1. A Macroeconomic Theory of the Open Economy
Chapter 30
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2. Key Macroeconomic Variables in an Open Economy
The important macroeconomic variables of an open economy include:
net exports
net foreign investment
nominal exchange rates
real exchange rates

3. Basic Assumptions of a Macroeconomic Model of an Open Economy
The model takes the economy’s GDP as given.
The model takes the economy’s price level as given.

4. The Market for Loanable Funds
S = I + NFI
At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net foreign investment.

5. The Market for Loanable Funds
The supply of loanable funds comes from national saving (S).
The demand for loanable funds comes from domestic investment (I) and net foreign investment (NFI).

6. The 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.

7. The Market for Loanable Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Demand for loanable funds (for domestic investment and net foreign investment)
Equilibrium
quantity
real interest
rate
Quantity of
Loanable Funds

8. The 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.

9. The Market for Foreign-Currency Exchange
The two sides of the foreign-currency exchange market are represented by NFI and NX.
NFI represents the imbalance between the purchases and sales of capital assets.
NX represents the imbalance between exports and imports of goods and services.

10. The Market for Foreign-Currency Exchange
In the market for foreign-currency exchange, U.S. dollars are traded for foreign currencies.
For an economy as a whole, NFI and NX must balance each other out, or:
NFI = NX

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

12. The Market for Foreign-Currency Exchange
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 foreign investment is unrelated to the real exchange rate.

13. The Market for Foreign-Currency Exchange...
Real
Exchange
Rate
Supply of dollars
(from net foreign investment)
Demand for dollars
(for net exports)
Equilibrium
quantity
Equilibrium real exchange rate
Quantity of Dollars Exchanged
into Foreign Currency

14. The Market for Foreign-Currency Exchange
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.

15. Equilibrium in the Open Economy
In the market for loanable funds, supply comes from national saving and demand comes from domestic investment and net foreign investment.
In the market for foreign-currency exchange, supply comes from net foreign investment and demand comes from net exports.

16. Equilibrium in the Open Economy
Net foreign investment links the loanable funds market and the foreign-currency exchange market.
The key determinant of net foreign investment is the real interest rate.

17. How Net Foreign Investment Depends on the Interest rate...
Real Interest Rate
Net Foreign Investment
Net foreign investment is negative.
Net foreign investment is positive.

18. Equilibrium in the 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.

19. The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds
(b) Net Foreign Investment
Real Interest Rate
Real Interest Rate
Supply r1 E1
Net foreign investment,
NFI
Demand
Quantity of
Net Foreign
Loanable Funds
Investment
Real Exchange Rate
Supply
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange

20. How Changes in Policies and Events Affect an Open Economy
The magnitude and variation in important macroeconomic variables depend on the following:
Government budget deficits
Trade policies
Political and economic stability

21. Government Budget Deficits
In an open economy, government budget deficits . . .
reduces the supply of loanable funds,
drives up the interest rate,
crowds out domestic investment,
cause net foreign investment to fall.

22. The Effects of Government Budget Deficit
(a) The Market for Loanable Funds
(b) Net Foreign Investment
Real Interest Rate
Real Interest Rate
1. A budget deficit reduces the supply of loanable funds... S2 B S1 r2 E2
2. ...which increases the real interest...
3. ...which in turn reduces net foreign investment. r1 A E1
Demand
NFI
Quantity of
Loanable Funds
Net Foreign
Investment
Real Exchange Rate
4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency… S2 S1
5. …which causes the real exchange
rate to appreciate.
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange

23. 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.

24. Effect of Budget Deficits on Net Foreign Investment
Higher interest rates reduce net foreign investment.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. The Effects of an Import Quota
(a) The Market for Loanable Funds
(b) Net Foreign Investment
Real Interest Rate
Real Interest Rate S1
3. Net exports, however, remain the same. r1 E1
Demand
NFI
Quantity of
Loanable Funds
Net Foreign
Investment
Real Exchange Rate
Supply
1. An import quota increases the demand for dollars… E2
2. …and causes the real exchange rate to appreciate.
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange

32. Effect of an Import Quota
Trade policies do not affect the trade balance.

33. Political Instability and Capital Flight
Capital flight is a large and sudden movement of funds out of a country, usually due to political instability.

34. Political Instability and Capital Flight
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.

35. Political Instability in Mexico and Capital Flight
When investors around the world observed political problems in Mexico in 1994, they sold some of their Mexican assets and used the proceeds to buy assets of other countries.

36. Political Instability in Mexico and Capital Flight
This increased Mexican net foreign investment.
The demand for loanable funds in the loanable funds market increased, which increased the interest rate.
This increased the supply of pesos in the foreign-currency exchange market.

37. The Effects of Capital Flight
(a) The Market for Loanable Funds
(b) Mexican Net Foreign Investment
Real Interest Rate
Real Interest Rate
2. …increases the demand for loanable funds... D2 S1
NFI1
1. An increase in net foreign investment...
NFI1 S2 r2 E2
3. …which increases the interest rate. E1 r1 D1
Quantity of
Net Foreign
Loanable Funds
Investment
Real Exchange Rate
4. At the same time, the increase in net foreign investment increases the supply of pesos... S1
5. …which causes the real exchange
rate to appreciate.
Demand
Quantity of Pesos
(c) The Market for Foreign-Currency Exchange

38. Summary
To analyze the macroeconomics of open economies, two markets are central – the market for loanable funds and the market for foreign-currency exchange.
In the market for loanable funds, the interest rate adjusts to balance supply for loanable funds (from national saving) and demand for loanable funds (from domestic investment and net foreign investment).

39. Summary
In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (for net foreign investment) and the demand for dollars (for net exports).
Net foreign investment is the variable that connects the two markets.

40. Summary
A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate.
The higher interest rate reduces net foreign investment, reducing the supply of dollars.
The dollar appreciates, and net exports fall.

41. Summary
A trade restriction increases net exports and increases the demand for dollars in the market for foreign-currency exchange.
As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods.
This appreciation offsets the initial impact of the trade restrictions on net exports.

42. Summary
When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound.
Political instability in a country can lead to capital flight.
Capital flight tends to increase interest rates and cause the country’s currency to depreciate.

43. Graphical Review

44. The Market for Loanable Funds
Quantity of
Loanable Funds
Real
Interest
Rate
Demand for loanable funds (for domestic investment and net foreign investment)
Supply of loanable funds
(from national saving)
Equilibrium
quantity
real interest
rate

45. The Market for Foreign-Currency Exchange...
Quantity of Dollars Exchanged
into Foreign Currency
Real
Exchange
Rate
Supply of dollars
(from net foreign investment)
Demand for dollars
(for net exports)
Equilibrium
quantity
Equilibrium real exchange rate

46. How Net Foreign Investment Depends on the Interest rate...
Net Foreign Investment
Real Interest Rate
Net foreign investment is positive.
Net foreign investment is negative.

47. The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds
(b) Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity of
Loanable Funds
Demand
Supply
Quantity of Dollars
Net Foreign
Investment
Net foreign investment,
NFI
Real Exchange Rate
Real Interest Rate r1 E1

48. The Effects of Government Budget Deficit
1. A budget deficit reduces the supply of loanable funds... S2 B
(a) The Market for Loanable Funds
(b) Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity of
Loanable Funds
Demand S1
Quantity of Dollars
Net Foreign
Investment
NFI
5. …which causes the real exchange
rate to appreciate.
Real Exchange Rate
Real Interest Rate
3. ...which in turn reduces net foreign investment.
4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency… r1 A E1
2. ...which increases the real interest...

49. The Effects of an Import Quota
1. An import quota increases the demand for dollars…
(a) The Market for Loanable Funds
(b) Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity of
Loanable Funds
Demand S1
Quantity of Dollars
Supply
Net Foreign
Investment
NFI
Real Exchange Rate
Real Interest Rate r1 E1 E2
2. …and causes the real exchange rate to appreciate.
3. Net exports, however, remain the same.

50. The Effects of Capital Flight
NFI1
1. An increase in net foreign investment...
2. …increases the demand for loanable funds... D2
(a) The Market for Loanable Funds
(b) Mexican Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity of
Loanable Funds D1 S1
Quantity of Pesos
Demand
Net Foreign
Investment
Real Exchange Rate
Real Interest Rate E1 r1 S2 r2 E2
5. …which causes the real exchange
rate to appreciate.
4. At the same time, the increase in net foreign investment increases the supply of pesos...
3. …which increases the interest rate.