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14. A Macroeconomic Theory of the Open Economy. SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE. We saw in chapter 13 (Open-Economy Macroeconomics: Basic Concepts) that: S = I + NCO There, the equation was an accounting identity

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slide1

14

A Macroeconomic Theory of the Open Economy

supply and demand for loanable funds and for foreign currency exchange
SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE
  • We saw in chapter 13 (Open-Economy Macroeconomics: Basic Concepts) that:

S = I + NCO

  • There, the equation was an accounting identity
  • In this chapter, the equation represents equilibrium in the Market for Loanable Funds:
  • supply of loanable funds is S,
  • demand for loanable funds is I + NCO.
  • At the equilibrium (real) interest rate, supply equals demand
the market for loanable funds
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 capital outflows (NCO).
the market for loanable funds4
The Market for Loanable Funds
  • The supply of loanable funds, S, is directly related to the real interest rate.
    • A higher real interest rate encourages people to save and raises the quantity of loanable funds supplied.
  • The demand for loanable funds, I + NCO, is inversely related to the real interest rate
    • A higher real interest rate discourages domestic investment and the net capital outflow to foreign countries
  • The interest rate adjusts to bring the supply and demand for loanable funds into balance.
figure 1 the market for loanable funds

Supply of loanable funds

(from national saving)

Equilibrium

real interest

rate

Demand for loanable

funds (for domestic

investment and net

capital outflow)

Equilibrium

quantity

Figure 1 The Market for Loanable Funds

Real

Interest

Rate

Quantity of

Loanable Funds

net capital outflow
Net Capital Outflow
  • The key factor that affects net capital outflow is the domestic real interest rate
  • We saw earlier that NCO is inversely related to the real interest rate
figure 3 how net capital outflow depends on the interest rate

1. Equilibrium in the market for loanable funds determines the real interest rate

2. That real interest rate then determines net capital outflow

Net capital outflow

Net capital outflow

is negative.

is positive.

Figure 3 How Net Capital Outflow Depends on the Interest Rate

Real

Interest

Rate

Net Capital

0

Outflow

the market for foreign currency exchange
The Market for Foreign-Currency Exchange
  • The two sides of the foreign-currency exchange market are represented by NCO and NX.
  • NCO represents the difference between the purchases and sales of capital assets.
  • NX represents the difference between exports and imports of goods and services.
the market for foreign currency exchange9
The Market for Foreign-Currency Exchange
  • In the market for foreign-currency exchange, U.S. dollars are traded for foreign currencies.
  • For an economy as a whole, NCO and NX must balance each other out, or:

NCO = NX

the market for foreign currency exchange10
The Market for Foreign-Currency Exchange
  • The price that balances the supply and demand for foreign-currency is the real exchange rate.
the market for foreign currency exchange11
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.
  • The supply curve is vertical because the quantity of dollars supplied for net capital outflow is unrelated to the real exchange rate.
    • (It is determined by the real interest rate that came out of equilibrium in the market for loanable funds.)
figure 2 the market for foreign currency exchange

Supply of dollars

(from net capital outflow, determined earlier)

Equilibrium

real exchange

rate

Demand for dollars

(for net exports)

Equilibrium

quantity

Figure 2 The Market for Foreign-Currency Exchange

Real

Exchange

Rate

Quantity of Dollars Exchanged

into Foreign Currency

the market for foreign currency exchange13
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, NX) exactly balances the supply of dollars (to be exchanged into foreign currency to buy assets abroad, NCO).
equilibrium in the open economy
EQUILIBRIUM IN THE OPEN ECONOMY
  • In the market for loanable funds,
    • supply comes from national saving and
    • demand comes from domestic investment and net capital outflow.
  • In the market for foreign-currency exchange,
    • supply comes from net capital outflow and
    • demand comes from net exports.
  • Net capital outflow links the two markets
equilibrium in the open economy15
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.
figure 4 the real equilibrium in an open economy

Supply

r

r

Demand

Net capital

outflow,

NCO

Supply

E

Demand

Figure 4 The Real Equilibrium in an Open Economy

(a) The Market for Loanable Funds

(b) Net Capital Outflow

Real

Real

Interest

Interest

Rate

Rate

Quantity of

Net Capital

Loanable Funds

Outflow

Real

Exchange

Rate

Quantity of

Dollars

(c) The Market for Foreign-Currency Exchange

how policies and events affect an open economy
HOW 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
Government Budget Deficits
  • In an open economy, government budget deficits . . .
    • reduce the supply of loanable funds,
    • drive up the interest rate,
    • Crowd-out domestic investment,
    • cause net capital outflow to fall.
figure 5 the effects of government budget deficit

1. A budget deficit reduces

the supply of loanable funds . . .

S

B

r2

r2

A

r

r

3. . . . which in

2. . . . which

turn reduces

increases

net capital

the real

outflow.

interest

rate . . .

S

4. The decrease

in net capital

outflow reduces

the supply of dollars

to be exchanged

E2

into foreign

currency . . .

E1

5. . . . which

causes the

real exchange

rate to

appreciate.

Figure 5 The Effects of Government Budget Deficit

(a) The Market for Loanable Funds

(b) Net Capital Outflow

Real

Real

Interest

Interest

S

Rate

Rate

Demand

NCO

Quantity of

Net Capital

Loanable Funds

Outflow

Real

S

Exchange

Rate

Demand

Quantity of

Dollars

(c) The Market for Foreign-Currency Exchange

government budget deficits20
Government Budget Deficits
  • 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.
government budget deficits21
Government Budget Deficits
  • Effect of Budget Deficits on Net Capital Outflow
    • Higher interest rates reduce net capital outflow.
government budget deficits22
Government Budget Deficits
  • Effect on the Foreign-Currency Exchange Market
    • A decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency.
    • This causes the real exchange rate to appreciate.
trade policy
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 policy24
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.
trade policy25
Trade Policy
  • 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.
trade policy26
Trade Policy
  • 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.
trade policy27
Trade Policy
  • 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.
figure 6 the effects of an import quota

r

r

3. Net exports,

however, remain

the same.

1. An import

quota increases

the demand for

E2

dollars . . .

2. . . . and

causes the

real exchange

rate to

D

appreciate.

Figure 6 The Effects of an Import Quota

(a) The Market for Loanable Funds

(b) Net Capital Outflow

Real

Real

Interest

Interest

Supply

Rate

Rate

Demand

NCO

Quantity of

Net Capital

Loanable Funds

Outflow

Real

Supply

Exchange

Rate

E

D

Quantity of

Dollars

(c) The Market for Foreign-Currency Exchange

trade policy29
Trade Policy
  • Effect of an Import Quota
    • Real exchange rate appreciates
    • Imports decrease
    • Exports decrease by the same amount
    • Net exports are unchanged
    • Everything else is unchanged
political instability and capital flight
Political Instability and Capital Flight
  • Capital flight is a large and sudden reduction in the demand for assets located in a country.
political instability and capital flight31
Political Instability and Capital Flight
  • Capital flight has its largest impact on the country from which the capital is fleeing, 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 real exchange rate depreciates.
political instability and capital flight32
Political Instability 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.
political instability and capital flight33
Political Instability and Capital Flight
  • This increased Mexican net capital outflow.
    • The demand for loanable funds in the loanable funds marketincreased, which increased the interest rate.
    • The higher interest rate reduced net capital outflow but this decrease was not as large as the increase caused by capital flight. Therefore, NCO increased.
    • This increased the supply of pesos in the foreign-currency exchange market.
    • This depreciated (i.e., reduced) the real exchange rate.
figure 7 the effects of capital flight

1. An increase

in net capital

outflow. . .

r2

r2

D2

3. . . . which

increases

the interest

rate.

NCO2

2. . . . increases the demand

for loanable funds . . .

S2

4. At the same

time, the increase

in net capital

outflow

increases the

E

supply of pesos . . .

5. . . . which

E

causes the

peso to

depreciate.

Figure 7 The Effects of Capital Flight

(a) The Market for Loanable Funds in Mexico

(b) Mexican Net Capital Outflow

Real

Real

Supply

Interest

Interest

Rate

Rate

r1

r1

D1

NCO1

Quantity of

Net Capital

Loanable Funds

Outflow

Real

S

Exchange

Rate

Demand

Quantity of

Pesos

(c) The Market for Foreign-Currency Exchange

summary
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 capital outflow).
summary36
Summary
  • In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (for net capital outflow) and the demand for dollars (for net exports).
  • Net capital outflow is the variable that connects the two markets.
summary37
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 capital outflow, reducing the supply of dollars.
  • The dollar appreciates, and net exports fall.
summary38
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.
summary39
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.