A MACROECONOMIC

THEORY OF THE OPEN

ECONOMY
Nargiz Heydarova
 If the government of a country wants to reduce trade deficits, what should it
do?
 Should it try to limit imports, perhaps by imposing a quota on the import of
cars from Japan or Germany? Or should it try to influence the country’s trade
deficit in some other way?
The market for loanable funds

In an open economy,
the demand for loanable funds
comes not only from those who
want loanable funds to buy
domestic
capital goods but also from
those who want loanable funds
to buy foreign assets.
The Market for Foreign Currency
Exchange
 Net capital outflow = Net exports
 The two sides of this identity as representing the two sides of the market for
foreign currency exchange. Net capital outflow represents the quantity of
pounds supplied for the purpose of buying foreign assets. when a UK
investment fund wants to buy a Japanese government bond, it needs to
change pounds into yen, so it supplies pounds in the market for foreign
currency exchange
 Net exports represent the quantity of pounds demanded for the purpose of
buying UK net exports of goods and services.
 The real exchange rate is the relative price of domestic and foreign goods and
=> is a key determinant of net exports.
The Market for Foreign Currency
Exchange
Net Capital Outflow: The Link Between
the Two Markets
 S = I + NCO
How Net Capital Outflow Depends on the
 NCO = NX Interest Rate
Because a higher domestic real interest rate makes
domestic assets more attractive, it reduces net
capital outflow. Note the position of zero on the
horizontal axis: net capital outflow can be positive
or negative. A negative value of net capital outflow
means that the economy is experiencing a net
inflow of capital.
Simultaneous Equilibrium in Two
Markets
Government Budget Deficits

twin deficits
 Trade Policy
 trade policy a government policy that directly influences the quantity of
goods and services that a country imports or exports

NX = NCO = S − I

Trade
policies do not alter the
trade balance because
they do not alter national
saving or domestic
investment.

the real exchange

rate adjusts to keep
the
trade balance the
same, regardless of
the trade policies the
government puts in
place.
 Capital Flight
 Large and sudden movement of funds out of a country is called capital flight.

To stem or prevent capital flight, a

government may impose capital controls
to limit the amount of money people can
take out of a country. However, in a
modern global economy, it can be
difficult to fully regulate these capital
flows.
 The Asian financial crisis of 1997 refers to a macroeconomic shock
experienced by several Asian economies  – including Thailand, Philippines,
Malaysia, South Korea and Indonesia.
 Countries experienced rapid devaluation and capital outflows as investor
confidence turned to pessimism as the structural imbalances in the economy
became more apparent.
 Suppose that Europeans decided to spend a smaller fraction of their incomes. ●
What would be the effect on saving, investment, interest rates, the real
exchange rate and the trade balance in the European Union?

 If the UK prime minister announces that the government are solidly on a course
of deficit reduction, which should make the pound more attractive to investors,
would such a deficit reduction in fact raise the value of the pound? Explain.

 Suppose that the government passes an investment tax credit, which subsidizes
domestic investment. How does this policy affect national saving, domestic
investment, net capital outflow, the interest rate, the exchange rate and the
trade balance?
 Suppose the French suddenly develop a strong taste for British wine. Answer
the following questions in words and using a diagram.
 a. What happens to the demand for pounds in the market for foreign currency
exchange?
 b. What happens to the value of pounds in the market for foreign currency
exchange?
 c. What happens to the quantity of UK net exports?
 Suppose that real interest rates increase across Europe. Explain how this
development will affect UK net capital outflow. Then explain how it will
affect UK net exports by using a formula from the chapter and by using a
diagram. What will happen to the UK real interest rate and real exchange
rate?
 Suppose that Germans decide to increase their saving.
 a. If the elasticity of German net capital outflow with respect to the real
interest rate is very high, will this increase in private saving have a large or
small effect on German domestic investment?
 b. If the elasticity of German exports with respect to the real exchange rate
is very low, will this increase in private saving have a large or small effect on
the German real exchange rate?
 Assume that saving in China has been used to finance investment into the EU.
That is, the Chinese have been buying European capital assets.
 a. If the Chinese decided they no longer wanted to buy European assets, what
would happen in the European market for loanable funds? In particular, what
would happen to European interest rates, European saving and European
investment?
 b. What would happen in the market for foreign currency exchange? In
particular, what would happen to the value of the euro and the European
trade balance?
 Suppose your country is running a trade deficit and you hear your trade
minister on the radio, saying: ‘The trade deficit must be reduced, but import
quotas only annoy our trading partners. If we subsidize our exports instead,
we can reduce the deficit by increasing our competitiveness.’ Using a three-
panel diagram, show the effect of an export subsidy on net exports and the
real exchange rate. Do you agree with the trade minister?
 Assume that there is a rise in the trade deficit of a country due largely to the
rise in a government budget deficit. Assume also that some commentators in
the popular press claim that the increased trade deficit resulted from a
decline in the quality of the country’s products relative to foreign products.
 a. Assume that the country’s products did decline in relative quality during
this period. How might this affect net exports at any given exchange rate?
 b. Use a three-panel diagram to show the effect of this shift in net exports on
the country’s real exchange rate and trade balance.
 c. Does a decline in the quality of the country’s products have any effect on
standards of living for its residents? (Hint: when a country’s residents sell
goods to non-country residents, what do they receive in return?)
 Suppose that people expect inflation to equal 3 per cent, but in fact prices
rise by 5 per cent. Describe how this unexpectedly high inflation rate would
help or hurt the following:
 a. the government
 b. a homeowner with a fixed-rate mortgage
 c. a union worker in the second year of a labor contract
 d. a retired person who has invested their savings in government bonds.
The main lesson from my lesson:
STUDY STUDY STUDY!!!