1. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Chapter 18 A Macroeconomic Theory of the Open Economy © 2002 by Nelson, a division of Thomson Canada Limited

2. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Overview  Examine the market for loanable funds.  Look at the foreign exchange market.  What is equilibrium in the open market?  How policies and events affect an open economy.

3. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Macroeconomic Variable Determination in an Open Economy  The important macroeconomic variables of an open economy include: National Saving, Domestic Investment, Net Foreign Investment and Net Exports.  The values of these variables are determined through the interaction of: the Loanable Funds Market, the Net Foreign Investment Market, and the Market for Foreign-Currency Exchange.

4. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market For Loanable Funds  Financial markets co-ordinate the economy’s saving and investment in The Loanable Funds Market  The Supply of Loanable Funds comes from national saving (S) and from net foreign investment (NFI).  The Demand for Loanable Funds comes from domestic investment (I).

5. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Supply Demand Real Interest Rate Loanable Funds Positive Net Foreign Investment World Interest Rate 100150 Net Foreign Investment

6. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Supply Demand Real Interest Rate Loanable Funds Negative Net Foreign Investment World Interest Rate 90 Net Foreign Investment 130

7. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market For Loanable Funds  In a small, open economy with perfect capital mobility, the interest rate is equal to the world interest rate.  National Saving represents the supply of loanable funds, while domestic investment represents demand.

8. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market For Loanable Funds  Recall the identity:

9. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market For Loanable Funds Saving = Domestic Investment + Net Foreign Investment  Recall the identity:

10. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market For Loanable Funds  At the equilibrium interest rate, the amount that people want to save, exactly balances the desired quantities of investment and net foreign investment. Saving = Domestic Investment + Net Foreign Investment  Recall the identity:

11. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Overview Examine the market for loanable funds.  Look at the foreign exchange market.  What is equilibrium in the open market?  How policies and events affect an open economy.

12. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Equality of Net Exports and Net Foreign Investment  Net exports (NX) and net foreign investment (NFI) are closely linked. For an economy as a whole, NX and NFI balance each other out so that: NX = NFI  NFI represents the quantity of dollars supplied for the purpose of buying assets abroad. NX determines the quantity of dollars demanded for the purpose of buying foreign goods.

13. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market for Foreign-Currency Exchange  The identity, NX = NFI represents the two sides of the foreign-exchange market in which Canadian dollars are traded for foreign currencies.  The price that balances the supply and demand is the “real exchange rate”, i.e. the relative price of domestic and foreign goods.

14. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market for Foreign-Currency Exchange Supply of Dollars (NFI) Demand for Dollars (NX) Quantity of Dollars Exchanged into Foreign Currency Real Exchange Rate

15. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market for Foreign-Currency Exchange  The demand curve is negatively related to the real exchange rate. A higher exchange rate makes domestic goods more expensive.  The supply curve is vertical because the quantity of dollars supplied for net foreign investment is unrelated to the real exchange rate.

16. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market for Foreign-Currency Exchange The real exchange rate adjusts to balance the supply and demand for dollars. At the equilibrium 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.

17. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market for Foreign-Currency Exchange Supply of Dollars (NFI) Demand for Dollars (NX) Quantity Equilibrium Quantity Real Exchange Rate Equilibrium Real Exchange Rate

18. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Quick Quiz!  Describe the sources of supply and demand in the market for loanable funds and the market for foreign- currency exchange.

19. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Overview Examine the market for loanable funds. Look at the foreign exchange market.  What is equilibrium in the open market?  How policies and events affect an open economy.

20. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Equilibrium in the Open Economy  Net foreign investment (NFI) links the loanable funds market with the foreign- currency exchange market. The key determinant of net foreign investment is the world interest rate.  In the market for loanable funds, NFI is a portion of demand. In the market for foreign-currency exchange, NFI is the source of supply.

21. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market for Loanable Funds Real Interest Rate World interest rate Supply of loanable funds from national saving (S) Demand for loanable funds for domestic investment (I) Net foreign investments (S – I) 100150 Quantity of Loanable Funds (billions of dollars)

22. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market for Foreign-Currency Exchange Real Exchange Rate Supply of dollars (S – I) Demand for dollars (NX) 50 Quantity of Dollars (in billions) E1E1

23. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Equilibrium in the Open Economy The market for loanable funds and the foreign-currency exchange market determine the real exchange rate, national saving, domestic investment, and the size of net foreign investment.

24. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Quick Quiz!  In the model of the open economy, two markets determine one price and the value of three variables. What are the markets? What three variables are determined? What price is determined?

25. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Overview Examine the market for loanable funds. Look at the foreign exchange market. What is equilibrium in the open market?  How policies and events affect an open economy.

26. Principles of Macroeconomics: Ch. 18 Second Canadian Edition How Policy and Events Affect an Open Economy  The magnitude and variation in important macroeconomic variables may be illustrated by these specific events: – Increase in world interest rates – Government Budget Deficits – Government Trade Policies – Political and Economic Stability

27. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Increase in World Interest Rates  In an open economy with perfect capital mobility, an increase in world interest rates crowds out domestic investment, causes the dollar to depreciate, and increases net exports.

28. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Government Budget Deficits and Surpluses  In a small open economy, - an increase in government budget deficits causes the dollar to appreciate and causes net exports to fall. - a decrease in government budget deficits causes the dollar to depreciate and causes net exports to rise.

29. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Government Budget Deficits: Specific Market Effects  Loanable Funds Market Effect: – Reduces national saving which... shifts the supply curve for loanable funds to the left, which reduces net foreign investment.

30. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market for Loanable Funds Real Interest Rate rwrw Demand for loanable funds for domestic investment (I) Supply of loanable funds from national saving (S) 1. An increase in the government budget deficit reduces national saving … CBA 2. … which reduces net foreign invest- ment. Quantity of Loanable Funds (billions of dollars)

31. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Government Budget Deficits: Specific Market Effects  Foreign-Currency Exchange Market: – The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency, which causes the real exchange rate to appreciate.

32. Principles of Macroeconomics: Ch. 18 Second Canadian Edition The Market for Foreign-Currency Exchange 3. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency … Demand for dollars (NX) E2E2 E1E1 4. … which causes the real exchange rate to appreciate. Quantity of Dollars (in billions) Real Exchange Rate Supply of dollars (S – I) 2 (S – I) 1

33. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Government Trade Policy  Government Trade Policy Effect: – Does not alter the trade balance because it does not alter national saving or domestic investment.  For given levels of national saving and domestic investment, the real exchange rate adjusts to keep the balance the same, regardless of the trade policies the government puts in place.  Trade policies are more microeconomic than macroeconomic.

34. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Government Trade Policies: Specific Market Effects  Foreign-Currency Exchange Market: – Nothing happens in the loanable funds market or to the supply of dollars in the market for foreign-currency exchange. – The only effect is a rise in net exports for any given exchange rate. This increases the demand for dollars, which causes the value of the dollar to appreciate.

35. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Government Trade Policies: Specific Market Effects  Net Foreign Investment Market: – Because there is no change in net foreign investment, there will be no change in net exports. – An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports which...... offsets the direct increase in net exports due to import quota.

36. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Political Instability and Capital Flight  Capital Flight is a situation in which a large and sudden movement of funds out of a country occurs due to political instability (e.g. 1994 Mexican government instability.)  When investors around the world observe political problems in one country (e.g. Mexico) they decide to sell some of their Mexican assets and use the proceeds to buy other countries’ assets.

37. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Political Instability and Capital Flight Specific Market Effects  Net Foreign Investment Market: – Observed political problems in Mexico in 1994 increased Mexican net foreign investment which... increased the interest rate paid on Mexican assets which… increased the supply of pesos in the Foreign-Currency Exchange Market.

38. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Quick Quiz!  Suppose that Canadians decided to spend a smaller fraction of their incomes. What would be the effect on saving, investment, interest rates, the real exchange rate and the trade balance?

39. Principles of Macroeconomics: Ch. 18 Second Canadian Edition Overview Examine the market for loanable funds. Look at the foreign exchange market. What is equilibrium in the open market? How policies and events affect an open economy.