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PowerPoint Slides prepared by:Andreea CHIRITESCUEastern Illinois University
A Macroeconomic Theory
of the Open Economy
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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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Market for Loanable Funds
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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Market for Loanable Funds
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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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
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Market for Loanable Funds
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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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 ofdomestic investment and net capitaloutflow
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Figure 1
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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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Foreign-Currency Exchange
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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Foreign-Currency Exchange
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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Foreign-Currency Exchange
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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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
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Fi 2
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Figure 2
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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
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E hibit 3
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Exhibit 3
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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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Equilibrium in the Open Economy
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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Equilibrium in the Open Economy
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 in the Open Economy
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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Equilibrium in the Open Economy
E and r - adjust simultaneously
Determine
National saving
Domestic investment
Net capital outflow
Net exports
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Fig re 4
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Figure 4
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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
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Exhibit 5
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Exhibit 5
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The Effects of a Government Budget Deficit
RealInterest
RateS1
Demand
Quantity of Loanable Funds
(a) The Market for Loanable Funds
RealInterest
Rate
NCO
Net capital outflow
(b) Net Capital Outflow
r1
Real ExchangeRate
S1
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
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
Macroeconomic impact of 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
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Figure 6
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Figure 6
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The Effects of an Import Quota
RealInterest
Rate Supply
Demand
Quantity of Loanable Funds
(a) The Market for Loanable Funds
RealInterest
Rate
NCO
Net capital outflow
(b) Net Capital Outflow
r1 r1
Real ExchangeRate
Supply
D1
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
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
Macroeconomic impact of 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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Political Instability &Capital Flight
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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Political Instability &Capital Flight
Mexico - capital flight affects both markets
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
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Figure 7
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Figure 7
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The Effects of Capital Flight
RealInterest
Rate SupplyD1
Quantity of Loanable Funds
(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
(c) The Market for Foreign-Currency Exchange
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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Political Instability &Capital Flight
Mexico - capital flight affects both markets
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
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Capital flows from China
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Capital flows from China
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.
Capital flows from China
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Capital flows from China
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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Capital flows from China
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Capital flows from China
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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Capital flows from China
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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
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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Capital flows from China
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Capital flows from China
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