1. A Macroeconomic Theory of the Open Economy Chapter 30 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

2. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Key Macroeconomic Variables in an Open Economy u The important macroeconomic variables of an open economy include: u net exports u net foreign investment u nominal exchange rates u real exchange rates

3. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Basic Assumptions of a Macroeconomic Model of an Open Economy u The model takes the economy’s GDP as given. u The model takes the economy’s price level as given.

4. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Market for Loanable Funds S = I + NFI u At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net foreign investment.

5. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Market for Loanable Funds u 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Market for Loanable Funds u The supply and demand for loanable funds depend on the real interest rate. u A higher real interest rate encourages people to save and raises the quantity of loanable funds supplied. u The interest rate adjusts to bring the supply and demand for loanable funds into balance.

7. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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 Equilibrium real interest rate

8. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Market for Foreign- Currency Exchange u 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Market for Foreign- Currency Exchange The price that balances the supply and demand for foreign-currency is the real exchange rate.

12. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Market for Foreign- Currency Exchange u The demand curve for foreign currency is downward sloping because a higher exchange rate makes domestic goods more expensive. u The supply curve is vertical because the quantity of dollars supplied for net foreign investment is unrelated to the real exchange rate.

13. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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

14. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Market for Foreign- Currency Exchange u The real exchange rate adjusts to balance the supply and demand for dollars. u 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium in the Open Economy u In the market for loanable funds, supply comes from national saving and demand comes from domestic investment and net foreign investment. u In the market for foreign-currency exchange, supply comes from net foreign investment and demand comes from net exports.

16. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium in the Open Economy u Net foreign investment links the loanable funds market and the foreign-currency exchange market. u The key determinant of net foreign investment is the real interest rate.

17. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How Net Foreign Investment Depends on the Interest rate... 0 Net Foreign Investment Real Interest Rate Net foreign investment is positive. Net foreign investment is negative.

18. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Equilibrium in the Open Economy u Prices in the loanable funds market and the foreign-currency exchange market adjust simultaneously to balance supply and demand in these two markets. u As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.

19. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. (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 Demand Supply Net Foreign Investment Net foreign investment, NFI Real Exchange Rate Real Interest Rate r1r1 E1E1 r1r1 The Real Equilibrium in an Open Economy

20. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How Changes in Policies and Events Affect an Open Economy u The magnitude and variation in important macroeconomic variables depend on the following: u Government budget deficits u Trade policies u Political and economic stability

21. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Government Budget Deficits u 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. r2r2 r2r2 E2E2 1. A budget deficit reduces the supply of loanable funds... S2S2 B (a) The Market for Loanable Funds(b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Quantity of Loanable Funds Demand S1S1 Quantity of Dollars Demand S1S1 S2S2 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… r1r1 A E1E1 r1r1 The Effects of Government Budget Deficit 2....which increases the real interest...

23. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Effect of Budget Deficits on the Loanable Funds Market u A government budget deficit reduces national saving, which...... shifts the supply curve for loanable funds to the left, which... raises interest rates.

24. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Effect of Budget Deficits on Net Foreign Investment u Higher interest rates reduce net foreign investment.

25. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Effect on the Foreign-Currency Exchange Market u A decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency. u This causes the real exchange rate to appreciate.

26. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trade Policy u A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports. u Tariff: A tax on an imported good. u Import quota: A limit on the quantity of a good produced abroad and sold domestically.

27. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trade Policy u Because they do not change national saving or domestic investment, trade policies do not affect the trade balance. u For a given level of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same. u Trade policies have a greater effect on microeconomic than on macroeconomic markets.

28. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Effect of an Import Quota u Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency. u This leads to an appreciation of the real exchange rate.

29. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Effect of an Import Quota u There is no change in the interest rate because nothing happens in the loanable funds market. u There will be no change in net exports. u There is no change in net foreign investment even though an import quota reduces imports.

30. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Effect of an Import Quota u An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports. u This offsets the initial increase in net exports due to import quota.

31. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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 S1S1 Quantity of Dollars Demand Supply Net Foreign Investment NFI Real Exchange Rate Real Interest Rate r1r1 E1E1 r1r1 The Effects of an Import Quota E2E2 2. …and causes the real exchange rate to appreciate. 3. Net exports, however, remain the same.

32. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Effect of an Import Quota Trade policies do not affect the trade balance.

33. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Political Instability and Capital Flight u Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries. u If investors become concerned about the safety of their investments, capital can quickly leave an economy. u Interest rates increase and the domestic currency depreciates.

35. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Political Instability in Mexico and Capital Flight u 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Political Instability in Mexico and Capital Flight u This increased Mexican net foreign investment. u The demand for loanable funds in the loanable funds market increased, which increased the interest rate. u This increased the supply of pesos in the foreign-currency exchange market.

37. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. NFI 1 1. An increase in net foreign investment... 2. …increases the demand for loanable funds... D2D2 (a) The Market for Loanable Funds(b) Mexican Net Foreign Investment (c) The Market for Foreign-Currency Exchange Quantity of Loanable Funds D1D1 S1S1 Quantity of Pesos Demand S1S1 Net Foreign Investment NFI 1 Real Exchange Rate Real Interest Rate E1E1 r1r1 r1r1 S2S2 r2r2 r2r2 E2E2 The Effects of Capital Flight 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.

38. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u To analyze the macroeconomics of open economies, two markets are central – the market for loanable funds and the market for foreign-currency exchange. u 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u 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). u Net foreign investment is the variable that connects the two markets.

40. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate. u The higher interest rate reduces net foreign investment, reducing the supply of dollars. u The dollar appreciates, and net exports fall.

41. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u A trade restriction increases net exports and increases the demand for dollars in the market for foreign-currency exchange. u As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods. u This appreciation offsets the initial impact of the trade restrictions on net exports.

42. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound. u Political instability in a country can lead to capital flight. u Capital flight tends to increase interest rates and cause the country’s currency to depreciate.

43. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Graphical Review

44. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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 Equilibrium real interest rate

45. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How Net Foreign Investment Depends on the Interest rate... 0 Net Foreign Investment Real Interest Rate Net foreign investment is positive. Net foreign investment is negative.

47. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. (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 Demand Supply Net Foreign Investment Net foreign investment, NFI Real Exchange Rate Real Interest Rate r1r1 E1E1 r1r1 The Real Equilibrium in an Open Economy

48. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Effects of Government Budget Deficit r2r2 r2r2 E2E2 1. A budget deficit reduces the supply of loanable funds... S2S2 B (a) The Market for Loanable Funds(b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Quantity of Loanable Funds Demand S1S1 Quantity of Dollars Demand S1S1 S2S2 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… r1r1 A E1E1 r1r1 2....which increases the real interest...

49. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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 S1S1 Quantity of Dollars Demand Supply Net Foreign Investment NFI Real Exchange Rate Real Interest Rate r1r1 E1E1 r1r1 E2E2 2. …and causes the real exchange rate to appreciate. 3. Net exports, however, remain the same.

50. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Effects of Capital Flight NFI 1 1. An increase in net foreign investment... 2. …increases the demand for loanable funds... D2D2 (a) The Market for Loanable Funds(b) Mexican Net Foreign Investment (c) The Market for Foreign-Currency Exchange Quantity of Loanable Funds D1D1 S1S1 Quantity of Pesos Demand S1S1 Net Foreign Investment NFI 1 Real Exchange Rate Real Interest Rate E1E1 r1r1 r1r1 S2S2 r2r2 r2r2 E2E2 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.