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 funds market and then the foreign exchange market. In each market, the demand and supply are analyzed, put together to determine equilibrium, and then the effects of shifts in demand and supply are analyzed. The two markets are linked together and r, NCO, EP/P *, and NX are jointly determined. Different policies and situations are then analyzed and their affect on r, NCO, EP/P *, and NX identified.

The Loanable Funds Market The supply and demand in the loanable funds market determines the real interest rate {r} –Closed Economy: S=I only domestic borrowing and lending are allowed. –Open Economy: S=I+NCO this allows trade and borrowing and lending from the ROW (rest of the world)

National Saving: S → S LF is positively related to r↓(↑) → S LF ↓(↑) Investment and Net Capital Flow: I+NCO → D LF is negatively related to r ↓(↑) → D LF ↑(↓) –r ↓(↑) I ↑(↓) r↓(↑) PV ↑(↓) of future returns –r ↓(↑) NCO ↑(↓) r US ↓(↑) US increases (decreases) demand for ROW assets and ROW decreases (increases) demand for US assets

The equilibrium r in the LF market brings national saving = investment +net capital outflow or S=I+NCO. Supply-side shocks to LF –S↓ (income taxes↑ or budget →deficit), then r↑→LF↓ –S↑ (income taxes↓ or budget →surplus), then r↓→LF↑ Demand-side shocks to LF –I↓ (tax credits↑ or expected Y↑), then r↑→LF↑ –I↑ (tax credits↓ or expected Y↓), then r↓→LF↓ –NCO↓ (political instability abroad↑), then r↑→LF↑ [US holds fewer ROW assets and ROW holds more US assets] –NCO↑ (political stability abroad↑), then r↓→LF↓ [US holds more ROW assets and ROW holds less US assets] We have now fully described the LF market and the determination of r

The Foreign Exchange Market The supply and demand in the foreign exchange market determines the real interest exchange rate EP/P * –Closed Economy: no trading, NX, or EP/P *. –Open Economy: NX=NCO this allows trade and borrowing and lending from the ROW (rest of the world)

Net Capital Outflow - NCO: S → S $ –If NCO↑, US is supplying more dollars, on net, to purchase foreign assets –If NCO↓, US is supplying fewer dollars, on net, to purchase fewer foreign assets –NCO is determined by r in the loanable funds markets and is not related to EP/P*. –As EP/P*↓(↑), NCO remains the same ↓

Net Exports - NX: → D $ is negatively related to EP/P*↓(↑) –If EP/P*↓, NX↑, D $ ↑ - US goods become cheaper, net exports increase, and ROW needs more US dollars to purchase more goods and services – If EP/P*↑, NX↓, D $ ↓ - US goods become more expensive, net exports decrease, and ROW needs fewer US dollars to purchase fewer goods and services Equilibrium in the foreign exchange market occurs when the EP/P* equates the D $ with the S $ or NX=NCO.

Linking the Loanable Funds and Foreign Exchange Market NCO link the two markets together Step 1: S=I+NCO or S LF =D LF →r Step 2: r →NCO Step 3: NCO →S $ Step 4: NX →D $ Step 5: D $ =S $ →EP/P * and NX=NCO

Examples of Transmission of LF and FEM Shocks Loanable Funds Shocks: –S↓, S LF ↓, r↑,NCO↓,S $ ↓, EP/P*↑,NX↓ –S↑, S LF ↑, r↓,NCO↑,S $ ↑, EP/P*↓,NX↑ –I↑, D LF ↑, r↑,NCO↓,S $ ↓, EP/P*↑,NX↓ –I↓, D LF ↓, r ↓,NCO↑,S $ ↑, EP/P*↓,NX↑ Exchange Rate Shocks –D $ ↑, S $ is constant from NCO, EP/P*↑, until quantity of D $ ↓, but NX are constant, r is constant –D $ ↓, S $ is constant from NCO, EP/P*↓, until quantity of D $ ↑, but NX are constant, r is constant