Chapter 32 A Macroeconomic Theory of The Open Economy

Principles of Economics, Ninth Edition
N. Gregory Mankiw
PowerPoint Slides prepared by:

V. Andreea CHIRITESCU
Eastern Illinois University
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in 1
part.
Chapter 32
A Macroeconomic Theory of the Open
Economy
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in 2
part.
Model of the Open Economy
• Model of the open economy
– To highlight the forces that determine the
economy’s trade balance and exchange
rate
– Looking simultaneously at the market for
loanable funds and the market for foreign-
currency exchange
– Examine how various events and policies
affect the economy’s trade balance and
exchange rate
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, 3in whole or in
part.
Market for Loanable Funds, Part 1
• 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)
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,4in whole or in
part.
• 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
part.
• 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
part.
• Higher real interest rate
– Encourages people to save: increases
quantity of loanable funds supplied
– Discourages investment: decreases quantity
of loanable funds demanded
– Discourages Americans from buying foreign
assets: reduces U.S. net capital outflow
– Encourages foreigners to buy U.S. assets:
reduces U.S. net capital outflow
part.
• 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
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, 8in whole or in
part.
Figure 1 The Market for 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.
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part. 9
Foreign-Currency Exchange, Part 1
• 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 ad services abroad
– Americans use the foreign currency to buy
foreign assets
• Capital is flowing abroad, NCO > 0
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,10
in whole or in
part.
• If trade deficit, NX < 0
– Imports > Exports
– Some of this spending is financed by
selling American assets abroad
• Foreign capital is flowing into U.S.
• NCO < 0
in whole or in
part.
• Supply of foreign-currency exchange
– Net capital outflow
• Quantity of dollars supplied to buy foreign
assets
– Supply curve is vertical
• Quantity of dollars supplied for net capital
outflow
• Does not depend on the real exchange rate
in whole or in
part.
• Demand for foreign-currency exchange
– Net exports
• Quantity of dollars demanded to buy U.S. net
exports of goods and services
– Demand curve is downward sloping
– A higher real exchange rate
• Makes U.S. goods more expensive
• Reduces the quantity of dollars demanded to
buy those goods
in whole or in
part.
• Equilibrium real exchange rate
– Demand for dollars
• By foreigners
• Arising from U.S. net exports of goods and
services
– Exactly balances supply of dollars
• From Americans
• Arising from U.S. net capital outflow
in whole or in
part.
Figure 2 The Market for Foreign-Currency Exchange
The real exchange rate is determined by the supply and demand for foreign-currency exchange.
The supply of dollars 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 dollars comes from net exports. Because a lower real exchange rate
stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net
exports), the demand curve slopes downward. At the equilibrium real exchange rate, the number
of dollars people supply to buy foreign assets exactly balances the number of dollars people
demand to buy net exports.
part. 15
Equilibrium in the Open Economy, Part 1
• Identities
– Market for loanable funds: S = I + NCO
– Market for foreign-currency exchange:
NCO = NX
• Net-capital-outflow curve
– Link between
• Market for loanable funds
• Market for foreign-currency exchange
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
16in whole or in
part.
Figure 3 How Net Capital Outflow Depends on the
Interest Rate
part. 17
• Market for loanable funds

– Supply: national saving
– Demand: domestic investment and net
capital outflow
– Equilibrium real interest rate, r
• Net capital outflow
– Slopes downward
– Equilibrium interest rate, r
in whole or in
part.
• Market for foreign-currency exchange

– Supply: net capital outflow
– Demand: net exports
– Equilibrium real exchange rate, E
• Equilibrium real interest rate, r
– Price of goods and services in the present
• Relative to goods and services in the future
19in whole or in
part.
• 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
20in whole or in
part.
• E and r adjust simultaneously

– Determine
• National saving
• Domestic investment
• Net capital outflow
• Net exports
21in whole or in
part.
Figure 4 The Real Equilibrium in an Open Economy
part. 22
Government Budget Deficits, Part 1
• 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
23in whole or in
part.
Government Budget Deficits, Part 2
• 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
in whole or in
part.
Figure 5 The Effects of a Government Budget Deficit
part. 25
Trade Policy, Part 1
• 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
in whole or in
part.
• Macroeconomic impact of trade policy
(import quota)
– Decrease imports
– Increase in net exports
– Increase in demand for dollars in the
market for foreign-currency exchange
– Real exchange rate appreciates
• Discourage exports
27in whole or in
part.
(import quota)
– No change in real interest rate
– No change in net capital outflow
– No change in net exports
• Decrease in imports
• Decrease in exports
28in whole or in
part.
Figure 6 The Effects of an Import Quota
part. 29
– Trade policies do not affect the U.S. trade
balance
• NX = NCO = S – I
– Trade policies affect specific
• Firms
• Industries
• Countries
30in whole or in
part.
ASK THE EXPERTS: Deficits
“If the United States reduced its fiscal deficit,

then its trade deficit would also shrink.”
part. 31
Political Instability and Capital Flight, Part 1
• Political instability
– Leads to capital flight
• Capital flight
– Large and sudden reduction in the
demand for assets located in a country
32in whole or in
part.
• 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
33in whole or in
part.
– 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
34in whole or in
part.
Figure 7 The Effects of Capital Flight
part. 35
– 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
36in whole or in
part.
Capital Flows from China, Part 1
• Nation that experiences capital flight
– Outflow of capital
– Its currency weaken in foreign exchange
markets (depreciation)
– Increases the nation’s net exports
• Nation that experiences inflow of capital
– Its currency strengthen (appreciation)
– Pushes its trade balance toward deficit
part. 37
• A nation’s government (policy):
– Encourages capital to flow to another
country
• By making foreign investments itself
– Effect?
• Nation encouraging capital outflows: weaker
currency and trade surplus
• For the recipient of capital flows: stronger
currency and trade deficit
part. 38
• 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: from 2000 to
2014, increased from $160 billion to $4
trillion (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
part. 39
• 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
part. 40
• 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
part. 41
ASK THE EXPERTS: Currency Manipulation
“Economic analysis can identify whether

countries are using their exchange rates to
benefit their own people at the expense of
their trading partners’ welfare.”
part. 42

Chapter 32 A Macroeconomic Theory of The Open Economy

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Principles of Economics, Ninth Edition

PowerPoint Slides prepared by:

• Market for loanable funds

• Market for foreign-currency exchange

• Equilibrium real exchange rate, E

• E and r adjust simultaneously

“If the United States reduced its fiscal deficit,

“Economic analysis can identify whether

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