1. A Macroeconomic Theory of the Open Economy32
A Macroeconomic Theory of the Open Economy
Economics
P R I N C I P L E S O F
N. Gregory Mankiw
Many instructors skip this chapter. I encourage you to consider keeping it: it sheds light on some of the most important and compelling topics in economics, and I have worked hard to make this PowerPoint easy to teach and easy to learn.
Students will learn in this chapter what I believe is one of the most important lessons economics has to offer the educated layperson: Trade policies designed to save jobs in one industry do so only by destroying jobs in other industries. This case against restricting imports has a much greater emotional impact on students than the deadweight loss triangles students learn in their micro courses.
The chapter also covers capital flight, the twin deficits, and – new to the 5th edition – a nice case study on capital flows from China.
Students can use the concepts in this chapter to better understand a very topical issue: the recent, sharp depreciation of the U.S. dollar. This PowerPoint presentation helps them do that with a new case study on the falling dollar.
Professors know that this chapter is one of the most difficult in the textbook. Yet, I have worked hard to make this presentation easy for you to teach and easy for students to learn. I hope you will consider covering it.
Premium PowerPoint Slides by Ron Cronovich

2. In this chapter, look for the answers to these questions:
In an open economy, what determines the real interest rate? The real exchange rate? 개방경제에서 실질이자율과 실질환율을 결정하는 것은 무엇?
How are the markets for loanable funds and foreign-currency exchange connected? 대부자금시장과 외환시장은 어떻게 연결되어 있나?
How do government budget deficits affect the exchange rate and trade balance? 정부의 재정적자는 환율과 무역수지에 어떻게 영향을 미치나?
How do other policies or events affect the interest rate, exchange rate, and trade balance? 다른 정책이나 사건들은 이자율, 환율, 무역수지에 어떻게 영향을 미치나? 1

3. Introduction
The previous chapter explained the basic concepts and vocabulary of the open economy: net exports (NX), net capital outflow (NCO), and exchange rates.
This chapter ties these concepts together into a theory of the open economy.
We will use this theory to see how govt policies and various events affect the trade balance, exchange rate, and capital flows.
We start with the loanable funds market…
A MACROECONOMIC THEORY OF THE OPEN ECONOMY 2

4. The Market for Loanable Funds
An identity from the preceding chapter:
S = I + NCO
Saving
Domestic investment
Net capital outflow
Supply of loanable funds = saving.
A dollar of saving can be used to finance
the purchase of domestic capital
the purchase of a foreign asset
So, demand for loanable funds = I + NCO
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5. The Market for Loanable Funds
Recall:
S depends positively on the real interest rate, r.
I depends negatively on r.
What about NCO?
A MACROECONOMIC THEORY OF THE OPEN ECONOMY 4

6. How NCO Depends on the Real Interest Rate
The real interest rate, r, is the real return on domestic assets. 실질이자율 r은 국내 자산의 실질 수익임
A fall in r makes domestic assets less attractive relative to foreign assets. r의 하락은 해외자산에 비해 국내자산을 덜 매력적이게 함
People in the U.S. purchase more foreign assets.
People abroad purchase fewer U.S. assets.
NCO rises.
Net capital outflow r
NCO
NCO r1
NCO1 r2
NCO2
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7. The Loanable Funds Market Diagram
r adjusts to balance supply and demand in the LF market.
Loanable funds r LF
S = saving
Both I and NCO depend negatively on r, so the D curve is downward-sloping.
D = I + NCO r1
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8. A C T I V E L E A R N I N G 1 Budget deficits and capital flows
Suppose the government runs a budget deficit (previously, the budget was balanced). 정부가 적자 재정을 시행하고 있다고 가정
Use the appropriate diagrams to determine the effects on the real interest rate and net capital outflow. 적절한 다이어그램을 사용하여 실질이자율과 순자본유출에 미치는 영향을 판단하라. 7

9. A C T I V E L E A R N I N G 1 Answers
A C T I V E L E A R N I N G Answers
When working with this model, keep in mind:
the LF market determines r (in left graph),
then this value of r determines NCO (in right graph).
A budget deficit reduces saving and the supply of LF, causing r to rise.
The higher r makes U.S. bonds more attractive relative to foreign bonds, reduces NCO.
Loanable funds
Net capital outflow r LF r
NCO S2 S1
NCO1 D1 r2 r2
This is the first time students are seeing the two graphs together. Be sure to point out that the vertical axis of both graphs measures the same variable on the same scale. Hence, r1 in the graph on the left is the same as r1 in the graph on the right.
Also, be sure to mention the direction of causality: the LF market diagram determines r, and then this value of r determines NCO in the diagram on the right. r1 r1 8

10. The Market for Foreign-Currency Exchange
Another identity from the preceding chapter:
NCO = NX
Net capital outflow
Net exports
In the market for foreign-currency exchange,
NX is the demand for dollars: Foreigners need dollars to buy U.S. net exports.
NCO is the supply of dollars: U.S. residents sell dollars to obtain the foreign currency they need to buy foreign assets.
That NX = demand for dollars and NCO = supply of dollars is critically important. Make sure to allow enough time for students to write this down in their notes.
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11. The Market for Foreign-Currency Exchange
Recall: The U.S. real exchange rate (E) measures the quantity of foreign goods & services that trade for one unit of U.S. goods & services. 미국의 실질환율(E)는 미국의 재화와 서비스 한단위와 교환되는 해외의 재화와 서비스의 양
E is the real value of a dollar in the market for foreign-currency exchange. 즉 외환시장에서 E는 1달러의 실질가치를 의미
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12. The Market for Foreign-Currency Exchange
An increase in E makes U.S. goods more expensive to foreigners, reduces foreign demand for U.S. goods – and U.S. dollars. E의 상승은 미국 재화를 외국인들에게 더 비싸게 만들어 미국재화와 달러에 대한 해외수요를 감소시킨다.
E adjusts to balance supply and demand for dollars in the market for foreign- currency exchange. E는 외환시장에서 달러에 대한 수요과 공급을 일치시킨다.
S = NCO E
Dollars
D = NX E1
An increase in E has no effect on saving or investment, so it does not affect NCO or the supply of dollars. E의 상승은 저축이나 투자에는 영향을 미치지 못하며, 따라서 NCO 또는 달러의 공급에도 영향을 미치지 않는다.
The 5th edition has a new paragraph with more intuition explaining why the S/NCO curve is vertical rather than positively sloped.
Here’s a quick summary:
If E rises, our dollars can buy more foreign assets (perhaps 60,000 pesos worth of Mexican bonds instead of 50,000).
Yet, what we care about is the rate of return on foreign assets.
This return does not depend on whether E is high or low.
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13. FYI: Disentangling Supply and Demand
When a U.S. resident buys imported goods, does the transaction affect supply or demand in the foreign exchange market? Two views: 미국의 내국인이 수입재를 살 때, 이 거래는 외환시장의 공급 또는 수요에 영향을 미치는가?
1. The supply of dollars increases. The person needs to sell her dollars to obtain the foreign currency she needs to buy the imports.
2. The demand for dollars decreases. The increase in imports reduces NX, which we think of as the demand for dollars.
(So, NX is really the net demand for dollars.)
Both views are equivalent. For our purposes, it’s more convenient to use the second. 두 가지 관점은 동일하다. 우리의 목적에는 후자를 사용하는 것이 보다 편리
It might be worth elaborating for a moment on the parenthetical remark: “Hence, NX is really the net demand for dollars.”
What we mean is that NX equals foreign demand for dollars to purchase U.S. exports minus U.S. supply of dollars to purchase imports.
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14. FYI: Disentangling Supply and Demand
When a foreigner buys a U.S. asset, does the transaction affect supply or demand in the foreign exchange market? Two views: 외국인이 미국의 자산을 살 때, 이 거래는 외환시장의 수요 또는 공급에 영향을 미치는가? 두가지 관점
1. The demand for dollars increases. The foreigner needs dollars in order to purchase the U.S. asset.
2. The supply of dollars falls. The transaction reduces NCO, which we think of as the supply of dollars.
(So, NCO is really the net supply of dollars.)
Again, both views are equivalent. We will use the second. 여기서도 두 가지 관점이 동등하지만 우리는 후자를 사용
Again, please consider elaborating on the parenthetical remark: “So, NCO is really the net supply of dollars.”
It means that NCO equals U.S. supply of dollars to purchase foreign assets minus foreign demand for dollars to purchase U.S. assets.
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15. A C T I V E L E A R N I N G 2 The budget deficit, exchange rate, and NX
Initially, the government budget is balanced and trade is balanced (NX = 0).
Suppose the government runs a budget deficit. As we saw earlier, r rises and NCO falls.
How does the budget deficit affect the U.S. real exchange rate? The balance of trade? 재정적자는 미국의 실질환율과 무역수지에 어떻게 영향을 미치는가?
This exercise, like the previous one, lets students work with one piece of the larger model before putting all the pieces together. 14

16. A C T I V E L E A R N I N G 2 Answers
Market for foreign-currency exchange
The budget deficit reduces NCO and the supply of dollars.
The real exchange rate appreciates,
reducing net exports.
Since NX = 0 initially, the budget deficit causes a trade deficit (NX < 0).
S2 = NCO2 E
Dollars
S1 = NCO1 E2 E1
D = NX 15

17. U.S. federal budget deficit
The “Twin Deficits”
Net exports and the budget deficit often move in opposite directions. 5%
U.S. federal budget deficit 4% 3% 2% 1%
Percent of GDP
U.S. net exports 0%
-1%
-2%
Data are 5-year averages of quarterly data. (This model applies to the long run, so using high-frequency data is not appropriate.)
Of course, there is not a perfect negative correlation. Other factors affect the trade deficit besides the budget deficit.
For example, consider the recession of The budget deficit increased, as usual in recessions, due to the fall in tax revenues and rise in automatic-stabilizer spending (like unemployment insurance benefits). Net exports increased (i.e., the trade deficit fell) due to a fall in imports.
But more generally, the data show that increases in the budget deficit are associated with decreases in the trade balance, as students found using the model in the preceding Active Learning exercises.
Source: Bureau of Economic Analysis, Department of Commerce. I got the data from
-3%
-4%
-5% 16

18. SUMMARY: The Effects of a Budget Deficit
National saving falls
The real interest rate rises
Domestic investment and net capital outflow both fall
The real exchange rate appreciates
Net exports fall (or, the trade deficit increases)
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19. SUMMARY: The Effects of a Budget Deficit
One other effect: As foreigners acquire more domestic assets, the country’s debt to the rest of the world increases.
Due to many years of budget and trade deficits, the U.S. is now the “world’s largest debtor nation.”
International investment position of the U.S. 31 December 2007
Value of U.S.-owned foreign assets
$17.6 trillion
Value of foreign-owned U.S. assets
$20.1 trillion
U.S.’ net debt to the rest of the world
$2.5 trillion
The last figure in the table, the U.S.’ net debt to the rest of the world, is bigger than any other country’s net debt to the rest of the world. Hence the expression “the U.S. is the world’s biggest debtor nation.”
Source: Bureau of Economic Analysis, Department of Commerce
Every June, the BEA publishes data for the previous year. By the time you teach this, the 2007 data will probably be available at the BEA’s website. If you’d like to update this chart, it’s pretty easy to find the data:
1. Visit the BEA’s website:
2. Under “international,” click on “international investment position.”
3. Download or open the table from the news release – it’s an Excel file.
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20. The Connection Between Interest Rates and Exchange Ratesr
NCO
NCO r2
NCO2 r1
S1 = NCO1
Keep in mind:
The LF market (not shown) determines r.
This value of r then determines NCO (shown in upper graph).
This value of NCO then determines supply of dollars in foreign exchange market (in lower graph).
Anything that increases r
will reduce NCO
and the supply of dollars in the foreign exchange market.
Result: The real exchange rate appreciates.
NCO1 S2 E
dollars
D = NX
In earlier slides, students analyzed the effects of a budget deficit on the real interest rate and net capital outflow separately from the effects of a change in NCO on the exchange rate.
This slide makes the connection between these events more explicit. Please point out to your students that both diagrams measure the same units on the horizontal axis.
This slide also reviews the order and direction of causality among the three diagrams:
1. The LF market determines the equilibrium value of r.
2. This value of r and the NCO curve determine the equilibrium value of NCO.
3. This value of NCO determines the position of the vertical supply curve in the foreign exchange market.
4. The real exchange rate adjusts to equate demand (net exports) with supply (NCO) in the foreign exchange market.
Students are much less likely to answer exam questions incorrectly if they carefully study this order and direction of causality among the various parts of this complicated model. E2 E1
NCO2
NCO1 19 19

21. A C T I V E L E A R N I N G 3 Investment incentives
Suppose the government provides new tax incentives to encourage investment.
Use the appropriate diagrams to determine how this policy would affect:
the real interest rate
net capital outflow
the real exchange rate
net exports
Students should find this policy experiment familiar; it was covered in the closed-economy loanable funds model from the chapter “Saving, Investment, and the Financial System.” 20

22. A C T I V E L E A R N I N G 3 Answers
r rises,
causing NCO to fall.
Investment – and the demand for LF – increase at each value of r.
Loanable funds
Net capital outflow r LF r
NCO S1 D2
NCO D1 r2 r2
NCO2 r1 r1
NCO1 21

23. A C T I V E L E A R N I N G 3 Answers
Market for foreign-currency exchange
The fall in NCO reduces the supply of dollars in the foreign exchange market.
The real exchange rate appreciates,
reducing net exports.
S2 = NCO2 E
Dollars
S1 = NCO1 E2 E1
D = NX 22

24. Budget Deficit vs. Investment Incentives
A tax incentive for investment has similar effects as a budget deficit: 투자에 대한 세제혜택은 재정적자와 유사한 효과를 나타낸다.
r rises, NCO falls
E rises, NX falls
But one important difference: 그러나 중요한 차이가 존재
Investment tax incentive increases investment, which increases productivity growth and living standards in the long run. 투자에 대한 세제혜택은 투자를 증가시켜 장기에 생산성의 상승과 생활수준의 향상을 가져온다.
Budget deficit reduces investment, which reduces productivity growth and living standards. 반면 재정적자는 투자를 감소시켜 생산성과 생활수준의 하락을 가져온다.
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25. Trade Policy
Trade policy: 무역정책 a govt policy that directly influences the quantity of g&s that a country imports or exports 한 나라가 수출 혹은 수입하는 재화와 서비스의 양에 직접 영향을 미치는 정부 정책
Examples:
Tariff – a tax on imports
Import quota – a limit on the quantity of imports
“Voluntary export restrictions” – the govt pressures another country to restrict its exports; essentially the same as an import quota
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26. Trade Policy Common reasons for policies to restrict imports:
Common reasons for policies to restrict imports:
Save jobs in a domestic industry that has difficulty competing with imports 수입재와 경쟁하기 힘든 국내 산업의 일자리를 보전하고
Reduce the trade deficit 무역적자를 축소
Do such trade policies accomplish these goals? 무역정책은 이러한 목표를 달성할 것인가?
Let’s use our model to analyze the effects of an import quota on cars from Japan designed to save jobs in the U.S. auto industry. 일본으로부터의 자동차 수입에 대한 수입쿼터의 효과 분석
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27. Analysis of a Quota on Cars from Japan
An import quota does not affect saving or investment, so it does not affect NCO. (Recall: NCO = S – I.)
Loanable funds
Net capital outflow r LF r
NCO S
NCO D
The supply of loanable funds is saving, which equals Y – C – G. A quota on imports does not affect Y or C or G, so it will not affect saving.
The demand for loanable funds equals investment + NCO, neither of which are affected by import quotas. Hence, r will not change.
The NCO curve does not shift in response to the import quota. The import quota is a restriction on international trade in goods & services. The NCO curve describes international trade in assets.
Hence, the equilibrium value of NCO is not affected by the import quota. r1 r1
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28. Analysis of a Quota on Cars from Japan
Since NCO unchanged, S curve does not shift.
The D curve shifts: At each E, imports of cars fall, so net exports rise, D shifts to the right.
At E1, there is excess demand in the foreign exchange market.
E rises to restore eq’m.
S = NCO E
Dollars D1 E1
Market for foreign-currency exchange D2 E2
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29. Analysis of a Quota on Cars from Japan
What happens to NX? Nothing! 순수출에는 어떤 변화도 없다.
If E could remain at E1, NX would rise, and the quantity of dollars demanded would rise. 만약 E가 E1으로 머물러 있다면 순수출이 증가하고 달러의 수요량이 증가할 것이다.
But the import quota does not affect NCO, so the quantity of dollars supplied is fixed. 그러나 수입쿼터는 NCO에 영향을 미치지 않아서 달러의 공급은 고정
Since NX must equal NCO, E must rise enough to keep NX at its original level. NX와 NCO가 일치해야 하기 때문에 NX가 원래수준을 유지할 수 있을 때까지 E가 상승해야
Hence, the policy of restricting imports does not reduce the trade deficit. 그래서 수입제한 정책은 무역적자를 줄이지 못한다.
The import quota on cars from Japan ends up having almost no macroeconomic effects. In particular, it does not affect the equilibrium values of r, S, I, NCO, or NX.
The only macro variable affected by the import quota is E, the real exchange rate.
Yet, the policy does have important microeconomic effects, as the next slide discusses.
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30. Analysis of a Quota on Cars from Japan
Does the policy save jobs?
The quota reduces imports of Japanese autos.
U.S. consumers buy more U.S. autos.
U.S. automakers hire more workers to produce these extra cars.
So the policy saves jobs in the U.S. auto industry.
But E rises, reducing foreign demand for U.S. exports.
Export industries contract, exporting firms lay off workers.
The import quota saves jobs in the auto industry but destroys jobs in U.S. export industries!!
A restriction on imports has important microeconomic effects.
It shifts demand to domestic autos, boosting output and employment in that industry.
But the exchange rate appreciation reduces foreign demand for U.S. exports, depressing output and employment in those industries.
If students have taken a semester of microeconomics, they have probably seen the deadweight loss triangles resulting from tariffs and quotas. On an intellectual level, they may understand what these deadweight losses represent. But job losses in struggling import-competing industries make a powerful impression on students.
The analysis here shows that the jobs import restrictions save come at the expense of other jobs. Understanding this lesson shatters the most common populist reason for supporting protectionism.
Also, if students remember anything about comparative advantage, they should understand that productivity is probably higher in the export sector, so wages are higher in the export sector, too. So it really doesn’t make sense to destroy good jobs in the export sector in order to save jobs in the lower-productivity import-competing sector.
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31. CASE STUDY: Capital Flows from China
In recent years, China has accumulated U.S. assets to reduce its exchange rate and boost its exports. 최근 중국은 자신의 환율을 낮추고 수출을 진작시키기 위해 미국 자산을 축적해왔다.
Results in U.S.:
Appreciation of $ relative to Chinese renminbi
Higher U.S. imports from China
Larger U.S. trade deficit
Some U.S. politicians want China to stop, argue for restricting trade with China to protect some U.S. industries. 일부 미국 정치가들은 중국이 멈추기를 원하며, 미국산업을 보호하기 위해 중국과의 무역을 제한할 것을 주장
Yet, U.S. consumers benefit, and the net effect of China’s currency intervention is probably small. 그러나 미국 소비자들은 이득을 보았으며 중국의 외환시장 개입의 순효과는 크지 않다.
This slide is based on a new Case Study in the 5th edition.
A MACROECONOMIC THEORY OF THE OPEN ECONOMY

32. Political Instability and Capital Flight
1994: Political instability in Mexico made world financial markets nervous. 1994년 멕시코의 정치적 불안정은 금융시장을 불안하게 만듬
People worried about the safety of Mexican assets they owned. 사람들은 자신이 소유한 멕시코 자산의 안전성을 염려
People sold many of these assets, pulled their capital out of Mexico. 사람들이 자산을 팔고 자신의 자본을 멕시코 바깥으로 가지고 나감
Capital flight: a large and sudden reduction in the demand for assets located in a country 자본도피는 한 나라에 소재하는 자산에 대한 대규모의 갑작스런 수요감소를 초래
We analyze this using our model, but from the prospective of Mexico, not the U.S. 멕시코의 입장에서 분석
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33. Capital Flight from Mexico
Demand for LF = I + NCO. 대부자금시장의 수요=I + NCO The increase in NCO increases demand for LF. NCO증가->수요증가
As foreign investors sell their assets and pull out their capital, NCO increases at each value of r. 해외투자자들이 자신의 자산을 팔고 자본을 가져나감에 따라 각 r의 수준에서 NCO는 증가
The equilibrium values of r and NCO both increase.
Loanable funds
Net capital outflow r LF r
NCO S1
NCO2 D2
NCO1 D1 r2 r2 r1
Students may ask “How can you be sure that NCO rises? Doesn’t the increase in r cause NCO to fall?”
You can convince them that NCO rises using simple algebra:
S = I + NCO
NCO = S – I
ΔNCO = ΔS – ΔI
where, for any variable X, ΔX = the change in X from one equilibrium to another.
Because r is higher in the new equilibrium,
ΔS > 0 and ΔI < 0
Hence, it must be true that ΔNCO > 0.
So, the increase in r reduces NCO somewhat, but not enough to reverse the initial capital outflow. r1
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34. Capital Flight from Mexico
Market for foreign-currency exchange E
Pesos D1
S1 = NCO1 E1
The increase in NCO causes an increase in the supply of pesos in the foreign exchange market. NCO의 증가는 외환시장에서 페소의 공급을 증가시킴
The real exchange rate value of the peso falls. 실질환율, 즉 페소의 가치는 하락
S2 = NCO2 E2
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35. Examples of Capital Flight: Mexico, 1994
The textbook briefly discusses four recent examples of capital flight. Here are a few slides showing the behavior of the exchange rate in each episode.
I would also like to include data on interest rates, but I cannot find reliable, weekly or monthly interest rate data for these countries. If you know of a good source, please let me know. Thanks! 34

36. Examples of Capital Flight: S.E. Asia, 199735

37. Examples of Capital Flight: Russia, 199836

38. Examples of Capital Flight: Argentina, 200237

39. CASE STUDY: The Falling Dollar65 70 75 80 85 90
2005
2006
2007
2008
U.S. trade-weighted nominal exchange rate index, March 1973 = 100
From 10/2005 to 6/2008, the dollar depreciated 17.3%
DISCLAIMER: This case study is not in the textbook and not supported with material in the study guide, instructors manual, or test bank, so please feel free to delete it.
However, this is a very topical issue that many students want to better understand. (The Daily Show with Jon Stewart and the Colbert Report, two shows many college students watch, make jokes about the falling dollar on occasion.)
Data description:
Trade-weighted exchange index: major currencies.
Source: Board of Governors, Federal Reserve, Release G.5 Foreign Exchange Rates
I used the series TWEXMMTH from FRED: 38

40. CASE STUDY: The Falling Dollar
Two likely causes: 두가지 가능한 원인
Subprime mortgage crisis
Reduced confidence in U.S. mortgage-backed securities 미국의 모기지에 기초한 증권에 대한 신뢰 감소
Increased NCO 순자본유출의 증가
U.S. interest rate cuts 미국의 이자율 인하
From 7/2006 to 7/2008, Federal Funds target rate reduced from 5.25% to 2.00% to stimulate the sluggish U.S. economy.
Increased NCO
This case study is not intended as a definitive explanation of the causes of the falling dollar. Rather, it mentions two of the most likely causes of the falling dollar, which students can now better understand using the analysis in this chapter.
Regarding the interest rate cuts:
Students learned in this and the previous chapter how changes in interest rates affect NCO, which in turn affects the supply of dollars in the foreign exchange market, which in turn affects the exchange rate.
What this chapter does NOT cover is how the Federal Reserve affects interest rates. The loanable funds framework in this chapter is not the best framework for illustrating Federal Reserve policy. (The loanable funds framework deals in flows, whereas we typically use the stocks model of money supply and demand to illustrate Fed policy.)
Students can see a discussion and illustration of Federal Reserve interest rate policy in the chapters “The Monetary System” and “The Influence of Monetary and Fiscal Policy on Aggregate Demand”.
A MACROECONOMIC THEORY OF THE OPEN ECONOMY

41. CONCLUSION The U.S. economy is becoming increasingly open:
The U.S. economy is becoming increasingly open:
Trade in g&s is rising relative to GDP.
Increasingly, people hold international assets in their portfolios and firms finance investment with foreign capital.
A MACROECONOMIC THEORY OF THE OPEN ECONOMY 40

42. CONCLUSION
Yet, we should be careful not to blame our problems on the international economy.
Our trade deficit is not caused by other countries’ “unfair” trade practices, but by our own low saving.
Stagnant living standards are not caused by imports, but by low productivity growth.
When politicians and commentators discuss international trade and finance, the lessons of this and the preceding chapter can help separate myth from reality.
A MACROECONOMIC THEORY OF THE OPEN ECONOMY 41

43. CHAPTER SUMMARY
In an open economy, the real interest rate adjusts to balance the supply of loanable funds (saving) with the demand for loanable funds (domestic investment and net capital outflow).
In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (net capital outflow) with the demand for dollars (net exports).
Net capital outflow is the variable that connects these markets. 42

44. CHAPTER SUMMARY
A budget deficit reduces national saving, drives up interest rates, reduces net capital outflow, reduces the supply of dollars in the foreign exchange market, appreciates the exchange rate, and reduces net exports.
A policy that restricts imports does not affect net capital outflow, so it cannot affect net exports or improve a country’s trade deficit. Instead, it drives up the exchange rate and reduces exports as well as imports. 43

45. CHAPTER SUMMARY
Political instability may cause capital flight, as nervous investors sell assets and pull their capital out of the country. As a result, interest rates rise and the country’s exchange rate falls. This occurred in Mexico in 1994 and in other countries more recently. 44