Chapter A Macroeconomic Theory of the Open Economy 19

Supply and Demand for Loanable Funds The 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) 2

Supply and Demand for Loanable Funds The 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 – If NCO > 0, net outflow of capital - adds to demand – If NCO < 0, net inflow of capital - reduce the demand 3

Supply and Demand for Loanable Funds The 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 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 4

Supply and Demand for Loanable Funds The 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 5

Figure Real Interest Rate The market for loanable funds 1 6 Quantity of Loanable Funds Equilibrium real interest rate Supply of loanable funds (from national saving) Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity 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.

Market for Foreign-Currency Exchange The market for foreign-currency exchange – Identity: NCO = NX – Net capital outflow = Net exports If trade surplus, NX > 0 – Foreigners - buy more U.S. goods & services Than Americans - buy foreign goods & services – Americans – use foreign currency Buy foreign assets – Capital is flowing abroad, NCO > 0 7

Market for Foreign-Currency Exchange The market for foreign-currency exchange If trade deficit, NX < 0 – Americans - buy more foreign goods & services Than foreigners - buy U.S. goods & services – Some of this spending Financed by selling American assets abroad – Foreign capital is flowing into U.S. – NCO < 0 8

Market for Foreign-Currency Exchange The market for foreign-currency exchange Supply of foreign-currency exchange – Net capital outflow – Quantity of dollars supplied - buy foreign assets – Supply curve – vertical Quantity of dollars supplied for net capital outflow Does not depend on the real exchange rate 9

Market for Foreign-Currency Exchange The market for foreign-currency exchange Demand for foreign-currency exchange – Net exports – Quantity of dollars demanded – buy U.S. net exports of goods and services – Demand curve - downward sloping A higher real exchange rate – Makes U.S. goods more expensive – Reduces the quantity of dollars demanded to buy those goods 10

Market for Foreign-Currency Exchange The market for foreign-currency exchange Equilibrium real exchange rate – Demand for dollars By foreigners Arising from U.S. net exports of goods & services – Exactly balances supply of dollars From Americans Arising from U.S. net capital outflow 11

Figure The market for foreign-currency exchange 2 12 Real Exchange Rate Quantity of Dollars Exchanged into Foreign Currency Equilibrium real exchange rate Supply of dollars (from net capital outflow) Demand for dollars (for net exports) Equilibrium quantity 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 Net capital outflow: link between the two markets 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 13

Figure How net capital outflow depends on the interest rate 3 14 Real Interest Rate Net Capital 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. 0 Net capital outflow is positive Net capital outflow is negative

Equilibrium in the Open Economy Simultaneous equilibrium in two markets – Market for loanable funds Supply: national saving Demand: domestic investment & net capital outflow Equilibrium real interest rate, r – Net capital outflow Slopes downward Equilibrium interest rate, r 15

Equilibrium in the Open Economy Simultaneous equilibrium in two markets – 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 real exchange rate, E Price of domestic goods and services – Relative to foreign goods and services 16

Equilibrium in the Open Economy Simultaneous equilibrium in two markets E and r - adjust simultaneously – To balance supply and demand In both markets – Loanable funds – Foreign-currency exchange – Determine National saving Domestic investment Net capital outflow Net exports 17

Figure The real equilibrium in an open economy 4 18 Real Interest Rate Supply Demand Quantity of Loanable Funds (a) The Market for Loanable Funds Real Interest Rate Net capital outflow, NCO Net capital outflow (b) Net Capital Outflow r1r1 r1r1 Real Exchange Rate Supply Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange E1E1 In panel (a), the supply and demand for loanable funds determine the real interest rate. In panel (b), the interest rate determines net capital outflow, which provides the supply of dollars in the market for foreign-currency exchange. In panel (c), the supply and demand for dollars in the market for foreign-currency exchange determine the real exchange rate.

How Policies & Events Affect an Open Economy Government budget deficits Negative public saving Reduces national saving Reduces supply of loanable funds Increase in interest rate Reduces net capital outflow Crowd-out domestic investment Decrease in supply of foreign-currency exchange Exchange rate appreciates Net exports fall Push the trade balance toward deficit 19

Figure The effects of a government budget deficit 5 20 Real Interest Rate S1S1 Demand Quantity of Loanable Funds (a) The Market for Loanable Funds Real Interest Rate NCO Net capital outflow (b) Net Capital Outflow r1r1 Real Exchange Rate S1S1 Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange E1E1 When the government runs a budget deficit, it reduces the supply of loanable funds from S 1 to S 2 in panel (a). The interest rate rises from r 1 to r 2 to balance the supply and demand for loanable funds. In panel (b), the higher interest rate reduces net capital outflow. Reduced net capital outflow, in turn, reduces the supply of dollars in the market for foreign-currency exchange from S 1 to S 2 in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate from E 1 to E 2. The appreciation of the exchange rate pushes the trade balance toward deficit. S2S2 r1r1 A 1. A budget deficit reduces the supply of loanable funds... r2r2 B which increases the real interest rate... r2r which in turn reduces net capital outflow. S2S2 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency... E2E Which causes the real exchange rate to appreciate.

How Policies & Events Affect an Open Economy 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 21

How Policies & Events Affect an Open Economy Trade policy Macroeconomic impact of trade policy Decrease imports Increase in net exports Increase in demand for foreign-currency exchange Real exchange rate appreciates – Discourage exports No change in real interest rate No change in net capital outflow No change in net exports 22

Figure The effects of an import quota 6 23 Real Interest Rate Supply Demand Quantity of Loanable Funds (a) The Market for Loanable Funds Real Interest Rate NCO Net capital outflow (b) Net Capital Outflow r1r1 r1r1 Real Exchange Rate Supply D1D1 Quantity of Dollars (c) The Market for Foreign-Currency Exchange E1E1 When the U.S. government imposes a quota on the import of Japanese cars, nothing happens in the market for loanable funds in panel (a) or to net capital outflow in panel (b). The only effect is a rise in net exports (exports minus imports) for any given real exchange rate. As a result, the demand for dollars in the market for foreign-currency exchange rises, as shown by the shift from D 1 to D 2 in panel (c). This increase in the demand for dollars causes the value of the dollar to appreciate from E 1 to E 2. This appreciation of the dollar tends to reduce net exports, offsetting the direct effect of the import quota on the trade balance. D2D2 1. An import quota increases the demand for dollars... E2E And causes the real exchange rate to appreciate. 3. Net exports, however, remain the same.

How Policies & Events Affect an Open Economy 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 24

How Policies & Events Affect an Open Economy 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 25

How Policies & Events Affect an Open Economy Mexico - capital flight affects both markets – Investors Sell Mexican assets & Buy U.S. assets – 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 – Interest rate – increases – The peso – depreciates 26

Figure The effects of capital flight 7 27 Real Interest Rate Supply D1D1 Quantity of Loanable Funds (a) The Market for Loanable Funds in Mexico Real Interest Rate NCO 1 Net capital outflow (b) Mexican Net Capital Outflow r1r1 r1r1 Real Exchange Rate S1S1 Demand Quantity of Pesos (c) The Market for Foreign-Currency Exchange E1E1 If people decide that Mexico is a risky place to keep their savings, they will move their capital to safer havens such as the U.S., resulting in an increase in Mexican net capital outflow. The demand for loanable funds in Mexico rises from D 1 to D 2, as shown in panel (a), and this drives up the Mexican real interest rate from r 1 to r 2. Because net capital outflow is higher for any interest rate, that curve also shifts to the right from NCO 1 to NCO 2 in panel (b). At the same time, in the market for foreign-currency exchange, the supply of pesos rises from S 1 to S 2, as shown in panel (c). This increase in the supply of pesos causes the peso to depreciate from E 1 to E 2, so the peso becomes less valuable compared to other currencies. NCO 2 1. An increase in net capital outflow... D2D increases the demand for loanable funds... r2r Which increases the interest rate. r2r2 S2S2 E2E2 4. At the same time, the increase in net capital outflow increases the supply of pesos which causes the peso to depreciate