A Macroeconomic Theory Of Open Economies. A Macroeconomic Theory of an Open Economy Open Economies...

A Macroeconomic Theory A Macroeconomic Theory Of Open EconomiesOf Open Economies

A Macroeconomic Theory of A Macroeconomic Theory of an an Open EconomyOpen Economy

Open EconomiesOpen EconomiesAn open economy is one that interacts freely with An open economy is one that interacts freely with

other economies around the world. other economies around the world.

A Macroeconomic Theory of A Macroeconomic Theory of anan Open Economy Open Economy

Key Macroeconomic Variables in an Key Macroeconomic Variables in an Open EconomyOpen Economy– net exports net exports – net capital outflownet capital outflow ((NCONCO) (opposite of ) (opposite of

net capital inflows)net capital inflows)

– nominal exchange ratesnominal exchange rates: E: EYTL/USDYTL/USD

– real exchange ratesreal exchange rates::

USUSDYTL

TURTURUS PE

PRER

//

A Macroeconomic A Macroeconomic ModelModel of of anan Open Economy Open Economy

Basic Assumptions of Basic Assumptions of the Modelthe Model– The model takes the economy’s The model takes the economy’s outputoutput

((GDPGDP)) as given. as given. Studied factors of Studied factors of output in Chapter 3. output in Chapter 3.

– The model takes the economy’s The model takes the economy’s price price levellevel as given. as given.

TWO MARKETS INTERACTING WITH TWO MARKETS INTERACTING WITH EACH OTHER:EACH OTHER:

1.1. The Market for Loanable FundsThe Market for Loanable Funds

2.2. The Market for Foreign ExchangeThe Market for Foreign Exchange

The Market for Loanable FundsThe Market for Loanable Funds

1.1. The Market for Loanable FundsThe Market for Loanable Funds is is the market where funds are traded.the market where funds are traded.

SS = = II + + NCONCO Holds aHolds at the equilibrium t the equilibrium real real

interest rateinterest rate.. Notice the equilibrium can change Notice the equilibrium can change

when the conditions of the economy when the conditions of the economy change.change.

Figure 1 The Market for Loanable Funds

Quantity ofLoanable Funds

RealInterest

Rate

Supply = S

Demand = I + NCO

Equilibriumquantity

Equilibriumreal interest

rate


The supply of loanable funds comes The supply of loanable funds comes from national saving (from national saving (SS).).

The demand for loanable funds The demand for loanable funds comes from domestic investment (comes from domestic investment (II) ) plusplus net capital outflows ( net capital outflows (NCONCO).).

For some countries such as Turkey, For some countries such as Turkey, NCO is negative. The model can still NCO is negative. The model can still work with a negative NCO. work with a negative NCO.


TThe real interest rate he real interest rate brings tbrings the he supply and demand for loanable supply and demand for loanable fundsfunds into a balance into a balance. .

A higher real interest rate A higher real interest rate increases increases savsavinging and the quantity of loanable and the quantity of loanable funds supplied.funds supplied.

So supply curve is positively related So supply curve is positively related with the real interest rate.with the real interest rate.


A higher real interest rateA higher real interest rate – discourages domestic investmentsdiscourages domestic investments and and

borrowing because it is more costly to borrow borrowing because it is more costly to borrow funds. funds.

– encourages foreigners to buy assets from encourages foreigners to buy assets from domestic economy, and discourages domestic domestic economy, and discourages domestic residents from buying foreign assets. So, residents from buying foreign assets. So, NCONCO decreases. decreases.

– Then Then I + NCOI + NCO decreases as int. rates increases. decreases as int. rates increases. – So demand curve is negatively related with the So demand curve is negatively related with the

real interest rate.real interest rate.


At the equilibrium interest rate, the At the equilibrium interest rate, the amount that people want to save amount that people want to save (supply of funds) (supply of funds) exactly balances exactly balances the desired quantities of domestic the desired quantities of domestic investment investment plusplus NCO NCO (demand for (demand for funds)funds)..

The Market for Foreign ExchangeThe Market for Foreign Exchange

1.1. The Market for Foreign Exchange The Market for Foreign Exchange is the is the market where domestic currency (liras) market where domestic currency (liras) are exchanged for foreign currency.are exchanged for foreign currency.

NXNX = NCO = NCO Holds at the equilibrium Holds at the equilibrium real exchange real exchange

rate.rate. Notice the equilibrium can change when Notice the equilibrium can change when

the conditions of the economy change.the conditions of the economy change.

Figure 2 The Market for Foreign Exchange

Quantity of Liras Exchangedinto Foreign Currency

RealExchange

Rate

Supply of liras = NCO

Demand for liras = NX

Equilibriumquantity

Equilibriumreal exchange

rate

The Market for ForeignThe Market for Foreign ExchangeExchange

Demand for domestic currencyDemand for domestic currency (liras) (liras) comes from comes from NX NX because this is the because this is the amount of extra domestic currency amount of extra domestic currency (liras) that foreigners need to buy the (liras) that foreigners need to buy the extra exports from domestic country extra exports from domestic country (Turkey). Foreigners want to sell (Turkey). Foreigners want to sell dollars and buy dollars and buy NXNX liras. They will liras. They will use these liras to buy extra exports use these liras to buy extra exports of the domestic country (Turkey).of the domestic country (Turkey).


Supply of domestic currencySupply of domestic currency (liras) (liras) come from come from NCONCO because this is the because this is the extra amount of liras that domestic extra amount of liras that domestic agents need to sell domestic agents need to sell domestic currency (liras) and buy foreign currency (liras) and buy foreign currency (dollars). Domestic agents currency (dollars). Domestic agents will use these (dollars) to buy foreign will use these (dollars) to buy foreign assets. assets.


The The priceprice that balances the supply that balances the supply and demand for foreignand demand for foreign currency is currency is the the real exchange ratereal exchange rate..


A higher Real Exchange Rate A higher Real Exchange Rate RERRERUS/TURUS/TUR makesmakes– domestic goods more expensivedomestic goods more expensive, foreign goods , foreign goods

cheapercheaper.. So NX decreases. So NX decreases. – Then quantity of domestic currency (liras) Then quantity of domestic currency (liras)

demanddemandeded decreases. Demand curve is decreases. Demand curve is downward slopingdownward sloping..

– Does not change nDoes not change net capital outflowset capital outflows (supply of (supply of liras). NCO changes only with real interest rates.liras). NCO changes only with real interest rates.

– TheThereforerefore supply curve is vertical. supply curve is vertical.


The real exchange rate adjusts to The real exchange rate adjusts to balance the supply and demand for balance the supply and demand for lirasliras..

At the equilibrium real exchange At the equilibrium real exchange rate, the demand for rate, the demand for lirasliras to buy net to buy net exports exactly balances the supply exports exactly balances the supply of of lirasliras to be exchanged into foreign to be exchanged into foreign currency to buy assets abroad.currency to buy assets abroad.

EQUILIBRIUM IN THE OPEN EQUILIBRIUM IN THE OPEN ECONOMYECONOMY

Combine the Funds Market and Combine the Funds Market and Foreign Exchange Market.Foreign Exchange Market.

Net capital outflow links the Net capital outflow links the two two markets. NCO is the supply of liras in markets. NCO is the supply of liras in Forex Market. NCO is part of the Forex Market. NCO is part of the demand for funds in Funds Market.demand for funds in Funds Market.

RReal interest rateeal interest rate is tis the key he key determinant of net capital outflowdeterminant of net capital outflows.s.

Figure 3 How Net Capital Outflow Depends on the Interest Rate

0 Net CapitalOutflow

Net capital outflowis negative.

Net capital outflowis positive.

RealInterest

Rate

Simultaneous Equilibrium in Simultaneous Equilibrium in Two MarketsTwo Markets

Prices in the Prices in the FFunds unds MMarket arket (real interest (real interest rate) rate) and the and the FForeign oreign EExchange xchange MMarket arket (real exchange rate) (real exchange rate) adjust simultaneously adjust simultaneously to balance supply and demand in these to balance supply and demand in these two markets.two markets.

When prices come to equilibriumWhen prices come to equilibrium, they , they determine the macroeconomic variables of determine the macroeconomic variables of national saving, domestic investment,national saving, domestic investment, NCO NCO , and net exports., and net exports.

Figure 4 The Real Equilibrium in an Open Economy

(a) The Market for Loanable Funds (b) Net Capital Outflow

Net capitaloutflow, NCO

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign-Currency Exchange

Quantity ofliras


Net CapitalOutflow

RealExchange

Rate

Supply

Supply

Demand

Demand

r r

E

HOW POLICIES AND EVENTS HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMYAFFECT AN OPEN ECONOMY

Let us analyze Let us analyze the followingthe following ::– Government budget deficitsGovernment budget deficits increase. increase.– Trade policiesTrade policies: New tariffs on imports : New tariffs on imports

imposed.imposed.– Political and economic stabilityPolitical and economic stability

decreases.decreases.– Saving Rate increases.Saving Rate increases.

Government Budget Deficits Government Budget Deficits

In an open economy, government In an open economy, government budget deficits . . . budget deficits . . . – reduce reduce national saving and hence national saving and hence the the

supply of loanable funds,supply of loanable funds,– drive up the interest rate,drive up the interest rate,– decreasesdecreases domestic investment, domestic investment,– decreasesdecreases NCO. NCO.

Figure 5 The Effects of Government Budget Deficit

(a) The Market for Loanable Funds (b) Net Capital Outflow

RealInterest

Rate

RealInterest

Rate


Quantity ofliras


Net CapitalOutflow

RealExchange

Rate

Demand

Demand

r2

NCO

SS

S S

r2

B

E1

r rA

1. A budget deficit reducesthe supply of loanable funds . . .

2. . . . which increasesthe real interestrate . . .

4. The decreasein net capitaloutflow reducesthe supply of lirasto be exchangedinto foreigncurrency . . .

5. . . . which causes thereal exchange rate toappreciate.

3. . . . which inturn reducesnet capitaloutflow.

E2

Government Budget Deficits Government Budget Deficits

Effect of Budget Deficits on NCOEffect of Budget Deficits on NCO– Higher interest rates reduce NCO. Higher interest rates reduce NCO.

Effect on the ForeignEffect on the Foreign Exchange MarketExchange Market– A decrease in NCO reduces the supply of A decrease in NCO reduces the supply of

liras.liras. Lira will appreciate. Lira will appreciate. This causes the real exchange rate to This causes the real exchange rate to

appreciate.appreciate. Reduces NX.Reduces NX.

Political Instability and Capital Political Instability and Capital FlightFlight

Capital flightCapital flight is a large and sudden is a large and sudden reduction in the demand for reduction in the demand for TL TL denominated denominated assets assets

Happens together with a financial Happens together with a financial crisis when a lot of banks go crisis when a lot of banks go bankrupt. bankrupt.

Happened in Turkey in 1994 and Happened in Turkey in 1994 and 2001. Mexico in 1994, Argentina 2001. Mexico in 1994, Argentina 2002, East Asia in 1997, Russia 1998.2002, East Asia in 1997, Russia 1998.


If investors become concerned about If investors become concerned about the safety of their investments, the safety of their investments, capital can quickly leave a capital can quickly leave a countrycountry..

Interest rates increase and the Interest rates increase and the domestic currency depreciatesdomestic currency depreciates sharplysharply..


When investors around the world observed When investors around the world observed political problems in political problems in TurkeyTurkey in in 2002001, they sold 1, they sold their their TL denominatedTL denominated assets and used the assets and used the proceeds to buy assets of other countries.proceeds to buy assets of other countries.

This increased Mexican net capital outflow.This increased Mexican net capital outflow.– The demand for loanable funds in the loanable The demand for loanable funds in the loanable

funds market increased, which increased the funds market increased, which increased the interest rate.interest rate.

– This increased the supply of pesos in the This increased the supply of pesos in the foreign-currency exchange marketforeign-currency exchange market..

Figure 7 The Effects of Capital Flight(a) The Market for Loanable Funds in Turkey (b) TR’s Net Capital Outflow

RealInterest

Rate

RealInterest

Rate


Quantity ofPesos


Net CapitalOutflow

RealExchange

Rate

r1 r1

D1

D2

E

Demand

S S2

Supply

NCO2NCO1

1. An increase in net capitaloutflow. . .

3. . . . which increasesthe interestrate.

2. . . . increases the demandfor loanable funds . . .

4. At the sametime, the increasein net capitaloutflowincreases thesupply of pesos . . .

5. . . . which causes thepeso todepreciate.

r2 r2

E

EFFECT OF AN İNCREASE IN EFFECT OF AN İNCREASE IN THE SAVING RATETHE SAVING RATE

What happens to investment, What happens to investment, interest rates, real exchange rate, interest rates, real exchange rate, and NX?and NX?

A Macroeconomic Theory Of Open Economies. A Macroeconomic Theory of an Open Economy Open Economies...

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