1. A Macroeconomic Theory of the Open Economy
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2. 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)
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3. Market for Loanable Funds
When NCO > 0
Net outflow of capital
Net purchase of overseas capital
When NCO < 0
Net inflow of capital
Capital resources coming from abroad
Loanable funds – interpreted as
Domestically generated flow of resources available for capital accumulation
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4. 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
Discourages Americans from buying foreign assets
Reduces U.S. net capital outflow
Encourages foreigners to buy U.S. assets
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5. Market for Loanable Funds
Supply of loanable funds (S; from national saving): Slopes upward
Demand of loanable funds (I+NCO): Slopes downward
At equilibrium interest rate,
Amount that people want to save exactly balances the desired quantities of domestic investment and net capital outflow
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6. 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.
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7. Foreign-Currency Exchange
The market for foreign-currency exchange
Identity: NCO = NX
If trade surplus, NX > 0 → NCO > 0
Exports > Imports: Americans use the foreign currency to buy foreign assets
If trade deficit, NX < 0 → NCO < 0
Imports > Exports: Some of this spending is financed by selling American assets abroad
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8. Foreign-Currency Exchange
Dollar supply of foreign-currency exchange
Net capital outflow
Quantity of dollars supplied to buy foreign assets
Supply curve is vertical
Quantity of dollars supplied for net capital outflow does not depend on the real exchange rate, but the real interest rate.
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9. Foreign-Currency Exchange
Dollar demand comes from net exports
Dollar is demanded to buy U.S. net exports by foreigners
Demand curve is downward sloping
A higher real exchange rate
Makes U.S. goods more expensive → Less export → Less dollar demand
Reduces the quantity of dollars demanded by foreigners to buy exported goods
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10. Foreign-Currency Exchange
Equilibrium real exchange rate equates the demand for dollars to supply of dollars
Demand for dollars
By foreigners who want to buy US exports
Arising from U.S. net exports of goods and services
Supply of dollars
From Americans who want to buy foreign assets
Arising from U.S. NCO to purchase foreign assets
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11. 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.
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12. Equilibrium in the Open Economy
Identities
Market for loanable funds: S = I + NCO
Market for foreign-currency exchange: NCO = NX
Net-capital-outflow curve
Links between
Market for loanable funds
Market for foreign-currency exchange
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13. Figure 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.
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14. Equilibrium in the Open Economy
Market for loanable funds
Supply: national saving
Demand: domestic investment and net capital outflow
Equilibrium real interest rate, r is determined
Net capital outflow (supply of dollars)
Slopes downward
Equilibrium interest rate, r determines NCO
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15. Equilibrium in the Open Economy
Market for foreign-currency exchange
Supply: net capital outflow
Demand: net exports
The supply and demand for dollars in the foreign currency exchange market determine the real exchange rate, E
Equilibrium real interest rate (r), and equilibrium real exchange rate (E) adjust simultaneously
To balance supply and demand in the loanable funds mkt and foreign-currency exchange mkt
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16. 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
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17. Government Budget Deficits
Effects of 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
Fall in the supply of dollars causes the real ex-rate to appreciate in foreign currency mkt
Net exports fall
Push the trade balance toward deficit ⇒ US Twin deficits in the 1980s
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18. Figure 5 The Effects of a Government Budget Deficit S2 S1 r2 r2 A B r1
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
which in turn reduces net capital outflow. r1
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
Which causes the real exchange rate to appreciate. E1
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
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19. Political Instability and Capital Flight
Leads to capital flight
Capital flight
Large and sudden reduction in the demand for assets located in a country
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20. Political Instability and Capital Flight
Mexico - capital flight affects both markets
1994, political instability caused the capital flight from Mexico
Sell Mexican assets to buy U.S. assets, “safe haven”
Increases in net-capital-outflow (demand for loanable funds) → Demand curve for loanable funds shifts right → Increases the interest rate
Supply of pesos in the market for foreign-currency exchange increases → Peso is depreciated
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21. Political Instability and 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 more
Imports less
Trade balance moves toward surplus
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22. 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
Which increases
the interest rate. r1 r1
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
which causes the peso to depreciate E2
Quantity of Pesos
(c) The Market for Foreign-Currency Exchange
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