A Macroeconomic Theory of the Open Economy Lecture 8 7.4.2015 Copyright © 2004 South-Western Open Economies • An open economy is one that interacts freely with other economies around the world. • An open economy interacts with other countries in world product and financial markets Copyright © 2004 South-Western Previous lecture • The important macroeconomic variables of an open economy include: • net exports • net capital outflow • Foreign direct investment and foreign portfolio investment • Identity – NX=NCO, savings = investment + NCO • nominal exchange rates • real exchange rates Copyright © 2004 South-Western Outline • Macroeconomic model of an Open Economy • the market for loanable funds • the foreign-currency exchange market • EQUILIBRIUM in an Open Economy • Policies and events that affect the Open Economy Equilibrium Copyright © 2004 South-Western 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. Copyright © 2004 South-Western SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE • The Market for Loanable Funds S = I + NCO Copyright © 2004 South-Western 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). Copyright © 2004 South-Western 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. Figure 1 The Market for Loanable Funds Copyright©2003 Southwestern/Thomson Learning Quantity of Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity Equilibrium real interest rate Copyright © 2004 South-Western 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 Copyright © 2004 South-Western The Market for Foreign-Currency Exchange • The two sides of the foreign-currency exchange market are represented by NCO and NX. • NCO represents the imbalance between the purchases and sales of capital assets. • NX represents the imbalance between exports and imports of goods and services. Copyright © 2004 South-Western The Market for Foreign-Currency Exchange • The price that balances the supply and demand for foreign-currency is the real exchange rate. • 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. Figure 2 The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning Quantity of Dollars Exchanged into Foreign Currency Real Exchange Rate Supply of dollars (from net capital outflow) Demand for dollars (for net exports) Equilibrium quantity Equilibrium real exchange rate Copyright © 2004 South-Western 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. Copyright © 2004 South-Western 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. Copyright © 2004 South-Western EQUILIBRIUM IN THE OPEN ECONOMY • 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. Figure 3 How Net Capital Outflow Depends on the Interest Rate Copyright©2003 Southwestern/Thomson Learning 0 Net Capital Outflow Net capital outflow is negative. Net capital outflow is positive. Real Interest Rate Figure 4 The Real Equilibrium in an Open Economy Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds (b) Net Capital Outflow Net capital outflow, NCO Real Interest Rate Real Interest 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 Copyright © 2004 South-Western 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. Copyright © 2004 South-Western 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 Copyright © 2004 South-Western Government Budget Deficits • In an closed economy, government budget deficits . . . • reduce the supply of loanable funds, • drive up the interest rate, • crowd out domestic investment. Figure 5 The Effects of Government Budget Deficit Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds (b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange 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. . . . which increases the real interest rate . . . 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency . . . 5. . . . which causes the real exchange rate to appreciate. 3. . . . which in turn reduces net capital outflow. E2 Copyright © 2004 South-Western 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. Figure 6 The Effects of an Import Quota Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds (b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate r r Supply Supply Demand NCO D D 3. Net exports, however, remain the same. 2. . . . and causes the real exchange rate to appreciate. E E2 1. An import quota increases the demand for dollars . . . Copyright © 2004 South-Western 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. Copyright © 2004 South-Western Political Instability and Capital Flight • Capital flight is a large and sudden reduction in the demand for assets located in a country. • 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. Copyright © 2004 South-Western 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. Figure 7 The Effects of Capital Flight Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange 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 outflow increases the supply of pesos . . . 5. . . . which causes the peso to depreciate. r2 r2 E Copyright © 2004 South-Western Summary • To analyze the macroeconomics of open economies, two markets are central • the market for loanable funds • the market for foreign-currency exchange. Copyright © 2004 South-Western Summary • In the market for loanable funds • the source of supply is ________, and the source of demand is ________. • ____________ adjusts to balance supply and demand • In the market for foreign-currency exchange • the supply of dollars comes from ________, and the demand for dollars comes from ________. • ___________ adjusts to balance the supply and demand Copyright © 2004 South-Western Summary • ____________ is the variable that connects the two markets. • If Net Capital Outflow increases, the demand/supply of loans will increase, causing the real domestic interest rate to rise/drop. • If the Net Capital Outflow increases, the demand/supply of dollars in the Foreign Currency Exchange Market will increase, causing the real exchange rate to appreciate/depreciate. Copyright © 2004 South-Western Summary • A government budget deficit • policy that reduces/increases national saving • reduces/increases the supply of loanable funds • reduces/increases the interest rate • The higher interest rate reduces/increases net capital outflow, reducing/increasing the supply of dollars. • The dollar appreciates/depreciates, and net exports fall/rise. Copyright © 2004 South-Western Summary • A trade restriction (import quota) • Increases/decreases net exports and increases/decreases the demand for dollars in the market for foreign-currency exchange • the dollar appreciates/depreciates in value (domestic goods less/more expensive relative to foreign goods) • this appreciation offsets the initial impact of the trade restrictions on net exports. Copyright © 2004 South-Western Summary • Political instability in a country can lead to capital flight. • Increase/decrease net capital outflow • Demand for loanable funds increases/decreases and supply for domestic currency increases/decreases. • This leads to lower/higher interest rate and causes the country’s currency to appreciate/depreciate.