff - tax on imports


Import quota - limit on quantity of imports
Voluntary export restrictions

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Trade Policy
Macroeconomic impact of trade policy
Decrease imports
Increase in net exports
Increase in demand for dollars in the
market for foreign-currency exchange
Real exchange rate appreciates
Discourage exports

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Trade Policy
Macroeconomic impact of trade policy
No change in real interest rate
No change in net capital outflow
No change in net exports
Decrease in imports
Decrease in exports

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Figure 6
The Effects of an Import Quota
(b) Net Capital Outflow

(a) The Market for Loanable Funds


Real
Interest
Rate

Supply

Real
Interest
Rate

r1

r1

Demand

3. Net exports,
however, remain
the same.

NCO

Quantity of Loanable Funds


Net capital outflow
Real Exchange
When the U.S. government imposes a quota on the
Rate
2. . . . And causes
import of Japanese cars, nothing happens in the market
Supply
the real exchange
for loanable funds in panel (a) or to net capital outflow
rate to appreciate.
in panel (b). The only effect is a rise in net exports
E2
(exports minus imports) for any given real exchange
E1
rate. As a result, the demand for dollars in the market
for foreign-currency exchange rises, as shown by the
D2
shift from D1 to D2 in panel (c). This increase in the
1. An import quota
D1
demand for dollars causes the value of the dollar to
increases the
appreciate from E1 to E2. This appreciation of the dollar
demand for
Quantity of Dollars
tends to reduce net exports, offsetting the direct effect
dollars . . .
(c) The Market for Foreign-Currency Exchange
of the import quota on the trade balance.
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Trade Policy
Macroeconomic impact of trade policy
Trade policies do not affect the U.S. trade
balance
NX = NCO = S I

Trade policies affect specific


Firms
Industries
Countries

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Political Instability &Capital Flight


Political instability
Leads to capital flight

Capital flight
Large and sudden reduction in the
demand for assets located in a country

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Political Instability &Capital Flight


Mexico - capital flight affects both markets
1994, political instability
Investors capital flight
Sell Mexican assets
Buy U.S. assets, safe haven

Net-capital-outflow curve increases


Supply of pesos in the market for foreign-

currency exchange increases

Demand curve in the market for loanable


funds increases
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Political Instability &Capital Flight


Mexico - capital flight affects both markets
Interest rate in Mexico increases
Reduce domestic investment
Slows capital accumulations
Slows economic growth

The peso depreciates


Exports cheaper
Imports - more expensive
Trade balance moves toward surplus

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Figure 7
The Effects of Capital Flight

(a) The Market for Loanable Funds in Mexico


Real
Real
D2
Interest
Interest
Rate
Rate
Supply
D1
r2
r2

1. An increase
in net capital
outflow . . .

r1

r1
3. . . . Which
increases
the interest
rate.

(b) Mexican Net Capital Outflow

2. . . . increases the
demand for loanable funds .
..
Quantity of Loanable Funds

NCO1

NCO2

Net capital outflow

If people decide that Mexico is a risky place to keep their Real Exchange
4. At the same
savings, they will move their capital to safer havens such Rate
S1
S2 time, the increase
as the U.S., resulting in an increase in Mexican net capital
in net capital
outflow. Consequently, the demand for loanable funds in
outflow increases
Mexico rises from D1 to D2, as shown in panel (a), and this
the supply of
drives up the Mexican real interest rate from r 1 to r2.
E1
pesos . . .
Because net capital outflow is higher for any interest rate,
E
2
that curve also shifts to the right from NCO 1 to NCO2 in
5. . . . which
panel (b). At the same time, in the market for foreignDemand
causes the peso
currency exchange, the supply of pesos rises from S 1 to
to depreciate
S2, as shown in panel (c). This increase in the supply of
Quantity of Pesos
pesos causes the peso to depreciate from E 1 to E2, so the (c) The Market for Foreign-Currency Exchange
becomes
less valuable
compared
other
currencies.
peso
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Political Instability &Capital Flight


Mexico - capital flight affects both markets
U.S. market
Fall in U.S. net capital outflow
The dollar appreciates in value
U.S. interest rates fall
Relatively small impact on the U.S. economy
Because the economy of the United States is so
large compared to that of Mexico

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Capital flows from China

Nation that experiences capital flight


Outflow of capital
Its currency weaken in foreign exchange
markets
Depreciation

Increases the nations net exports

Nation that experiences inflow of capital


Its currency strengthen
Appreciation

Pushes its trade balance toward deficit


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Capital flows from China

A nations government policy:


Encourages capital to flow to another
country
By making foreign investments itself

Effect?
Nation encouraging capital outflows
Weaker currency
Trade surplus

For the recipient of capital flows


Stronger currency
Trade deficit
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Capital flows from China

Ongoing policy disputes: U.S. and China


China tried to depress its currency
(renminbi) in foreign exchange markets
Promote its export industries
Accumulate foreign assets, $2.4 trillion, 2009
Including U.S. government bonds

Chinese goods - less expensive


Contributes to the U.S. trade deficit
Hurts American producers who make
products that compete with imports from
China
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Capital flows from China

Ongoing policy disputes: U.S. and China


U.S. government
Encouraged China to stop influencing the
exchange value of its currency

American consumers of Chinese imports


Benefit from lower prices

Inflow of capital from China


Lowers U.S. interest rates
Increases investment in the U.S. economy

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Capital flows from China

Chinese policy of investing in U.S.


economy
Creates winners and losers among
Americans
Net impact on U.S. economy - probably
small

Motives behind the policy


China - wants to accumulate a reserve of
foreign assets - national rainy-day fund
Misguided policy
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