Macroeconomic Theory of Open Economy

Slides:



Advertisements
Similar presentations
A Macroeconomic Theory of the Open-Economy. Outline:  Develop a model to study forces that determine the open economy variables (NX, NFI, RER)  How.
Advertisements

Copyright © 2004 South-Western 19 A Macroeconomic Theory of the Open Economy.
14 A Macroeconomic Theory of the Open Economy. Open Economies An open economy is one that interacts freely with other economies around the world.
A Macroeconomic Theory of the Open Economy
M ACROECONOMIC T HEORY OF O PEN E CONOMY ETP Economics 102 Jack Wu.
Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 32.
Chapter 18 A Macroeconomic Theory Of the Open Economy
Chapter 5: The Open Economy
A Macroeconomic Theory of the Open Economy
C h a p t e r seventeen © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. Prepared by: Fernando & Yvonn.
February exam  Answers and grades are on WebCT  Problems: me.  ECON me.
OPEN ECONOMY MACROECONOMICS
A GGREGATE SUPPLY AND AGGREGATE DEMAND C HAPTERS 31, 32, AND 33 By Thuy Le.
11 THE MACROECONOMICS OF OPEN ECONOMIES. Copyright © 2010 Cengage Learning 6 Open-Economy Macroeconomics.
In this chapter, look for the answers to these questions:
© 2009 Prentice Hall Business Publishing Economics Hubbard/O’Brien UPDATE EDITION. Fernando & Yvonn Quijano Prepared by: Chapter 29 Macroeconomics in an.
Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 13: A Macroeconomic Theory of the Open Economy.
Chapter 32 A Macroeconomic Theory of the Open Economy
Open Macroeconomic Economy Part 2 (Chapter 32) Barnett UHS AP Econ.
© 2008 Nelson Education Ltd. N. G R E G O R Y M A N K I W R O N A L D D. K N E E B O N E K E N N E T H J. M c K ENZIE NICHOLAS ROWE PowerPoint ® Slides.
Balance of Payments Accounts Payments from foreigners Payments to foreigners Net S/P of goods & services $1,994 billion$2,523 billion-$529 billion Factor.
Principles of Macroeconomics: Ch. 18 Second Canadian Edition Chapter 18 A Macroeconomic Theory of the Open Economy © 2002 by Nelson, a division of Thomson.
Copyright © 2006 Thomson Learning 32 A Macroeconomic Theory of the Open Economy.
The Balance of Payments: Linking the United States to the International Economy Current account records a country’s net exports, net income on investments,
N. G R E G O R Y M A N K I W Premium PowerPoint ® Slides by Ron Cronovich 2008 update © 2008 South-Western, a part of Cengage Learning, all rights reserved.
© 2007 Thomson South-Western. Open-Economy Macroeconomics: Basic Concepts Open and Closed Economies –A closed economy is one that does not interact with.
A Macroeconomic Theory of the Open Economy
The Theory of the Open Economy: A Complete Logical Flow The theory relates and determines r, NCO, EP/P *, and NX It begins with conditions in the loanable.
A Macroeconomic Theory of an Open Economy
© 2007 Thomson South-Western. A Macroeconomics Theory of the Open Economy Open Economies An open economy is one that interacts freely with other economies.
A Macroeconomic Theory of the Open Economy Chapter 30 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of.
A Macroeconomic Theory of the Open Economy Chapter 14.
Copyright © 2010 Cengage Learning 32 A Macroeconomic Theory of the Open Economy.
ECO1000 Economics Semester One, 2004 Lecture Nine.
© 2007 Thomson South-Western. Open-Economy Macroeconomics: Basic Concepts Open and Closed Economies –A closed economy is one that does not interact with.
© 2007 Thomson South-Western. A Macroeconomics Theory of the Open Economy Open Economies An open economy is one that interacts freely with other economies.
Financial System:Loanable Fund and Exchange Markets IMBA Macroeconomics II Lecturer: Jack Wu.
Lectures (Chap. 32) A Macroeconomic Theory of the Open Economy.
Chapter A Macroeconomic Theory of the Open Economy 19.
A Macroeconomic Theory of the Open Economy Chapter 30.
Chapter Open-Economy Macroeconomics: Basic Concepts 18.
Chapter 32 Open Economies An open economy is one that interacts _________ with other economies around the world.
ETP Economics 102 Jack Wu. Key Macroeconomic Variables The important macroeconomic variables of an open economy include: net exports net foreign investment.
31 Open-Economy Macroeconomics: Basic Concepts. Open and Closed Economies – A closed economy is one that does not interact with other economies in the.
A MACROECONOMIC THEORY OF THE OPEN ECONOMY 0. 1 Introduction  The previous chapter explained the basic concepts and vocabulary of the open economy: net.
PowerPoint Presentations for Principles of Macroeconomics Sixth Canadian Edition by Mankiw/Kneebone/McKenzie Adapted for the Sixth Canadian Edition by.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license.
THE MACROECONOMICS OF OPEN ECONOMIES
A Macroeconomic Theory of the Open Economy
© 2007 Thomson South-Western
A Macroeconomic Theory of the Open Economy
A Macroeconomic Theory of the Open Economy
Open-Economy Macroeconomics
Open Economy Macroeconomics
A Macroeconomic Theory of the Open Economy
Loanable Fund and Exchange Markets
Macroeconomic Theory of Open Economy
A Macroeconomic Theory of the Open Economy
Open-Economy Macroeconomics
Open-Economy Macroeconomics: Basic Concepts
A Macroeconomic Theory of the Open Economy
Saving, Investment, and the Financial System
A Macroeconomic Theory of the Open Economy
THE MACROECONOMICS OF OPEN ECONOMIES
Open Economy Macroeconomics
Macroeconomic Theory of Open Economy
Open-Economy Macroeconomics: Basic Concepts
OPEN ECONOMY MACROECONOMICS
THE MACROECONOMICS OF OPEN ECONOMIES
Presentation transcript:

Macroeconomic Theory of Open Economy ETP Economics 102 Jack Wu

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

NET FOREIGN INVESTMENT Foreign investment includes foreign direct investment and foreign portfolio investment. Direct investment: physical capital such as factory, office, and so on. Portfolio investment: financial asset such as currency, stock, bond and so on. Net foreign investment = outbound foreign investment – inbound foreign investment Net foreign investment = Net capital outflow

Basic Assumptions The model takes the economy’s GDP as given. The model takes the economy’s price level as given.

Market for Loanable Funds The Market for Loanable Funds S = 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. 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).

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 capital outflow) Equilibrium quantity real interest rate Quantity of Loanable Funds Copyright©2003 Southwestern/Thomson Learning

Equilibrium in 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 (net capital outflow).

Foreign-Currency Exchange Market 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

Foreign-Currency Exchange Market 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 The price that balances the supply and demand for foreign-currency is the real exchange rate.

Foreign-Currency Exchange Market 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.

The Market for Foreign-Currency Exchange Real Exchange Rate Supply of dollars (from net capital outflow) Demand for dollars (for net exports) Equilibrium quantity real exchange rate Quantity of Dollars Exchanged into Foreign Currency Copyright©2003 Southwestern/Thomson Learning

Equilibrium in Foreign-Currency Exchange Market 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 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.

Equilibrium in 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.

How Net Capital Outflow Depends on the Interest Rate Real Interest Rate Net capital outflow is negative. Net capital outflow is positive. Net Capital Outflow Copyright©2003 Southwestern/Thomson Learning

Equilibrium in 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 Capital Outflow Real Real Interest Interest Net capital outflow, NCO Supply Rate Rate Demand r Quantity of Net Capital Loanable Funds Outflow Real Exchange Supply Rate Demand E Quantity of Dollars (c) The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning

Policies 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 . . . reduce the supply of loanable funds, drive up the interest rate, crowd out domestic investment, cause net foreign investment to fall.

The Effects of Government Budget Deficit 1. A budget deficit reduces the supply of loanable funds . . . (a) The Market for Loanable Funds (b) Net Capital Outflow Real Real Interest S S Interest Rate Rate r2 B r2 E1 r A 2. . . . which increases the real interest rate . . . 3. . . . which in turn reduces net capital outflow. Demand NCO Quantity of Net Capital Loanable Funds Outflow Real Exchange S S Rate 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency . . . E2 5. . . . which causes the real exchange rate to appreciate. Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning

Effects 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.

Effects 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.

The Effects of an Import Quota (a) The Market for Loanable Funds (b) Net Capital Outflow Real Real Interest Supply Interest Rate Rate r r 3. Net exports, however, remain the same. Demand NCO Quantity of Net Capital Loanable Funds Outflow Real Exchange Supply Rate D 1. An import quota increases the demand for dollars . . . E2 2. . . . and causes the real exchange rate to appreciate. E D Quantity of Dollars (c) The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning

Effects 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.

Effects 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.

Effects 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. Trade policies do not affect the trade balance.

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. Interest rates increase and the domestic currency depreciates.

The Effects of Capital Flight (a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow Real Real Supply NCO2 1. An increase in net capital outflow. . . Interest Interest Rate D2 Rate r2 3. . . . which increases the interest rate. r1 r1 2. . . . increases the demand for loanable funds . . . D1 NCO1 Quantity of Net Capital Loanable Funds Outflow Real Exchange S S2 Rate 4. At the same time, the increase in net capital outflow increases the supply of pesos . . . E 5. . . . which causes the peso to depreciate. E Demand Quantity of Pesos (c) The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning