1. 19 A Macroeconomic Theory of the Open Economy P R I N C I P L E S O F
F O U R T H E D I T I O N
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 impacts students more than all the deadweight loss triangles in the world.
Other important topics in this chapter include the “twin deficits” and the effects of capital flight.
Unfortunately, this is also one of the most challenging chapters for most students to learn. It uses a 3-panel diagram to describe a general equilibrium model which simultaneously determines the real interest rate, real exchange rate, national saving, investment, net capital outflow, and net exports.
Presenting this model in PowerPoint raises special challenges: a slide does not have enough room to display all three panels of the diagram. (I’ve tried, believe me!)
To address both of these challenges, I have adopted the following approach:
I build up the model piece by piece, letting students absorb and work with each part before adding in another part. This allows me to introduce each of the three diagrams separately.
I also show the connections between the diagrams, though only two at a time.
Finally, to use the full model for policy experiments, I split the analysis into two slides: the first slide shows the loanable funds diagram and the diagram of the net capital outflow curve. The second slide shows the market for foreign-currency exchange. Captions clarify the connections between slides and graphs.
I hope this approach works well for you and your students. Please any comments to me if you can think of ways to improve this chapter for the updates I will be doing annually between major editions of the textbook.

2. In this chapter, look for the answers to these questions:
In this chapter, look for the answers to these questions:
In an open economy, what determines the real interest rate? The real exchange rate?
How are the markets for loanable funds and foreign-currency exchange connected?
How do government budget deficits affect the exchange rate and trade balance?
How do other policies or events affect the interest rate, exchange rate, and trade balance?
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

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…
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

4. The Market for Loanable Funds
An identity from the preceding chapters:
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
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

5. The Market for Loanable Funds
Recall:
S depends positively on the real interest rate, r.
I depends negatively on r.
What about NCO?
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

6. How NCO Depends on the Real Interest Rate
The real interest rate, r, is the real return on domestic assets.
A fall in r makes domestic assets less attractive relative to foreign assets.
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
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

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
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

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).
Use the appropriate diagrams to determine the effects on the real interest rate and net capital outflow. 7

9. A C T I V E L E A R N I N G 1: 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 preceding chapters:
NCO = NX
Net capital outflow
Net exports
In the market for foreign-currency exchange,
NX is the demand for dollars, because foreigners need dollars to buy U.S. net exports.
NCO is the supply of dollars, because 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.
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

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.
E is the real value of a dollar in the market for foreign-currency exchange.
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

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.
E adjusts to balance supply and demand for dollars in the market for foreign- currency exchange.
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.
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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:
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.
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).
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

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:
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.
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?
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%

18. The Effects of a Budget Deficit: Summary
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)
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

19. The Effects of a Budget Deficit: Summary
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. at end of 2006
Value of U.S.-owned foreign assets
$13.8 trillion
Value of foreign-owned U.S. assets
$16.3 trillion
U.S.’ net debt to the rest of the world
$2.5 trillion
The 4th edition of the textbook includes an “In the News” box containing a Washington Post column by Kenneth Rogoff on the U.S.’ trade deficit and net indebtedness to the rest of the world. Encourage your students to check it out.
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.
4. The figures I used here are “with direct investment at market value.” If you prefer, you can use “with direct investment at current cost,” though the figures are fairly similar in either case.
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

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

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
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY 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:
r rises, NCO falls
E rises, NX falls
But one important difference:
Investment tax incentive increases investment, which increases productivity growth and living standards in the long run.
Budget deficit reduces investment, which reduces productivity growth and living standards.
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

25. Trade Policy
Trade policy: a govt policy that directly influences the quantity of g&s that a country imports or exports
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
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

26. Political Instability and Capital Flight
1994: Political instability in Mexico made world financial markets nervous.
People worried about the safety of Mexican assets they owned.
People sold many of these assets, pulled their capital out of Mexico.
Capital flight: a large and sudden reduction in the demand for assets located in a country
We analyze this using our model, but from the prospective of Mexico, not the U.S.
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

27. Capital Flight from Mexico
Demand for LF = I + NCO. The increase in NCO increases demand for LF.
The equilibrium values of r and NCO both increase.
As foreign investors sell their assets and pull out their capital, NCO increases at each value of r.
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
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

28. 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.
The real exchange rate value of the peso falls.
S2 = NCO2 E2
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

29. 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.
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

30. 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 chapter can help separate myth from reality.
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

31. 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.
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY

32. 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.
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33. 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.
CHAPTER A MACROECONOMIC THEORY OF THE OPEN ECONOMY