Chapter 32- A Macro Economic Theory of the Open Economy
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Transcript of Chapter 32- A Macro Economic Theory of the Open Economy
8/2/2019 Chapter 32- A Macro Economic Theory of the Open Economy
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Chapter
A Macroeconomic Theoryof the Open Economy
32
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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)
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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
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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
– Reduces U.S. net capital outflow4
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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
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Figure
RealInterest
Rate
The market for loanable funds
1
6
Quantity of
Loanable Funds
Equilibriumreal interest
rate
Supply of loanable funds(from national saving)
Demand for loanablefunds (for domesticinvestment and netcapital outflow)
Equilibrium
quantity
The interest rate in an open economy, as in a closed economy, is determined by the supplyand demand for loanable funds. National saving is the source of the supply of loanablefunds. Domestic investment and net capital outflow are the sources of the demand forloanable 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 capitaland foreign assets.
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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
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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
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Market for Foreign-Currency Exchange
• The market for foreign-currency exchange
• Supply of foreign-currency exchange
– Net capital outflow
–
Quantity of dollars supplied - buy foreignassets
– Supply curve – vertical
•
Quantity of dollars supplied for net capitaloutflow
• Does not depend on the real exchange rate
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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. 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 to buy
those goods
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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
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Figure
The market for foreign-currency exchange
2
12
RealExchangeRate
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, the
number of dollars people supply to buy foreign assets exactly balances the number of dollarspeople demand to buy net exports.
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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
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Figure
How net capital outflow depends on the interest rate
3
14
RealInterestRate
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 that the
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
• 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
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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
– Equilibrium real exchange rate, E
• Price of domestic goods and services
– Relative to foreign goods and services 16
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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 17
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Figure
The real equilibrium in an open economy
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Real
InterestRate
Supply
Demand
Quantity of
Loanable Funds
(a) The Market for Loanable Funds
Real
Interest
Rate
Net capital
outflow, NCO
Net capital outflow
(b) Net Capital Outflow
r1 r1
Real
Exchange
Rate
Supply
Demand
Quantity of Dollars(c) The Market for Foreign-Currency Exchange
E1
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-currencyexchange.
In panel (c), the supply and demand for dollars
in the market for foreign-currency exchangedetermine the real exchange rate.
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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 19
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Figure
The effects of a government budget deficit
5
20
Real
InterestRate
S1
Demand
Quantity of
Loanable Funds
(a) The Market for Loanable Funds
Real
Interest
Rate
NCO
Net capital outflow
(b) Net Capital Outflow
r1
Real
Exchange
Rate
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 S1 to
S2 in panel (a). The interest rate rises from r1 to r2to balance the supply and demand for loanablefunds. In panel (b), the higher interest rate
reduces net capital outflow. Reduced net capital
outflow, in turn, reduces the supply of dollars inthe 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 ratepushes the trade balance toward deficit.
S2
r1
A
1. A budget deficit reducesthe supply of loanable funds . . .
r2B
2. . . .
whichincreases
the real
interest
rate . . .
r23. . . . which in
turn reduces
net capital
outflow.
S2
4. The decrease
in net capital
outflow reducesthe supply of dollars
to be exchangedinto foreign
currency . . .
E2
5. . . . Which
causes the real
exchange rate
to appreciate.
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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
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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 22
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Figure
The effects of an import quota
6
23
Real
InterestRate
Supply
Demand
Quantity of Loanable Funds
(a) The Market for Loanable Funds
Real
Interest
Rate
NCO
Net capital outflow
(b) Net Capital Outflow
r1 r1
RealExchange
RateSupply
D1
Quantity of Dollars(c) The Market for Foreign-Currency Exchange
E1
When the U.S. government imposes a quota on
the import of Japanese cars, nothing happens inthe market for loanable funds in panel (a) or to net
capital outflow in panel (b). The only effect is a risein net exports (exports minus imports) for anygiven 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.
D2
1. An import
quota increasesthe demand for
dollars . . .
E2
2. . . . And causes
the real exchange
rate to appreciate.
3. Net exports,however, remain
the same.
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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
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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
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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 – depreciates26
Figure 7
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Figure
The effects of capital flight
7
27
Real
InterestRate
SupplyD1
Quantity of Loanable Funds
(a) The Market for Loanable Funds in Mexico
Real
Interest
Rate
NCO1
Net capital outflow
(b) Mexican Net Capital Outflow
r1 r1
Real
Exchange
Rate
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 netcapital outflow. The demand for loanable funds inMexico rises from D1 to D2, as shown in panel (a), andthis drives up the Mexican real interest rate from r1 to r2.Because net capital outflow is higher for any interestrate, that curve also shifts to the right from NCO1 toNCO2 in panel (b). At the same time, in the market forforeign-currency exchange, the supply of pesos risesfrom S1 to S2, as shown in panel (c). This increase in thesupply of pesos causes the peso to depreciate from E1
to E2, so the peso becomes less valuable compared toother currencies.
NCO2
1. An increase
in net capital
outflow . . .
D2
2. . . . increases the demandfor loanable funds . . .
r2
3. . . . Which increasesthe interest rate.
r2
S2
E2
4. At the same time, the
increase in net capital
outflow increases thesupply of pesos . . .
5. . . . which causes
the peso to depreciate
C it l fl f Chi
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• 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
Capital flows from China
28
C it l fl f Chi
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• 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
Capital flows from China
29
Capital flo s from China
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• 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
Capital flows from China
30
Capital flows from China
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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
–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
Capital flows from China
31
Capital flows from China
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• 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
Capital flows from China
32