1. A Macroeconomic Theory of the Open Economy19
A Macroeconomic Theory of the Open Economy

2. Supply and Demand for Loanable Funds
The 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)

3. Supply and Demand for Loanable Funds
The market for loanable funds
Loanable funds - interpreted as
Domestically generated flow of resources available for capital accumulation
Purchase of a capital asset
Adds to the demand for loanable funds
Asset – located at home: I
Asset – located abroad: NCO
If NCO > 0, net outflow of capital - adds to demand
If NCO < 0, net inflow of capital - reduce the demand

4. Supply and Demand for Loanable Funds
The 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

5. Supply and Demand for Loanable Funds
The market for loanable funds
Supply of loanable funds
Slopes upward
Demand of loanable funds
Slopes downward
At equilibrium interest rate
Amount that people want to save
Exactly balances the desired quantities of domestic investment and net capital outflow

6. The market for loanable funds1
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.

7. Market for Foreign-Currency Exchange
The market for foreign-currency exchange
Identity: NCO = NX
Net capital outflow = Net exports
If trade surplus, NX > 0
Foreigners - buy more U.S. goods & services
Than Americans - buy foreign goods & services
Americans – use foreign currency
Buy foreign assets
Capital is flowing abroad, NCO > 0

8. Market for Foreign-Currency Exchange
The market for foreign-currency exchange
If trade deficit, NX < 0
Americans - buy more foreign goods & services
Than foreigners - buy U.S. goods & services
Some of this spending
Financed by selling American assets abroad
Foreign capital is flowing into U.S.
NCO < 0

9. Market for Foreign-Currency Exchange
The market for foreign-currency exchange
Supply of foreign-currency exchange
Net capital outflow
Quantity of dollars supplied - buy foreign assets
Supply curve – vertical
Quantity of dollars supplied for net capital outflow
Does not depend on the real exchange rate

10. Market for Foreign-Currency Exchange
The market for foreign-currency exchange
Demand for foreign-currency exchange
Net exports
Quantity of dollars demanded – buy U.S. net exports of goods and services
Demand curve - downward sloping
A higher real exchange rate
Makes U.S. goods more expensive
Reduces the quantity of dollars demanded to buy those goods

11. Market for Foreign-Currency Exchange
The market for foreign-currency exchange
Equilibrium real exchange rate
Demand for dollars
By foreigners
Arising from U.S. net exports of goods & services
Exactly balances supply of dollars
From Americans
Arising from U.S. net capital outflow

12. The market for foreign-currency exchange2
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.

13. Equilibrium in the Open Economy
Net capital outflow: link between the two markets
Identities
Market for loanable funds: S = I + NCO
Market for foreign-currency exchange: NCO=NX
Net-capital-outflow curve
Link between
Market for loanable funds
Market for foreign-currency exchange

14. How net capital outflow depends on the interest rate3
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.

15. Equilibrium in the Open Economy
Simultaneous equilibrium in two markets
Market for loanable funds
Supply: national saving
Demand: domestic investment & net capital outflow
Equilibrium real interest rate, r
Net capital outflow
Slopes downward
Equilibrium interest rate, r

16. Equilibrium in the Open Economy
Simultaneous equilibrium in two markets
Market for foreign-currency exchange
Supply: net capital outflow
Demand: net exports
Equilibrium real exchange rate, E
Equilibrium real interest rate, r
Price of goods and services in the present
Relative to goods and services in the future
Price of domestic goods and services
Relative to foreign goods and services

17. Equilibrium in the Open Economy
Simultaneous equilibrium in two markets
E and r - adjust simultaneously
To balance supply and demand
In both markets
Loanable funds
Foreign-currency exchange
Determine
National saving
Domestic investment
Net capital outflow
Net exports

18. The real equilibrium in an open economy4
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

19. How Policies & Events Affect an Open Economy
Government budget deficits
Negative public saving
Reduces national saving
Reduces supply of loanable funds
Increase in interest rate
Reduces net capital outflow
Crowd-out domestic investment
Decrease in supply of foreign-currency exchange
Exchange rate appreciates
Net exports fall
Push the trade balance toward deficit

20. The effects of a government budget deficit5
The effects of a government budget deficit
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
which in
turn reduces
net capital
outflow. r2 B
Demand r2 r1 A r1
which
increases
the real
interest
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.
Real
Exchange
Rate
4. The decrease
in net capital
outflow reduces
the supply of dollars
to be exchanged
into foreign
currency . . . S2 S1
Demand E2
Which causes the real exchange rate to appreciate. E1
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange

21. How Policies & Events Affect an Open Economy
Trade policy
Government policy
Directly influences the quantity of goods and services
That a country imports or exports
Tariff
Tax on imports
Import quota
Limit on quantity of imports

22. How Policies & Events Affect an Open Economy
Trade policy
Macroeconomic impact of trade policy
Decrease imports
Increase in net exports
Increase in demand for foreign-currency exchange
Real exchange rate appreciates
Discourage exports
No change in real interest rate
No change in net capital outflow
No change in net exports

23. The effects of an import quota6
The effects of an import quota
Quantity of Loanable Funds
(a) The Market for Loanable Funds
Net capital outflow
(b) Net Capital Outflow
Real
Interest
Rate
Real
Interest
Rate
Supply
NCO
3. Net exports,
however, remain
the same.
Demand r1 r1
Real
Exchange
Rate
When the U.S. government imposes a quota on the import of Japanese cars, nothing happens in the market for loanable funds in panel (a) or to net capital outflow in panel (b). The only effect is a rise in net exports (exports minus imports) for any given real exchange rate. As a result, the demand for dollars in the market for foreign-currency exchange rises, as shown by the shift from D1 to D2 in panel (c). This increase in the demand for dollars causes the value of the dollar to appreciate from E1 to E2. This appreciation of the dollar tends to reduce net exports, offsetting the direct effect of the import quota on the trade balance.
Supply
And causes the real exchange
rate to appreciate. D2 E2 D1 E1
1. An import
quota increases
the demand for
dollars . . .
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange

24. How Policies & Events Affect an Open Economy
Trade policy
Macroeconomic impact of trade policy
Trade policies do not affect the U.S. trade balance
NX = NCO = S – I
Trade policies affect specific
Firms
Industries
Countries

25. How Policies & Events Affect an Open Economy
Political instability and capital flight
Political instability
Leads to capital flight
Capital flight
Large and sudden reduction in the demand for assets located in a country

26. How Policies & Events Affect an Open Economy
Mexico - capital flight affects both markets
Investors
Sell Mexican assets & Buy U.S. assets
Net-capital-outflow curve – increases
Supply of pesos in the market for foreign-currency exchange – increases
Demand curve in the market for loanable funds – increases
Interest rate – increases
The peso – depreciates

27. The effects of capital flight7
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
Which increases
the interest rate.
Real
Interest
Rate D2
NCO2
1. An increase
in net capital
outflow . . .
NCO1 D1
Supply r2 r2 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. 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

28. Capital flows from China
Nation that experiences capital flight
Outflow of capital
Its currency weaken in foreign exchange markets
Depreciation
Increases the nation’s net exports
Nation that experiences inflow of capital
Its currency strengthen
Appreciation
Pushes its trade balance toward deficit

29. Capital flows from China
A nation’s government – policy:
Encourages capital to flow to another country
By making foreign investments itself
Effect?
Nation encouraging capital outflows
Weaker currency
Trade surplus
For the recipient of capital flows
Stronger currency
Trade deficit

30. Capital flows from China
Ongoing policy disputes: U.S. and China
China – tried to depress its currency (renminbi) in foreign exchange markets
Promote its export industries
Accumulate foreign assets
Including U.S. government bonds
In 2007: $1.5 trillion
Chinese goods - less expensive
Contributes to the U.S. trade deficit
Hurts American producers who make products that compete with imports from China

31. Capital flows from China
Ongoing policy disputes: U.S. and China
U.S. government
Encouraged China to stop influencing the exchange value of its currency
Impact of the Chinese policy on the U.S. economy
American consumers of Chinese imports
Benefit from lower prices
Inflow of capital from China
Lowers U.S. interest rates
Increases investment in the U.S. economy
Chinese government - financing U.S. economic growth

32. Capital flows from China
Chinese policy of investing in U.S. economy
Creates winners and losers among Americans
Net impact on U.S. economy - probably small
Motives behind the policy
China - wants to accumulate a reserve of foreign assets
National “rainy-day fund”
Misguided policy