A Macroeconomic

Theory of the Open

Economy
Chapter 30
Learning objectives
 The Market for Loanable Funds
 The Market for Foreign-Currency
Exchange
 Equilibrium in the Open Economy
 Government Budget Deficits
 Effect of Budget Deficits on the Loanable
Funds Market
 Trade Policy
Key Macroeconomic Variables
in an Open Economy
 The important macroeconomic
variables of an open economy
include:
 net exports
 net foreign investment
 nominal exchange rates
 real exchange rates
Basic Assumptions of a Macroeconomic
Model of an Open Economy

 The model takes the economy’s

GDP as given.
 The model takes the economy’s
price level as given.
The Market for Loanable Funds

S = I + NFI

供给 = 需求
 At the equilibrium interest rate, the
amount that people want to save exactly
balances the desired quantities of
investment and net foreign investment.
The Market for Loanable Funds

 The supply of loanable funds comes from

national saving (S).
 The demand for loanable funds comes
from domestic investment (I) and net
foreign investment (NFI).
The Market for Loanable Funds

 The supply and demand for loanable

funds depend on the real interest rate.
 A higher real interest rate encourages
people to save and raises the quantity of
loanable funds supplied.
 The interest rate adjusts to bring the
supply and demand for loanable funds
into balance.
 The Market for Loanable Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)

Equilibrium
real interest
rate Demand for loanable
funds (for domestic
investment and net
foreign investment)

Equilibrium Quantity
quantity Loanable
of Funds
The Market for Loanable Funds

At the equilibrium interest rate 均衡利率 ,

the amount that people want to save exactly
balances the desired quantities of domestic
investment and net foreign investment 与
国内投资和资本净流出相平衡 .
 The Market for Foreign-
Currency Exchange 外汇市场
 The two sides of the foreign-currency
exchange market are represented by NFI and
NX.
 NFI represents the imbalance between the
purchases and sales of capital assets. 国外资
本资产的购买与出售不平衡
 NX represents the imbalance between
exports and imports of goods and services. 物
品与服务之间的进口与出口不平衡
 The Market for Foreign-
Currency Exchange

 In the market for foreign-currency exchange,

U.S. dollars are traded for foreign currencies.
用美元兑换外国通货
 For an economy as a whole, NFI and NX
must balance each other out, or:

NFI = NX
 The Market for Foreign-
Currency Exchange

The price that balances the supply

and demand for foreign-currency is
the real exchange rate.
使外汇市场供求平衡的价格是真实
汇率
 The Market for Foreign-
Currency Exchange
 The demand curve for foreign currency is
downward sloping because a higher
exchange rate makes domestic goods
more expensive. 较高的真实汇率使美国
物品价格更昂贵，减少了美元量的需求
 The supply curve is vertical because the
quantity of dollars supplied for net
foreign investment is unrelated to the real
exchange rate. 资本净流出不取决于真实
汇率，而是真实利率
 The Market for Foreign-Currency
Exchange...
Real
Exchange
Rate
Supply of dollars
(from net foreign investment)

Equilibrium
real exchange
rate

Demand for dollars

(for net exports)

Equilibrium Quantity of Dollars Exchanged

quantity into Foreign Currency
 The Market for Foreign-
Currency Exchange
 The real exchange rate adjusts to balance
the supply and demand for dollars.
 At the equilibrium real exchange rate,
the demand for dollars to buy net exports
exactly balances the supply of dollars to
be exchanged into foreign currency to
buy assets abroad. 人们为购买外国资产
而供给的美元数量正好与人们购买净出
口而需求的美元数量平衡
 Equilibrium in the Open
Economy
 In the market for loanable funds, supply
comes from national saving and demand
comes from domestic investment and net
foreign investment.
 In the market for foreign-currency
exchange, supply comes from net foreign
investment and demand comes from net
exports.
 Equilibrium in the Open
Economy

 Net foreign investment links the

loanable funds market and the
foreign-currency exchange market.
资本净流出是连接两个市场的变量
 The key determinant of net foreign
investment is the real interest rate.
How Net Foreign Investment
Depends on the Interest rate...
Real
Interes
t Rate

Net Foreign
0 Investment
Net foreign investment is Net foreign investment is
negative. positive.
 Equilibrium in the Open
Economy
 Prices in the loanable funds market and
the foreign-currency exchange market
adjust simultaneously to balance supply
and demand in these two markets.
 As they do, they determine the
macroeconomic variables of national
saving, domestic investment, net foreign
investment, and net exports.
 The Real Equilibrium in an Open Economy

(a) The Market for Loanable Funds (b) Net Foreign Investment
Real Real
Interest Supply Interest
Rate Rate

r1 r1
Net foreign
investment,
Demand NFI

Quantity of Net Foreign

Loanable Funds Investment

Real
Exchange Supply
Rate

E1

Demand

Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
 How Changes in Policies and
Events Affect an Open Economy

 The magnitude and variation in

important macroeconomic
variables depend on the following:
 Government budget deficits
 Trade policies
 Political and economic stability
 Government Budget Deficits

 In an open economy, government budget

deficits . . .
¼reduces the supply of loanable funds,
¼drives up the interest rate,
¼crowds out domestic investment 挤出了投
资,
¼cause net foreign investment to fall.
The Effects of Government Budget Deficit

(a) The Market for Loanable Funds (b) Net Foreign Investment
Real Real
Interest S2 S1 Interest
Rate Rate
B
r2 r2
3. ...which in
A turn reduces
r1 r1 net foreign
investment.
Demand
NFI
Quantity of Net Foreign
1. A budget deficit Loanable Funds Investment
reduces the supply
of loanable funds... Real 4. The decrease in
S2 S1 net foreign
Exchange
investment
2. ...which Rate reduces the
increases the supply of dollars
real interest... to be exchanged
E2
into foreign
5. …which causes the E1 currency…
real exchange
rate to appreciate.
Demand

Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
Effect of Budget Deficits on the
Loanable Funds Market

 A government budget deficit reduces

national saving, which . . .
. . . shifts the supply curve for
loanable funds to the left, which
. . . raises interest rates.
Effect of Budget Deficits on Net
Foreign Investment

 Higher interest rates reduce net

foreign investment. 反比
 Effect on the Foreign-Currency
Exchange Market

 A decrease in net foreign investment

reduces the supply of dollars to be
exchanged into foreign currency.
 This causes the real exchange rate to
appreciate.
 Trade Policy
 A trade policy is a government policy that
directly influences the quantity of goods
and services that a country imports or
exports.
 Tariff: A tax on an imported good.
 Import quota: A limit on the quantity of a
good produced abroad and sold
domestically.
 Trade Policy
 Because they do not change national saving
or domestic investment, trade policies do not
affect the trade balance.
 For a given level of national saving and domestic
investment, the real exchange rate adjusts to
keep the trade balance the same.
 Trade policies have a greater effect on
microeconomic than on macroeconomic
markets.
 Effect of an Import Quota

 Because foreigners need dollars to buy

U.S. net exports, there is an increased
demand for dollars in the market for
foreign-currency.
 This leads to an appreciation of the real
exchange rate.
 Effect of an Import Quota

 There is no change in the interest rate

because nothing happens in the loanable
funds market.
 There will be no change in net exports.
 There is no change in net foreign
investment even though an import quota
reduces imports.
 Effect of an Import Quota

 An appreciation of the dollar in the

foreign exchange market encourages
imports and discourages exports.
 This offsets the initial increase in net
exports due to import quota.
 The Effects of an Import Quota
(a) The Market for Loanable Funds (b) Net Foreign Investment
Real Real
Interest S1 Interest
Rate Rate
3. Net exports,
however, remain
r1 r1 the same.

Demand NFI

Quantity of Net Foreign

Loanable Funds Investment

Real
Exchange Supply
Rate 1. An import
quota increases
E2 the demand for
2. …and causes dollars…
the real exchange
rate to appreciate. E1

Demand

Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
Effect of an Import Quota

Trade policies do not

affect the trade balance.
Political Instability and Capital
Flight 资本外逃

Capital flight is a large and sudden

movement of funds out of a country
一国资产需求大量或突然地减少 ,
usually due to political instability 不
稳定 .
（例子： 1994 年墨西哥）
Political Instability and Capital
Flight
 Capital flight has its largest impact on the
country from which the capital is fleeing 对
资本逃离国家影响最大 , but it also affects
other countries.
 If investors become concerned about the
safety of their investments, capital can
quickly leave an economy.
 Interest rates increase and the domestic
currency depreciates. 国内货币贬值
Political Instability in Mexico
and Capital Flight

 When investors around the world

observed political problems in Mexico in
1994, they sold some of their Mexican
assets and used the proceeds to buy assets
of other countries.
 从墨西哥撤出资产，以便转移到美国和
其他一些安全的地方
Political Instability in Mexico
and Capital Flight

 This increased Mexican net foreign

investment.
 The demand for loanable funds in the
loanable funds market increased, which
increased the interest rate.
 This increased the supply of pesos 比索 in
the foreign-currency exchange market.
 The Effects of Capital Flight

(a) The Market for Loanable Funds (b) Mexican Net Foreign Investment
Real Real
Interest S1 Interest
Rate NFI1 NFI1
Rate 1. An increase in
r2 r2 net foreign
investment...
r1 r1
D2

D1

Quantity of Net Foreign

2. …increases Loanable Funds Investment
the demand for
3. …which loanable funds... Real 4. At the same
increases S1 S2 time, the
Exchange
the increase in net
Rate foreign
interest
rate. investment
E1 increases the
supply of
5. …which causes the pesos...
real exchange E2
rate to appreciate.
Demand

Quantity of Pesos
(c) The Market for Foreign-Currency Exchange
 Summary
 To analyze the macroeconomics of open
economies, two markets are central – the
market for loanable funds and the market for
foreign-currency exchange.
 In the market for loanable funds, the
interest rate adjusts to balance supply for
loanable funds (from national saving) and
demand for loanable funds (from domestic
investment and net foreign investment).
 Summary
 In the market for foreign-currency
exchange, the real exchange rate adjusts
to balance the supply of dollars (for net
foreign investment) and the demand for
dollars (for net exports).
 Net foreign investment is the variable
that connects the two markets.
 Summary
 A policy that reduces national saving, such
as a government budget deficit, reduces the
supply of loanable funds and drives up the
interest rate.
 The higher interest rate reduces net foreign
investment, reducing the supply of dollars.
 The dollar appreciates, and net exports fall.
 Summary
 A trade restriction increases net exports and
increases the demand for dollars in the
market for foreign-currency exchange.
 As a result, the dollar appreciates in value,
making domestic goods more expensive
relative to foreign goods.
 This appreciation offsets the initial impact of
the trade restrictions on net exports.
 Summary
 When investors change their attitudes
about holding assets of a country, the
ramifications for the country’s economy
can be profound.
 Political instability in a country can lead to
capital flight.
 Capital flight tends to increase interest
rates and cause the country’s currency to
depreciate.
Graphical
Review
 The Market for Loanable Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)

Equilibrium
real interest
rate Demand for loanable
funds (for domestic
investment and net
foreign investment)

Equilibrium Quantity
quantity Loanable
of Funds
 The Market for Foreign-Currency
Exchange...
Real
Exchange
Rate
Supply of dollars
(from net foreign investment)

Equilibrium
real exchange
rate

Demand for dollars

(for net exports)

Equilibrium Quantity of Dollars Exchanged

quantity into Foreign Currency
How Net Foreign Investment
Depends on the Interest rate...
Real
Interes
t Rate

Net Foreign
0 Investment
Net foreign investment is Net foreign investment is
negative. positive.
 The Real Equilibrium in an Open Economy

(a) The Market for Loanable Funds (b) Net Foreign Investment
Real Real
Interest Supply Interest
Rate Rate

r1 r1
Net foreign
investment,
Demand NFI

Quantity of Net Foreign

Loanable Funds Investment

Real
Exchange Supply
Rate

E1

Demand

Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
The Effects of Government Budget Deficit

(a) The Market for Loanable Funds (b) Net Foreign Investment
Real Real
Interest S2 S1 Interest
Rate Rate
B
r2 r2
3. ...which in
A turn reduces
r1 r1 net foreign
investment.
Demand
NFI
Quantity of Net Foreign
1. A budget deficit Loanable Funds Investment
reduces the supply
of loanable funds... Real 4. The decrease in
S2 S1 net foreign
Exchange
investment
2. ...which Rate reduces the
increases the supply of dollars
real interest... to be exchanged
E2
into foreign
5. …which causes the E1 currency…
real exchange
rate to appreciate.
Demand

Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
 The Effects of an Import Quota
(a) The Market for Loanable Funds (b) Net Foreign Investment
Real Real
Interest S1 Interest
Rate Rate
3. Net exports,
however, remain
r1 r1 the same.

Demand NFI

Quantity of Net Foreign

Loanable Funds Investment

Real
Exchange Supply
Rate 1. An import
quota increases
E2 the demand for
2. …and causes dollars…
the real exchange
rate to appreciate. E1

Demand

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

(a) The Market for Loanable Funds (b) Mexican Net Foreign Investment
Real Real
Interest S1 Interest
Rate NFI1 NFI1
Rate 1. An increase in
r2 r2 net foreign
investment...
r1 r1
D2

D1

Quantity of Net Foreign

2. …increases Loanable Funds Investment
the demand for
3. …which loanable funds... Real 4. At the same
increases S1 S2 time, the
Exchange
the increase in net
Rate foreign
interest
rate. investment
E1 increases the
supply of
5. …which causes the pesos...
real exchange E2
rate to appreciate.
Demand

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