32

A Macroeconomic Theory
of the Open Economy

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
 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)
 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
 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
 Market for Loanable Funds
• Higher real interest rate
– Encourages people to save
• Increases quantity of loanable funds supplied
– Discourages investment
• Decreases quantity of loanable funds
demanded
 Market for Loanable Funds
• Higher real interest rate
– 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
 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
 Figure 1
The Market for Loanable Funds
Real
Interest Supply of loanable funds
Rate (from national saving)

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

Equilibrium quantity 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.
 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 ad services abroad
– Americans use the foreign currency to buy
foreign assets
• Capital is flowing abroad, NCO > 0
 Foreign-Currency Exchange
• 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
 Foreign-Currency Exchange
• 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
 Foreign-Currency Exchange
• 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
 Foreign-Currency Exchange
• 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
 Figure 2
The Market for Foreign-Currency Exchange
Real
Exchange Supply of dollars
Rate (from net capital outflow)

Equilibrium real
exchange rate

Demand for dollars

(for net exports)
Equilibrium Quantity of Dollars Exchanged
quantity into Foreign Currency
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 is downward sloping. 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.
 Equilibrium in the Open Economy
• 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
 Figure 3
How Net Capital Outflow Depends on the Interest Rate
Real
Interest
Rate

Net capital outflow 0 Net capital outflow Net Capital

is negative is positive Outflow

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.
 Equilibrium in the Open Economy
• 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
 Equilibrium in the Open Economy
• 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
 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
 Equilibrium in the Open Economy
• E and r adjust simultaneously
– Determine
• National saving
• Domestic investment
• Net capital outflow
• Net exports
 Figure 4
The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds (b) Net Capital Outflow
Real Real
Interest Supply Interest
Rate Rate

r1 r1

Net capital
Demand outflow, NCO
Quantity of Net capital outflow
Loanable Funds
Real
Supply
In panel (a), the supply and demand for Exchange
loanable funds determine the real interest Rate
rate. In panel (b), the interest rate
determines net capital outflow, which E1
provides the supply of dollars in the market
for foreign-currency exchange. In panel (c),
the supply and demand for dollars in the Demand
market for foreign-currency exchange
Quantity of Dollars
determine the real exchange rate.
(c) The Market for Foreign-Currency Exchange
 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
 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
 Figure 5
The Effects of a Government Budget Deficit
(a) The Market for Loanable Funds (b) Net Capital Outflow
Real 1. A budget deficit reduces the Real
Interest supply of loanable funds . . . Interest
Rate S2 Rate
S1
r2 r2
B A 3. . . . which in
r1 r1 turn reduces net
capital outflow.
2. . . . which
increases the
real interest Demand NCO
rate . . .
Quantity of Loanable Funds Net capital outflow
Real Exchange
When the government runs a budget deficit, it
Rate
reduces the supply of loanable funds from S1 to S2 S2 S1 4. The decrease in net
in panel (a). The interest rate rises from r1 to r2 to capital outflow reduces
balance the supply and demand for loanable funds. the supply of dollars to
E2 be exchanged into
In panel (b), the higher interest rate reduces net
capital outflow. Reduced net capital outflow, in turn, E1 foreign currency . . .
reduces the supply of dollars in the market for 5. . . . Which
foreign-currency exchange from S1 to S2 in panel causes the real
(c). This fall in the supply of dollars causes the real exchange rate Demand
exchange rate to appreciate from E1 to E2. The to appreciate.
Quantity of Dollars
appreciation of the exchange rate pushes the trade
(c) The Market for Foreign-Currency Exchange
balance toward deficit.
 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
 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
 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
 Figure 6
The Effects of an Import Quota
(a) The Market for Loanable Funds (b) Net Capital Outflow
Real Real
Interest Supply Interest
Rate Rate
3. Net exports,
however, remain
the same.
r1 r1

Demand NCO
Quantity of Loanable Funds Net capital outflow
Real Exchange
When the U.S. government imposes a quota on the
Rate
import of Japanese cars, nothing happens in the market Supply 2. . . . And causes
for loanable funds in panel (a) or to net capital outflow the real exchange
in panel (b). The only effect is a rise in net exports E2 •rate to appreciate.
(exports minus imports) for any given real exchange
rate. As a result, the demand for dollars in the market E1
for foreign-currency exchange rises, as shown by the
shift from D1 to D2 in panel (c). This increase in the D2
1. An import quota D1
demand for dollars causes the value of the dollar to increases the demand
appreciate from E1 to E2. This appreciation of the dollar for dollars . . .
tends to reduce net exports, offsetting the direct effect Quantity of Dollars
of the import quota on the trade balance. (c) The Market for Foreign-Currency Exchange
 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
 Political Instability and Capital Flight
• Political instability
– Leads to capital flight
• Capital flight
– Large and sudden reduction in the
demand for assets located in a country
 Political Instability and 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
 Political Instability and 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
 Figure 7
The Effects of Capital Flight
(a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow
Real Real
Interest D2 Interest 1. An increase
Rate Rate in net capital
D1 Supply
outflow . . .
r2 r2
r1 r1
3. . . . Which
increases 2. . . . increases the demand
NCO2
the interest for loanable funds . . . NCO1
rate.
Quantity of Loanable Funds Net capital outflow
•If people decide that Mexico is a risky place to keep their Real Exchange
savings, they will move their capital to safer havens such Rate 4. At the same
as the U.S., resulting in an increase in Mexican net capital
S1 S2 time, the increase
outflow. Consequently, the demand for loanable funds in in net capital
Mexico rises from D1 to D2, as shown in panel (a), and this outflow increases
drives up the Mexican real interest rate from r 1 to r2. E1 the supply of
Because net capital outflow is higher for any interest rate, pesos . . .
that curve also shifts to the right from NCO 1 to NCO2 in E 2

panel (b). At the same time, in the market for foreign- 5. . . . which
Demand
currency exchange, the supply of pesos rises from S 1 to causes the peso
S2, as shown in panel (c). This increase in the supply of to depreciate Quantity of Pesos
pesos causes the peso to depreciate from E 1 to E2, so the (c) The Market for Foreign-Currency Exchange
peso becomes less valuable compared to other currencies.
 Political Instability and 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
 Capital flows from China
• 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
 Capital flows from China
• A nation’s 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
 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, $3 trillion, 2012
– 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
 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
 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
Tutorial Exercise Week 13

Have you heard about ‘The Silk Road’?

In pairs, make a mini research about the
above and present your findings in tutorial.

(Notes: Submit your answer in GOALS as well

because only few have the chances to present due
to time constraint).