A Macroeconomic Theory of the Open Economy © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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) © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market for Loanable Funds When NCO > 0 Net outflow of capital Net purchase of capital overseas Adds to the demand for domestically generated loanable funds When NCO < 0 Net inflow of capital Capital resources coming from abroad Reduce the demand for domestically generated loanable funds © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market for Loanable Funds Higher real interest rate Discourages Americans from buying foreign assets Reduces U.S. net capital outflow Encourages foreigners to buy U.S. assets © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1 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 real interest rate Equilibrium quantity Quantity of Loanable Funds 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. © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Foreign-Currency Exchange The market for foreign-currency exchange Identity: NCO = NX Net capital outflow = Net exports If trade surplus, NX > 0 Exports > Imports Net sale of goods ad services abroad Americans use the foreign currency to buy foreign assets Capital is flowing abroad, NCO > 0 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Foreign-Currency Exchange If trade deficit, NX < 0 Imports > Exports Some of this spending - financed by selling American assets abroad Foreign capital is flowing into U.S. NCO < 0 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Foreign-Currency Exchange Supply of foreign-currency exchange Net capital outflow Quantity of dollars supplied to buy foreign assets Supply curve – vertical Quantity of dollars supplied for net capital outflow Does not depend on the real exchange rate © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Foreign-Currency Exchange Demand for foreign-currency exchange Net exports Quantity of dollars demanded to 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 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 2 The Market for Foreign-Currency Exchange Real Exchange Rate Supply of dollars (from net capital outflow) Demand for dollars (for net exports) Equilibrium real exchange rate Equilibrium quantity Quantity of Dollars Exchanged into Foreign Currency 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. © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Equilibrium in the Open Economy 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 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 3 How Net Capital Outflow Depends on the Interest Rate Real Interest Rate Net capital outflow is negative Net Capital Outflow Net capital outflow is positive 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. © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Equilibrium in the Open Economy 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 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Equilibrium in the Open Economy 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 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Equilibrium in the Open Economy Equilibrium real exchange rate, E Price of domestic goods and services Relative to foreign goods and services E and r - adjust simultaneously To balance supply and demand In both markets Loanable funds Foreign-currency exchange © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Equilibrium in the Open Economy E and r - adjust simultaneously Determine National saving Domestic investment Net capital outflow Net exports © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 4 The Real Equilibrium in an Open Economy Quantity of Loanable Funds (a) The Market for Loanable Funds Net capital outflow (b) Net Capital Outflow Real Interest Rate Real Interest Rate Supply Net capital outflow, NCO Demand r1 r1 Real Exchange Rate Supply 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. Demand E1 Quantity of Dollars (c) The Market for Foreign-Currency Exchange © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Government Budget Deficits When government spending exceeds government revenue Negative public saving Reduces national saving Reduces supply of loanable funds Increase in interest rate Reduces net capital outflow © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Government Budget Deficits Crowd-out domestic investment Decrease in supply of foreign-currency exchange Currency appreciates Net exports fall Push the trade balance toward deficit © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 5 The Effects of a Government Budget Deficit S2 S1 r2 r2 A B Quantity of Loanable Funds (a) The Market for Loanable Funds Net capital outflow (b) Net Capital Outflow Real Interest Rate 1. A budget deficit reduces the supply of loanable funds . . . Real Interest Rate NCO S2 S1 r2 B Demand r2 r1 A 3. . . . which in turn reduces net capital outflow. r1 2. . . . which increases the real interest rate . . . Real Exchange Rate When the government runs a budget deficit, it reduces the supply of loanable funds from S1 to S2 in panel (a). The interest rate rises from r1 to r2 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 S1 to S2 in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate from E1 to E2. The appreciation of the exchange rate pushes the trade balance toward deficit. S2 S1 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency . . . Demand E2 5. . . . Which causes the real exchange rate to appreciate. E1 Quantity of Dollars (c) The Market for Foreign-Currency Exchange © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Trade Policy 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 Voluntary export restrictions © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Trade Policy Macroeconomic impact of trade policy Decrease imports Increase in net exports Increase in demand for dollars in the market for foreign-currency exchange Real exchange rate appreciates Discourage exports © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Trade Policy Macroeconomic impact of trade policy No change in real interest rate No change in net capital outflow No change in net exports Decrease in imports Decrease in exports © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 6 The Effects of an Import Quota Quantity of Loanable Funds (a) The Market for Loanable Funds Net capital outflow (b) Net Capital Outflow Real Interest Rate Real Interest Rate Supply NCO 3. Net exports, however, remain the same. Demand r1 r1 Real Exchange Rate 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 D1 to D2 in panel (c). This increase in the demand for dollars causes the value of the dollar to appreciate from E1 to E2. This appreciation of the dollar tends to reduce net exports, offsetting the direct effect of the import quota on the trade balance. 2. . . . And causes the real exchange rate to appreciate. Supply D2 E2 D1 E1 1. An import quota increases the demand for dollars . . . Quantity of Dollars (c) The Market for Foreign-Currency Exchange © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Political Instability &Capital Flight Leads to capital flight Capital flight Large and sudden reduction in the demand for assets located in a country © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Political Instability &Capital Flight Mexico - capital flight affects both markets 1994, political instability Investors – capital flight Sell Mexican assets Buy U.S. assets, “safe haven” 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 © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Political Instability &Capital Flight Mexico - capital flight affects both markets Interest rate in Mexico – increases Reduce domestic investment Slows capital accumulations Slows economic growth The peso depreciates Exports – cheaper Imports - more expensive Trade balance moves toward surplus © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 7 The Effects of Capital Flight Quantity of Loanable Funds (a) The Market for Loanable Funds in Mexico Net capital outflow (b) Mexican Net Capital Outflow Real Interest Rate Real Interest Rate D2 NCO2 1. An increase in net capital outflow . . . NCO1 D1 Supply r2 r2 3. . . . Which increases the interest rate. r1 r1 2. . . . increases the demand for loanable funds . . . 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. Consequently, the demand for loanable funds in Mexico rises from D1 to D2, as shown in panel (a), and this drives up the Mexican real interest rate from r1 to r2. Because net capital outflow is higher for any interest rate, that curve also shifts to the right from NCO1 to NCO2 in panel (b). At the same time, in the market for foreign-currency exchange, the supply of pesos rises from S1 to S2, as shown in panel (c). This increase in the supply of pesos causes the peso to depreciate from E1 to E2, so the peso becomes less valuable compared to other currencies. Real Exchange Rate 4. At the same time, the increase in net capital outflow increases the supply of pesos . . . S1 S2 Demand E1 5. . . . which causes the peso to depreciate E2 Quantity of Pesos (c) The Market for Foreign-Currency Exchange © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Political Instability &Capital Flight Mexico - capital flight affects both markets U.S. market Fall in U.S. net capital outflow The dollar appreciates in value U.S. interest rates fall Relatively small impact on the U.S. economy Because the economy of the United States is so large compared to that of Mexico © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital flows from China Nation that experiences capital flight Outflow of capital Its currency weaken in foreign exchange markets Depreciation Increases the nation’s net exports Nation that experiences inflow of capital Its currency strengthen Appreciation Pushes its trade balance toward deficit © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital flows from China A nation’s government – policy: Encourages capital to flow to another country By making foreign investments itself Effect? Nation encouraging capital outflows Weaker currency Trade surplus For the recipient of capital flows Stronger currency Trade deficit © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital flows from China Ongoing policy disputes: U.S. and China China – tried to depress its currency (renminbi) in foreign exchange markets Promote its export industries Accumulate foreign assets, $2.4 trillion, 2009 Including U.S. government bonds Chinese goods - less expensive Contributes to the U.S. trade deficit Hurts American producers who make products that compete with imports from China © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital flows from China Ongoing policy disputes: U.S. and China U.S. government Encouraged China to stop influencing the exchange value of its currency American consumers of Chinese imports Benefit from lower prices Inflow of capital from China Lowers U.S. interest rates Increases investment in the U.S. economy © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital flows from China Chinese policy of investing in U.S. economy Creates winners and losers among Americans Net impact on U.S. economy - probably small Motives behind the policy China - wants to accumulate a reserve of foreign assets - national “rainy-day fund” Misguided policy © 2011 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 distributed with a certain product or service or otherwise on a password-protected website for classroom use.