Chapter 32_Macroeconomics of the Open Economy

7/25/2019 Chapter 32_Macroeconomics of the Open Economy

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PowerPoint Slides prepared by:Andreea CHIRITESCUEastern Illinois University

A Macroeconomic Theory

of the Open Economy

1 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use aspermitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.


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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)



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When NCO > 0

Net outflow of capital

Net purchase of capital overseas

Adds to the demand for domestically generatedloanable funds

When NCO < 0

Net inflow of capital Capital resources coming from abroad

Reduce the demand for domestically generatedloanable funds



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Loanable funds - interpreted as

Domestically generated flow of resourcesavailable for capital accumulation

Purchase of a capital assetAdds to the demand for loanable funds

Assetlocated at home: I

Assetlocated abroad: NCO



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Higher real interest rate

Encourages people to save

Increases quantity of loanable funds supplied

Discourages investment Decreases quantity of loanable funds

demanded



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Higher real interest rate

Discourages Americans from buyingforeign assets

Reduces U.S. net capital outflow

Encourages foreigners to buy U.S. assets

Reduces U.S. net capital outflow



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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 ofdomestic investment and net capitaloutflow



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Figure 1


The Market for Loanable FundsReal

Interest

Rate

Quantity ofLoanable Funds

Equilibriumreal interest

rate

Supply of loanable funds

(from national saving)

Demand for loanable

funds (for domesticinvestment and netcapital outflow)

Equilibriumquantity

The interest rate in an open economy, as in a closed economy, is determined by thesupply and demand for loanable funds. National saving is the source of the supply ofloanable funds. Domestic investment and net capital outflow are the sources of thedemand for loanable funds. At the equilibrium interest rate, the amount that peoplewant to save exactly balances the amount that people want to borrow for the purposeof buying domestic capital and foreign assets.


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Foreign-Currency Exchange

The market for foreign-currency exchange

Identity: NCO = NX

Net capital outflow = Net exports

If trade surplus, NX > 0 Exports > Imports

Net sale of goods ad services abroad

Americans use the foreign currency to buyforeign assets

Capital is flowing abroad, NCO > 0



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If trade deficit, NX < 0

Imports > Exports

Some of this spending - financed by

selling American assets abroad Foreign capital is flowing into U.S.

NCO < 0



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Supply of foreign-currency exchange

Net capital outflow

Quantity of dollars supplied to buy foreignassets

Supply curvevertical

Quantity of dollars supplied for net capitaloutflow

Does not depend on the real exchange rate



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Demand for foreign-currency exchange

Net exports

Quantity of dollars demanded to buy U.S. netexports 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 tobuy those goods



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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


Fi 2


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Figure 2


The Market for Foreign-Currency ExchangeReal

Exchange

Rate

Quantity of Dollars Exchangedinto Foreign Currency

Equilibrium realexchange rate

Supply of dollars

(from net capital outflow)

Demand for dollars(for net exports)

Equilibriumquantity

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 isvertical. The demand for dollars comes from net exports. Because a lower real exchange ratestimulates net exports (and thus increases the quantity of dollars demanded to pay for these netexports), the demand curve is downward sloping. At the equilibrium real exchange rate, thenumber of dollars people supply to buy foreign assets exactly balances the number of dollars

people demand to buy net exports.


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Equilibrium in the Open Economy

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


E hibit 3


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Exhibit 3


How Net Capital Outflow Depends on the Interest Rate

RealInterest

Rate

Net CapitalOutflow

Because a higher domestic real interest rate makes domestic assets more attractive, itreduces net capital outflow. Note the position of zero on the horizontal axis: Net capitaloutflow can be positive or negative. A negative value of net capital outflow means thatthe economy is experiencing a net inflow of capital.

0 Net capital outflowis positive

Net capital outflowis negative


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Market for loanable funds

Supply: national saving

Demand: domestic investment & netcapital outflow

Equilibrium real interest rate, r

Net capital outflow

Slopes downward Equilibrium interest rate, r



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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



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Equilibrium real exchange rate, E

Price of domestic goods and services

Relative to foreign goods and services

E and r - adjust simultaneously To balance supply and demand In both markets

Loanable funds

Foreign-currency exchange



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E and r - adjust simultaneously

Determine

National saving

Domestic investment

Net capital outflow

Net exports


Fig re 4


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Figure 4


The Real Equilibrium in an Open Economy

RealInterest

Rate Supply

Demand

Quantity ofLoanable Funds

(a) The Market for Loanable Funds

RealInterest

Rate

Net capital

outflow, NCO

Net capital outflow

(b) Net Capital Outflow

r1 r1

RealExchange

Rate

Supply

Demand

Quantity of Dollars

(c) The Market for Foreign-Currency Exchange

E1

In panel (a), the supply and demand forloanable funds determine the real interest

rate. In panel (b), the interest ratedetermines net capital outflow, whichprovides the supply of dollars in the marketfor foreign-currency exchange. In panel (c),the supply and demand for dollars in themarket for foreign-currency exchangedetermine the real exchange rate.


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Government Budget Deficits

Government budget deficits

When government spending exceedsgovernment revenue

Negative public saving

Reduces national saving

Reduces supply of loanable funds

Increase in interest rate Reduces net capital outflow



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Government Budget Deficits

Government budget deficits

Crowd-out domestic investment

Decrease in supply of foreign-currencyexchange

Currency appreciates

Net exports fall

Push the trade balance toward deficit


Exhibit 5


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Exhibit 5


The Effects of a Government Budget Deficit

RealInterest

RateS1

Demand

Quantity of Loanable Funds


RealInterest

Rate

NCO

Net capital outflow


r1

Real ExchangeRate

S1

Demand

Quantity of Dollars


E1

When the government runs a budget deficit, itreduces the supply of loanable funds from S1to S2in panel (a). The interest rate rises from r1to r2tobalance the supply and demand for loanable funds.

In panel (b), the higher interest rate reduces netcapital outflow. Reduced net capital outflow, in turn,reduces the supply of dollars in the market forforeign-currency exchange from S1to S2in panel(c). This fall in the supply of dollars causes the realexchange rate to appreciate from E1to E2. Theappreciation of the exchange rate pushes the tradebalance toward deficit.

S2

r1A

1. A budget deficit reduces thesupply of loanable funds . . .

r2B

2. . . . whichincreases the

real interestrate . . .

r2 3. . . . which inturn reduces netcapital outflow.

S2 4. The decrease in netcapital outflow reducesthe supply of dollars to

be exchanged intoforeign currency . . .

E2

5. . . . Whichcauses the realexchange rateto appreciate.


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Trade Policy

Trade policy

Government policy

Directly influences the quantity of goodsand services

That a country imports or exports

Tariff - tax on imports

Import quota - limit on quantity of imports Voluntary export restrictions



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Trade Policy

Macroeconomic impact of trade policy

Decrease imports

Increase in net exports

Increase in demand for dollars in themarket for foreign-currency exchange

Real exchange rate appreciates

Discourage exports



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Trade Policy


No change in real interest rate

No change in net capital outflow

No change in net exports Decrease in imports

Decrease in exports


Figure 6


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Figure 6


The Effects of an Import Quota

RealInterest

Rate Supply

Demand



RealInterest

Rate

NCO

Net capital outflow


r1 r1

Real ExchangeRate

Supply

D1

Quantity of Dollars


E1

When the U.S. government imposes a quota on theimport of Japanese cars, nothing happens in the marketfor loanable funds in panel (a) or to net capital outflowin panel (b). The only effect is a rise in net exports(exports minus imports) for any given real exchangerate. As a result, the demand for dollars in the marketfor foreign-currency exchange rises, as shown by theshift from D1to D2in panel (c). This increase in thedemand for dollars causes the value of the dollar toappreciate from E1to E2. This appreciation of the dollartends to reduce net exports, offsetting the direct effectof the import quota on the trade balance.

D21. An import quotaincreases the demandfor dollars . . .

E2

2. . . . And causesthe real exchangerate to appreciate.

3. Net exports,however, remainthe same.


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Trade Policy


Trade policies do not affect the U.S. tradebalance

NX = NCO = SI

Trade policies affect specific

Firms

Industries

Countries



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Political Instability &Capital Flight

Political instability

Leads to capital flight

Capital flight

Large and sudden reduction in thedemand for assets located in a country



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Mexico - capital flight affects both markets

1994, political instability

Investorscapital flight

Sell Mexican assets

Buy U.S. assets, safe haven

Net-capital-outflow curveincreases

Supply of pesos in the market for foreign-currency exchangeincreases

Demand curve in the market for loanablefundsincreases



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Interest rate in Mexicoincreases

Reduce domestic investment

Slows capital accumulations

Slows economic growth

The peso depreciates

Exportscheaper

Imports - more expensive

Trade balance moves toward surplus


Figure 7


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Figure 7


The Effects of Capital Flight

RealInterest

Rate SupplyD1


(a) The Market for Loanable Funds in Mexico

RealInterest

Rate

NCO1

Net capital outflow

(b) Mexican Net Capital Outflow

r1 r1

Real ExchangeRate

S1

Demand

Quantity of Pesos


E1

If people decide that Mexico is a risky place to keep theirsavings, they will move their capital to safer havens suchas the U.S., resulting in an increase in Mexican net capitaloutflow. Consequently, the demand for loanable funds inMexico rises from D1to D2, as shown in panel (a), and this

drives up the Mexican real interest rate from r1to r2.Because net capital outflow is higher for any interest rate,that curve also shifts to the right from NCO1to NCO2inpanel (b). At the same time, in the market for foreign-currency exchange, the supply of pesos rises from S1toS2, as shown in panel (c). This increase in the supply ofpesos causes the peso to depreciate from E1to E2, so thepeso becomes less valuable compared to other currencies.

NCO2

1. An increasein net capitaloutflow . . .

D2

2. . . . increases the demand

for loanable funds . . .

r2

3. . . . Whichincreases

the interestrate.

r2

S2

E2

4. At the sametime, the increasein net capitaloutflow increases

the supply ofpesos . . .

5. . . . whichcauses the pesoto depreciate


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U.S. market

Fall in U.S. net capital outflow

The dollar appreciates in value

U.S. interest rates fall

Relatively small impact on the U.S. economy

Because the economy of the United States is so

large compared to that of Mexico


Capital flows from China


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Nation that experiences capital flight

Outflow of capital Its currency weaken in foreign exchange

markets

Depreciation Increases the nations net exports

Nation that experiences inflow of capital

Its currency strengthenAppreciation

Pushes its trade balance toward deficit35 2011 Cengage Learning. 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.



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A nations government policy:

Encourages capital to flow to anothercountry

By making foreign investments itself

Effect? Nation encouraging capital outflows

Weaker currency

Trade surplus

For the recipient of capital flows

Stronger currency

Trade deficit




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Ongoing policy disputes: U.S. and China

Chinatried to depress its currency(renminbi) in foreign exchange markets

Promote its export industries

Accumulate foreign assets, $2.4 trillion, 2009 Including U.S. government bonds

Chinese goods - less expensive

Contributes to the U.S. trade deficit

Hurts American producers who makeproducts that compete with imports fromChina




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Ongoing policy disputes: U.S. and China

U.S. government Encouraged China to stop influencing the

exchange value of its currency

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




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Chinese policy of investing in U.S.

economy Creates winners and losers among

Americans

Net impact on U.S. economy - probablysmall

Motives behind the policy

China - wants to accumulate a reserve offoreign assets - national rainy-day fund

Misguided policy

Chapter 32_Macroeconomics of the Open Economy

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