ECON 1002D

Chapter 13: A Macro Theory of the Open Economy

Class 8: Mar 13, 2023

Overview

• What determines the:

– Real Interest Rate?
– Real Exchange Rate?
• How are the markets for Loanable Funds and Foreign-currency Exchange
connected?
• How do govt budget deficits affect the Exchange Rate and Trade Balance?
• How do other policies or events affect the Interest Rate, Exchange Rate, and
Trade Balance?

Open Economies
• economies that ____________________ with other economies around the world
• important Macro variables include:
– Net Exports
– Net Foreign Investment
– Nominal Exchange Rates
– Real Exchange Rates

Basic Assumptions of a Macro Model of an Open Economy

• The model takes as given the economy´s:

– ______________
– ______________

Open Economy: Important Markets

• Two important markets in understanding the workings of an open economy:
1. _______________ Funds
2. ______________________ Exchange

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1. Market for Loanable Funds (revisited): Closed Economy

Real • Supply and Demand depend on the

Interest Real _______________ Rate.
Rate
• _______________ Rate adjusts to
balance Supply and Demand

➔ amount people want to save

____________________ desired
quantities of Domestic
Investment.

Quantity of Loanable Funds

Market for Loanable Funds: Open Economy

• Coordinates the economy’s ______________________________ and the flow of

_______________________________________.
– Supply: from _____________ making deposits
– Demand: from
– Domestic Investment (I); and
– Net Capital Outflows(NCO)

• There is one market Interest Rate, which is both the return to saving and the cost
of borrowing.

________
Saving = + ______________ Outflow
Investment

___ = ___ + ______

___ = ___ − ______
(Note: This is the critical identify to understand the next model)

• Open Economy – amount a nation __________ does not have to equal the
amount it ________________________________________
– If National Saving > purchase of domestic Capital (I) ➔ NCO is ________.
– If National Saving < purchase of domestic Capital (I) ➔ NCO is ________.

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 • For a Small Open Economy with perfect capital mobility, the Domestic Interest
Rate will equal the ____________________________.
• Result: quantity of Loanable Funds available through Savings of
Canadians _________________________ the quantity of Loanable Funds
___________________________________
- difference between these two amounts: _______

Market for Loanable Funds

(a) Positive Net Capital Outflow
Real
Interest
Rate

Quantity of Loanable Funds

(b) Negative Net Capital Outflow

Real
Interest
Rate

Quantity of Loanable Funds

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 2. Market for Foreign-currency Exchange
• Market consisting of people who want to trade with people in other countries, but
want to be paid in _______________________.
• Two sides of market represented by
– NCO: the imbalance between the ___________________________;
– NX: the imbalance between _______________________________.

• For an economy as a whole, ____ and ____ must balance: ______ = ________

➔ The ______________ must balance Supply and Demand for ____________.

Market for Foreign Currency Exchange

Real • Demand: _________ward sloping since

a higher Exchange Rate makes domestic
Exchange goods __________ expensive.
Rate
• Supply: _____________ because
quantity of dollars supplied for Net Capital
Outflow is ______________ to the Real
Exchange Rate.

• Real Exchange Rate _____________ to

______________ the Supply and
Demand for dollars.

Quantity of Dollars
Exchanged into Foreign Currency

Equilibrium in the Open Economy

• _______________________ is the variable that links these two markets
• Market for _____________________:
- Supply: from National ______________
- Demand: from __________________ and ___________________.
• Market for _________________________
- Supply: from ________________
- Demand: from ______________

• Key determinant of Net Capital Outflow: __________________________.

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 Real Equilibrium in a Small Open Economy

(a) Market for Loanable Funds

Real
Interest
Rate

Quantity of Loanable Funds

(b) Market for Foreign Currency Exchange

Real
Exchange
Rate

Quantity of Dollars
Exchanged into Foreign Currency

• Prices in the Loanable Funds Market and the Foreign-currency Exchange Market
________________________ to balance Supply and Demand in these markets.
• Determine several key Macro variables in the process:
– National __________
– Domestic ___________
– Net Foreign ___________
– Net __________.
Open Economy:
Impacts of Policies and Events

• Important Macroeconomic variables depend on:

i. Increase in World Interest Rates
ii. Government budget deficits and surpluses
iii. Trade policies
iv. Political and economic stability

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 Steps:

1. First, determine where the first change occurs (either top or lower
panel).
2. Next, identify whether NCO increases (larger gap), decreases (smaller
gap) or remains unchanged in the top panel.
3. If it increases, shift the Supply of Dollars in the lower panel right (or left
for a decrease), In other words, NCO=(S-I) identity gives the link between
panels.
4. All outcomes of the model can then be determined.

i. An Increase in the World Interest Rate

(a) Market for Loanable Funds

Real
Interest
Rate

Quantity of Loanable Funds

(b) Market for Foreign Currency Exchange
Real
Exchange
Rate

Quantity of Dollars

1, An increase in the World Interest Rate . . .

2. causes NCO to ____crease . . .
3. which increases the Supply of dollars to be exchanged into foreign currency. . .
4. which causes the Real Exchange Rate to ___preciate.

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 ii. An Increase in the Government Budget Deficits
(a) Market for Loanable Funds
Real
Interest
Rate

Quantity of Loanable Funds

(b) Market for Foreign Currency Exchange
Real
Exchange
Rate

Quantity of Dollars

1. An increase in the government budget deficit ____creases National Savings

2. … which ____creases Net Capital Outflow
3. The decrease in NCO ____creases the Supply of dollars to be
exchanged into foreign currency…
4. … which causes the Real Exchange Rate to ____preciate.

iii. Trade Policy

• a govt policy that directly influences the _______________ of G&S a country
imports or exports
• _____________: a tax on an imported good
• ___________________: a limit on the quantity of a good produced abroad
and sold domestically

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 Effects:
• Reduces Imports (at any Exchange Rate), and Net Exports will ________.
- Increases the _______________ for dollars in the Market for
Foreign Currency.

Effect of an Import Quota

(a) Market for Loanable Funds

Real
Interest
Rate

Quantity of Loanable Funds

(b) Market for Foreign Currency Exchange

Real
Exchange
Rate

Quantity of Dollars

1. An import quota ___creases the Demand for dollars …

2 , , , which causes the Real Exchange Rate to ____preciate.
3. Net Capital Outflow and Net Exports ___________________________.
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 • There will be ___________________ in Net Exports even though an
Import Quota reduces Imports.

• An _____preciation of the dollar in the Foreign Exchange Market:

- encourages ___ports; and
- discourages ____ports.

• This offsets the ______________________ in Net Exports due to the

Import Quota.

➔ Trade policies _____________ affect the Trade _____________.

iv. Political and Economic Stability

Capital Flight
• ___________________________ reduction in demand for assets
__________________________
- occurs when ____________________________________ about
_______________ of their investments
➔ Mexico, 1994: political tensions → investors sold Mexican
assets en masse (Net Capital Outflow)
➔ Canada, 1995: ____________________________________
➔ Iceland, 2008: collapse of kronur due to bank bonds that
couldn’t be repaid
 Interest Rates _____crease
 domestic currency ______preciates
- largest impact on the country from which the capital is fleeing
- but also affects other countries

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 Effects of Capital Flight

(a) Market for Loanable Funds

Real
Interest
Rate

Quantity of Loanable Funds

(b) Market for Foreign Currency Exchange

Real
Exchange
Rate

Quantity of Pesos

1. An increase in the perceived risk of holding Mexican assets increases the interest
rate paid on Mexican assets by the amount of the ______________________, .

2. To save the same amount as before, Mexican savers must also receive the risk
premium.

3. With the quantity of Loanable Funds supplied unchanged and the quantity demanded
reduced, Mexico’s net capital outflow rises.

4. The increase in Mexico’s net capital outflow increases the supply of pesos.

5. Which causes the peso to ___preciate.

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 SUMMARY

• Model of Small Open Economy with perfect capital mobility

• applies to countries like Canada that represent a small portion of the
global economy
• two markets are central:
- Loanable Funds: Interest Rate adjusts to balance Supply (from
National Saving) and Demand (from Domestic Investment and Net
Capital Outflow).
- Foreign-currency Exchange: Real Exchange Rate adjusts to
balance Supply of dollars (for Net Capital Outflow) and the Demand
for dollars (for Net Exports)
- Net Capital Outflow is the variable that connects the two markets.

Policies
• Govt Budget Deficits
• reduces National Saving
– increases Interest Rates
– decreases Net Capital Outflow
– decreases Supply of dollars in the Foreign Exchange Market
– Exchange Rate appreciates
– decreases Net Exports

• Trade Restrictions – e.g., restricting imports

• increase Net Exports (for a given Exchange Rate) and thus increase
Demand for dollars in the Market for Foreign-currency Exchange
- dollar appreciates in value, making domestic goods more
expensive relative to foreign goods
- appreciation offsets initial impact of the trade restrictions on Net
Exports

• Capital Flight
• investors change their attitudes about holding assets of a country, e.g.,
due to political instability
• ramifications for the country’s economy can be profound
- increase Interest Rates
- country’s currency depreciates

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