1. Economics N. Gregory Mankiw & Mohamed H. Rashwan Principles of
Arab World Edition

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?
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?

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… 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 3

5. The Market for Loanable Funds
Recall:
S depends positively on the real interest rate, r.
I depends negatively on r.
What about NCO? 4

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 purchase more foreign assets.
People abroad purchase fewer of your country’s assets.
NCO rises.
Net capital outflow r
NCO
NCO r1
NCO1 r2
NCO2 5

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 6

8. ACTIVE LEARNING 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.
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9. ACTIVE LEARNING 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).
The higher r makes U.S. bonds more attractive relative to foreign bonds, reduces NCO.
A budget deficit reduces saving and the supply of LF, causing r to rise.
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
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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 your country’s currency: Foreigners need your currency to buy your net exports.
NCO is the supply of your currency: Your country’s residents sell domestic currency to obtain the foreign currency they need to buy foreign assets.
That NX = demand for domestic currency and NCO = supply of domestic currency is critically important. Make sure to allow enough time for students to write this down in their notes. 9

11. The Market for Foreign-Currency Exchange
Recall: The real exchange rate (E) measures the quantity of foreign goods & services that trade for one unit of domestic goods & services.
E is the real value of a unit of your currency in the market for foreign-currency exchange. 10

12. The Market for Foreign-Currency Exchange
E adjusts to balance supply and demand for dollars in the market for foreign- currency exchange.
S = NCO E
Your currency
D = NX E1
An increase in E has no effect on saving or investment, so it does not affect NCO or the supply of your country’s currency.
The textbook has good intuition explaining why the S/NCO curve is vertical rather than positively sloped.
Here’s a quick summary:
If E rises, our currencycan buy more foreign assets
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. 11

13. FYI: Disentangling Supply and Demand
When a country’s resident buys imported goods, does the transaction affect supply or demand in the foreign exchange market? Two views:
1. The supply of domestic currency increases. The person needs to sell domestic currency to obtain the foreign currency needed to buy the imports.
2. The demand for domestic currency decreases. The increase in imports reduces NX, which we think of as the demand for domestic currency.
(So, NX is really the net demand for domestic currency.)
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: “So, NX is really the net demand for domestic currency.”
What we mean is that NX equals foreign demand for domestic currency to purchase our exports minus our supply of domestic currency to purchase imports. 12

14. FYI: Disentangling Supply and Demand
When a foreigner buys an asset from your country, does the transaction affect supply or demand in the foreign exchange market? Two views:
1. The demand for your currency increases. The foreigner needs your currency in order to purchase the asset.
2. The supply of your currency falls. The transaction reduces NCO, which we think of as the supply of domestic currency.
(So, NCO is really the net supply of domestic currency.)
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 domestic currency.”
It means that NCO equals supply of domestic currency to purchase foreign assets minus foreign demand for domestic currency to purchase domestic assets. 13

15. ACTIVE LEARNING 2 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.
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16. ACTIVE LEARNING 2 Answers
Market for foreign-currency exchange
The budget deficit reduces NCO and the supply of domestic currency.
The real exchange rate appreciates, reducing net exports.
Since NX = 0 initially, the budget deficit causes a trade deficit (NX < 0).
S2 = NCO2 E
Currency
S1 = NCO1 E2 E1
D = NX
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17. 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) 16

18. 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 2009
Value of U.S.-owned foreign assets
$18.4 trillion
Value of foreign-owned U.S. assets
$21.1 trillion
U.S.’ net debt to the rest of the world
$2.7 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. If you are reading this after June 2011, you should be able to find the 2010 data here:
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. 17

19. 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
currency
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 18

20. ACTIVE LEARNING 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.”
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21. ACTIVE LEARNING 3 Answers
Investment—and the demand for LF—increase at each value of r. r rises, causing NCO to fall .
Loanable funds
Net capital outflow r LF r
NCO S1 D2
NCO D1 r2 r2
NCO2 r1 r1
NCO1
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22. ACTIVE LEARNING 3 Answers
Market for foreign-currency exchange
The fall in NCO reduces the supply of your currency in the foreign exchange market.
The real exchange rate appreciates,
reducing net exports.
S2 = NCO2 E
currency
S1 = NCO1 E2 E1
D = NX
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23. 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. 22

24. 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 23

25. Trade Policy Common reasons for policies that restrict imports:
Common reasons for policies that restrict imports:
Save jobs in a domestic industry that has difficulty competing with imports
Reduce the trade deficit
Do such trade policies accomplish these goals?
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. 24

26. 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 25

27. 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 26

28. Analysis of a Quota on Cars from Japan
What happens to NX? Nothing!
If E could remain at E1, NX would rise, and the quantity of dollars demanded would rise.
But the import quota does not affect NCO, so the quantity of dollars supplied is fixed.
Since NX must equal NCO, E must rise enough to keep NX at its original level.
Hence, the policy of restricting imports does not reduce the trade deficit.
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. 27

29. 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. 28

30. CASE STUDY: Capital Flows from China
In recent years, China has accumulated U.S. assets to reduce its exchange rate and boost its exports.
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.
Yet, U.S. consumers benefit, and the net effect of China’s currency intervention is probably small.
This slide is based on a Case Study in the textbook.

31. 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 perspective of Mexico, not the U.S. 30

32. Capital Flight from Mexico
As foreign investors sell their assets and pull out their capital, NCO increases at each value of r. Demand for LF = I + NCO. The increase in NCO increases demand for LF.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 31

33. 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 32

34. 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! 33

35. Examples of Capital Flight: S.E. Asia, 199734

36. Examples of Capital Flight: Russia, 199835

37. Examples of Capital Flight: Argentina, 200236

38. CONCLUSION Many economies are becoming increasingly open:
Many economies are 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. 37

39. 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. 38

40. 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 domestic currency (net capital outflow) with the demand for domestic currency (net exports).
Net capital outflow is the variable that connects these markets.
© 2015 Cengage Learning EMEA. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

41. SUMMARY
A budget deficit reduces national saving, drives up interest rates, reduces net capital outflow, reduces the supply of domestic currency 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.
© 2015 Cengage Learning EMEA. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

42. 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.
© 2015 Cengage Learning EMEA. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.