CHAP 19: A MACROECONOMIC THEORY OF THE OPEN ECONOMY

The real exchange rate: e × P/ P¿

e×P
 PPP theory of the real exchange rate: ¿ =1
P
Private-sector saving = Y – T – C
Government saving = T – G
 National saving (S) = Y – C – G = I + NX = I + NCO
I. Supply and Demand for Loanable Funds and for Foreign-Currency
Exchange
1. The market for Loanable Funds
+ Supply : National saving
+ Demand : Domestic saving (I) + NCO
 NCO > 0, net outflow of capital:
→ Net purchase of capital overseas
 Add to demand (+ NCO)
 NCO < 0, net inflow of capital:
→ Capital resources come from abroad
 Reduce the demand ( - NCO)

Both I and NCO depend negatively on

r, so the D curve is downward-sloping
Real interest rate adjusts to balance
supply and demand in the loanable
fund market

The market for Loanable Funds

*How NCO depends on the real interest rate ?
A fall in r makes domestic assets less attractive
relative to foreign assets
→ People in the U.S purchase more foreign assets
→ People abroad purchase fewer U.S assets
 NCO rises

Active learning 1: Suppose the government runs a budget deficit (previously, the
budget was balanced).
Use the appropriate diagrams to determine the effects on the real interest rate and
net capital outflow.
 Solve:
Note:

2. The market for Foreign-Currency Exchange

- NCO = NX
- Supply: NCO
Ex: U.S residents sell dollars to obtain the foreign currency they
need to buy foreign assets
- Demand: NX
Ex: Foreigners need dollars to buy U.S net exports.
- The U.S real exchange rate (E) :
 E is the real value of a dollar in the market for foreign-currency
exchange
 Measure the quantity of foreign G&S that trade for one unit of
U.S G&S

An increase in real exchange

rate (E):
U.S goods more
expensive to foreigners,
reduces foreign demand
for U.S goods – U.S
dollars
 No effect on saving or investment, so it does not affect NCO or the supply of
dollar
The market for Foreign-Currency Exchange
 The effect of a budget deficit:
- S falls
- r rises
- I & NCO falls
- E appreciates
- NX falls

3. The connection between Interest Rate and Exchange Rate

Active learning 3:
Suppose the government provides new tax incentives to encourage investment.
Use the appropriate diagrams to determine how this policy would affect:
• the real interest rate
• net capital outflow
• the real exchange rate
• net exports
 Solve:
Encourage investment → increase demand for LF → r rises, causing NCO
to fall

The fall in NCO reduces the supply of

dollars
→ The real exchange rate appreciate
→ Net exports reduced ( since NCO
reduced)
 II. How policies and events affect an open economy
1. Budget deficit vs. Investment incentives
 A tax incentives for investment has similar effects as a budget
deficit:
+ r rises, NCO falls
+ E rises, NX falls
 But difference:
+ Investment tax incentive: ↑ investment → ↑ productivity +
living standard in long run
+ Budget deficit: ↓ investment → ↓ productivity + living
standards
2. Trade policy
- GO policy directly influences the quantity of G&S
- Tariff – a tax on imports
- Quota – a limit on the quantity of imports
- Voluntary export restriction – the GO pressures another country to
restrict its exports
- Common reason for restricting imports:
+ Save jobs in a domestic industry ( does )
+ Reduce trade deficit ( does not )
*Analysis of a Quota on Cars from Japan
- An import quota does not affect saving or
investment → does not affect NCO
- Since NCO is unchanged, S curve does not
shift
- Imports of cars fall → net exports rise
 D curve shifts to the right
- At E1, there is excess demand in foreign
exchange market
 E rise to restore equilibrium

3. Political Instability and Capital Flight

- Political Instability: concerning about the
safety of the asset → sold, pulled the capital
out of that country
- Capital Flight:
+ Large and sudden reduction in the demand
for assets located in a country
→ NCO increase
→ Since demand for LF = I + NCO. The
increase in NCO increase demand for LF
→ The equilibrium values of r and NCO both increase