32 macroeconomic

8/7/2019 32 macroeconomic

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Copyright 2004 South-Western

3232A Macroeconomic

Theory of the OpenEconomy


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Open Economies

An open economy is one that interacts freely

with other economies around the world.


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Basic Assumptions of a MacroeconomicModel of an Open Economy

The model takes the economys GDP as given.

The model takes the economys price level as

given.


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SUPPLY AND DEMAND FORLOANABLE FUNDS AND FOR

FOREIGN-CU

RRENCY

EXCHANGE The Market for Loanable FundsS = I + NCO

At the equilibrium interest rate, the amount that

people want to save exactly balances the desired

quantities of investment and net capital outflows.


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The Market forLoanable 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).


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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.


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Figure 1 The Market forLoanable Funds

Copyright2003 Southwestern/Thomson Learning

Quantity of

Loanable Funds

RealInterest

Rate

Supply of loanable funds

(from national saving)

Demand for loanable

funds (for domesticinvestment and net

capital outflow)

Equilibrium

quantity

Equilibrium

real interest

rate


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At the equilibrium interest rate, the amount that

people want to save exactly balances the

desired quantities of domestic investment and

net foreign investment.


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The Market for Foreign-Currency Exchange

The two sides of the foreign-currency exchange

market are represented byNCO andNX.

NCO represents the imbalance between the

purchases and sales of capital assets.

NXrepresents the imbalance between exports

and imports of goods and services.


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In the market for foreign-currency exchange,

U.S. dollars are traded for foreign currencies.

For an economy as a whole,NCO andNXmust

balance each other out, or:

NCO = NX


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The price that balances the supply and demand

for foreign-currency is the real exchange rate.


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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.


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Figure 2 The Market for Foreign-CurrencyExchange


Quantity of Dollars Exchanged

into Foreign Currency

RealExchange

RateSupply of dollars

(from net capital outflow)

Demand for dollars

(for net exports)

Equilibrium

quantity

Equilibrium

real exchange

rate


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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.


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EQUILIBRIUM IN THE OPENECONOMY

In the market for loanable funds, supply comes

from national saving and demand comes from

domestic investment and net capital outflow.


supply comes from net capital outflow and

demand comes from net exports.


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Net capital outflow links the loanable funds

market and the foreign-currency exchange

market.

The key determinant of net capital outflow is the

real interest rate.


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Figure 3 How Net Capital Outflow Depends on theInterest Rate


0 Net Capital

Outflow

Net capital outflow

is negative.

Net capital outflow

is positive.

RealInterest

Rate


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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 netexports.


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Figure 4 The Real Equilibrium in an OpenEconomy


(a) The Market for Loanable Funds (b) Net Capital Outflow

Net capitaloutflow, NCO

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign-Currency Exchange

Quantity of

Dollars

Quantity of

Loanable Funds

Net Capital

Outflow

Real

Exchange

Rate

Supply

Supply

Demand

Demand

r r

E


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HOW POLICIES AND EVENTSAFFECT AN OPEN ECONOMY

The magnitude and variation in important

macroeconomic variables depend on the

following:

Government budget deficits

Trade policies

Political and economic stability


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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 foreign investment to fall.


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Figure 5 The Effects of Government Budget Deficit



RealInterest

Rate

RealInterest

Rate


Quantity ofDollars

Quantity ofLoanable Funds

Net CapitalOutflow

RealExchange

Rate

Demand

Demand

r2

NCO

SS

S S

r2

B

E1

r r

A

1. A budget deficit reduces

the supply of loanable funds . . .

2. . . . whichincreases

the realinterest

rate . . .

4. The decrease

in net capitaloutflow reduces

the supply of dollarsto be exchangedinto foreign

currency . . .5. . . . which

causes thereal exchangerate to

appreciate.

3. . . . which inturn reducesnet capital

outflow.

E2


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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.


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Effect of Budget Deficits on Net Foreign

Investment

Higher interest rates reduce net foreign investment.


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Effect on the Foreign-Currency Exchange

Market

A decrease in net foreign investment reduces the

supply of dollars to be exchanged into foreigncurrency.

This causes the real exchange rate to appreciate.


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Trade Policy

A tradepolicyis 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.


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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 onmicroeconomic than on macroeconomic

markets.


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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.


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Trade Policy


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.


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Trade Policy


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.


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Figure 6 The Effects of an Import Quota



RealInterest

Rate

RealInterest

Rate


Quantity ofDollars

Quantity ofLoanable Funds

Net CapitalOutflow

RealExchange

Rate

r r

Supply

Supply

Demand

NCO

D

D

3. Net exports,

however, remain

the same.

2. . . . andcauses the

real exchangerate toappreciate.

E

E2

1. An importquota increases

the demand fordollars . . .


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Trade Policy


Trade policies do not affect the trade balance.


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Political Instability and Capital Flight

Capitalflightis a large and sudden reduction in

the demand for assets located in a country.


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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 domesticcurrency depreciates.


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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.


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This increased Mexican net capital outflow.

The demand for loanable funds in the loanable

funds market increased, which increased the interest

rate. This increased the supply of pesos in the foreign-

currency exchange market.


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Figure 7 The Effects of Capital Flight


(a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow

RealInterest

Rate

RealInterest

Rate


Quantity of

Pesos

Quantity of

Loanable Funds

Net Capital

Outflow

Real

Exchange

Rate

r1 r1

D1

D2

E

Demand

S S2

Supply

NCO2NCO1

1. An increase

in net capital

outflow. . .

3. . . . which

increases

the interest

rate.

2. . . . increases the demand

for loanable funds . . .

4. At the same

time, the increase

in net capital

outflowincreases the

supply of pesos . . .5. . . . which

causes the

peso to

depreciate.

r2 r2

E


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Summary

To analyze the macroeconomics of open

economies, two markets are centralthe

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 loanablefunds (from domestic investment and net

capital outflow).


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Summary


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.


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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.


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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 ofthe trade restrictions on net exports.


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C i ht 2004 S th W t

Summary

When investors change their attitudes about

holding assets of a country, the ramifications

for the countrys economy can be profound.

Political instability in a country can lead to

capital flight.

Capital flight tends to increase interest rates and

cause the countrys currency to depreciate.

Documents

32 macroeconomic