A Macroeconomic Theory of the Open Economy Chapter 30 Copyright © 2001 by Harcourt, Inc. All rights reserved.   Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

Key Macroeconomic Variables in an Open Economy The important macroeconomic variables of an open economy include: net exports net foreign investment nominal exchange rates real exchange rates

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.

The Market for Loanable Funds S = I + NFI At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net foreign investment.

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 foreign investment (NFI).

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.

The Market for Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Demand for loanable funds (for domestic investment and net foreign investment) Equilibrium quantity real interest rate Quantity of Loanable Funds

The Market for Loanable Funds At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment.

The Market for Foreign-Currency Exchange The two sides of the foreign-currency exchange market are represented by NFI and NX. NFI represents the imbalance between the purchases and sales of capital assets. NX represents the imbalance between exports and imports of goods and services.

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, NFI and NX must balance each other out, or: NFI = NX

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 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 foreign investment is unrelated to the real exchange rate.

The Market for Foreign-Currency Exchange... Real Exchange Rate Supply of dollars (from net foreign investment) Demand for dollars (for net exports) Equilibrium quantity Equilibrium real exchange rate Quantity of Dollars Exchanged into Foreign Currency

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.

Equilibrium in the Open Economy In the market for loanable funds, supply comes from national saving and demand comes from domestic investment and net foreign investment. In the market for foreign-currency exchange, supply comes from net foreign investment and demand comes from net exports.

Equilibrium in the Open Economy Net foreign investment links the loanable funds market and the foreign-currency exchange market. The key determinant of net foreign investment is the real interest rate.

How Net Foreign Investment Depends on the Interest rate... Real Interest Rate Net Foreign Investment Net foreign investment is negative. Net foreign investment is positive.

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.

The Real Equilibrium in an Open Economy (a) The Market for Loanable Funds (b) Net Foreign Investment Real Interest Rate Real Interest Rate Supply r1 E1 Net foreign investment, NFI Demand Quantity of Net Foreign Loanable Funds Investment Real Exchange Rate Supply Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange

How Changes in 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 In an open economy, government budget deficits . . . reduces the supply of loanable funds, drives up the interest rate, crowds out domestic investment, cause net foreign investment to fall.

The Effects of Government Budget Deficit (a) The Market for Loanable Funds (b) Net Foreign Investment Real Interest Rate Real Interest Rate 1. A budget deficit reduces the supply of loanable funds... S2 B S1 r2 E2 2. ...which increases the real interest... 3. ...which in turn reduces net foreign investment. r1 A E1 Demand NFI Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate 4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency… S2 S1 5. …which causes the real exchange rate to appreciate. Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange

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.

Effect of Budget Deficits on Net Foreign Investment Higher interest rates reduce net foreign investment.

Effect on the Foreign-Currency Exchange Market A decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency. This causes the real exchange rate to appreciate.

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 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.

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.

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.

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.

The Effects of an Import Quota (a) The Market for Loanable Funds (b) Net Foreign Investment Real Interest Rate Real Interest Rate S1 3. Net exports, however, remain the same. r1 E1 Demand NFI Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate Supply 1. An import quota increases the demand for dollars… E2 2. …and causes the real exchange rate to appreciate. Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange

Effect of an Import Quota Trade policies do not affect the trade balance.

Political Instability and Capital Flight Capital flight is a large and sudden movement of funds out of a country, usually due to political instability.

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 currency depreciates.

Political Instability in Mexico 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 in Mexico and Capital Flight This increased Mexican net foreign investment. 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.

The Effects of Capital Flight (a) The Market for Loanable Funds (b) Mexican Net Foreign Investment Real Interest Rate Real Interest Rate 2. …increases the demand for loanable funds... D2 S1 NFI1 1. An increase in net foreign investment... NFI1 S2 r2 E2 3. …which increases the interest rate. E1 r1 D1 Quantity of Net Foreign Loanable Funds Investment Real Exchange Rate 4. At the same time, the increase in net foreign investment increases the supply of pesos... S1 5. …which causes the real exchange rate to appreciate. Demand Quantity of Pesos (c) The Market for Foreign-Currency Exchange

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 foreign investment).

Summary In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (for net foreign investment) and the demand for dollars (for net exports). Net foreign investment is the variable that connects the two markets.

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 foreign investment, reducing the supply of dollars. The dollar appreciates, and net exports fall.

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.

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.

Graphical Review

The Market for Loanable Funds Quantity of Loanable Funds Real Interest Rate Demand for loanable funds (for domestic investment and net foreign investment) Supply of loanable funds (from national saving) Equilibrium quantity real interest rate

The Market for Foreign-Currency Exchange... Quantity of Dollars Exchanged into Foreign Currency Real Exchange Rate Supply of dollars (from net foreign investment) Demand for dollars (for net exports) Equilibrium quantity Equilibrium real exchange rate

How Net Foreign Investment Depends on the Interest rate... Net Foreign Investment Real Interest Rate Net foreign investment is positive. Net foreign investment is negative.

The Real Equilibrium in an Open Economy (a) The Market for Loanable Funds (b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Quantity of Loanable Funds Demand Supply Quantity of Dollars Net Foreign Investment Net foreign investment, NFI Real Exchange Rate Real Interest Rate r1 E1

The Effects of Government Budget Deficit 1. A budget deficit reduces the supply of loanable funds... S2 B (a) The Market for Loanable Funds (b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Quantity of Loanable Funds Demand S1 Quantity of Dollars Net Foreign Investment NFI 5. …which causes the real exchange rate to appreciate. Real Exchange Rate Real Interest Rate 3. ...which in turn reduces net foreign investment. 4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency… r1 A E1 2. ...which increases the real interest...

The Effects of an Import Quota 1. An import quota increases the demand for dollars… (a) The Market for Loanable Funds (b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Quantity of Loanable Funds Demand S1 Quantity of Dollars Supply Net Foreign Investment NFI Real Exchange Rate Real Interest Rate r1 E1 E2 2. …and causes the real exchange rate to appreciate. 3. Net exports, however, remain the same.

The Effects of Capital Flight NFI1 1. An increase in net foreign investment... 2. …increases the demand for loanable funds... D2 (a) The Market for Loanable Funds (b) Mexican Net Foreign Investment (c) The Market for Foreign-Currency Exchange Quantity of Loanable Funds D1 S1 Quantity of Pesos Demand Net Foreign Investment Real Exchange Rate Real Interest Rate E1 r1 S2 r2 E2 5. …which causes the real exchange rate to appreciate. 4. At the same time, the increase in net foreign investment increases the supply of pesos... 3. …which increases the interest rate.