Chap_30 - Macroeconomics Theory of the Open Economy

A Macroeconomic
Theory of the Open

Economy
Chapter 30
Copyright © 2001 by Harcourt, Inc.
All rights reserved. Requests for permission to make copies of any part of
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Key Macroeconomic Variables
in an Open Economy
 The important macroeconomic
variables of an open economy
include:
 net exports
 net foreign investment
 nominal exchange rates
 real exchange rates
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Basic Assumptions of a Macroeconomic
Model of an Open Economy
 The model takes the economy’s

GDP as given.
 The model takes the economy’s
price level as given.
The Market for Loanable Funds
S = I + NFI
 At the equilibrium interest rate, the
amount that people want to save exactly
balances the desired quantities of
investment and net foreign investment.
 The supply of loanable funds comes from

national saving (S).
 The demand for loanable funds comes
from domestic investment (I) and net
foreign investment (NFI).
 The supply and demand for loanable

funds depend on the real interest rate.
 A higher real interest rate encourages
people to save and raises the quantity of
loanable funds supplied.
 The interest rate adjusts to bring the
supply and demand for loanable funds
into balance.
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate Demand for loanable
funds (for domestic
investment and net
foreign investment)
Equilibrium Quantity
quantity Loanable
of Funds
At the equilibrium interest rate, the

amount that people want to save exactly
balances the desired quantities of domestic
investment and net foreign investment.
The Market for Foreign-
Currency Exchange
 The two sides of the foreign-currency
exchange market are represented by NFI
and NX.
 NFI represents the imbalance between the
purchases and sales of capital assets.
 NX represents the imbalance between
exports and imports of goods and services.
Currency Exchange
 In the market for foreign-currency exchange,

U.S. dollars are traded for foreign
currencies.
 For an economy as a whole, NFI and NX
must balance each other out, or:
NFI = NX
Currency Exchange
The price that balances the supply

and demand for foreign-currency is
the real exchange rate.
Currency Exchange
 The demand curve for foreign currency
is downward sloping because a higher
exchange rate makes domestic goods
more expensive.
 The supply curve is vertical because the
quantity of dollars supplied for net
foreign investment is unrelated to the
real exchange rate.
The Market for Foreign-Currency
Exchange...
Real
Exchange
Rate
Supply of dollars
(from net foreign investment)
Equilibrium
real exchange
rate
Demand for dollars

(for net exports)
Equilibrium Quantity of Dollars Exchanged

quantity into Foreign Currency
Currency Exchange
 The real exchange rate adjusts to balance
the supply and demand for dollars.
 At the equilibrium real exchange rate,
the demand for dollars to buy net exports
exactly balances the supply of dollars to
be exchanged into foreign currency to
buy assets abroad.
Equilibrium in the Open
Economy
 In the market for loanable funds, supply
comes from national saving and demand
comes from domestic investment and net
foreign investment.
 In the market for foreign-currency
exchange, supply comes from net foreign
investment and demand comes from net
exports.
Economy
 Net foreign investment links the

loanable funds market and the
foreign-currency exchange market.
 The key determinant of net foreign
investment is the real interest rate.
How Net Foreign Investment
Depends on the Interest rate...
Real
Interes
t Rate
Net Foreign
0 Investment
Net foreign investment is Net foreign investment is
negative. positive.
Economy
 Prices in the loanable funds market and
the foreign-currency exchange market
adjust simultaneously to balance supply
and demand in these two markets.
 As they do, they determine the
macroeconomic variables of national
saving, domestic investment, net foreign
investment, and net exports.
The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds (b) Net Foreign Investment
Real Real
Interest Supply Interest
Rate Rate
r1 r1
Net foreign
investment,
Demand NFI
Quantity of Net Foreign

Loanable Funds Investment
Real
Exchange Supply
Rate
E1
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
How Changes in Policies and
Events Affect an Open Economy
 The magnitude and variation in

important macroeconomic
variables depend on the following:
 Government budget deficits
 Trade policies
 Political and economic stability
Government Budget Deficits
 In an open economy, government budget

deficits . . .
reduces the supply of loanable funds,
drives up the interest rate,
crowds out domestic investment,
cause net foreign investment to fall.
The Effects of Government Budget Deficit
Real Real
Interest S2 S1 Interest
Rate Rate
B
r2 r2
3. ...which in
A turn reduces
r1 r1 net foreign
investment.
Demand
NFI
1. A budget deficit Loanable Funds Investment
reduces the supply
of loanable funds... Real 4. The decrease in
S2 S1 net foreign
Exchange
investment
2. ...which Rate reduces the
increases the supply of dollars
real interest... to be exchanged
E2
into foreign
5. …which causes the E1 currency…
real exchange
rate to appreciate.
Demand
Quantity of Dollars
Effect of Budget Deficits on the
Loanable Funds Market
 A government budget deficit reduces

national saving, which . . .
. . . shifts the supply curve for
loanable funds to the left, which
. . . raises interest rates.
Effect of Budget Deficits on Net
Foreign Investment
 Higher interest rates reduce net

foreign investment.
Effect on the Foreign-Currency
Exchange Market
 A decrease in net foreign investment

reduces the supply of dollars to be
exchanged into foreign currency.
 This causes the real exchange rate to
appreciate.
Trade Policy
 A trade policy is a government policy that
directly influences the quantity of goods
and services that a country imports or
exports.
 Tariff: A tax on an imported good.
 Import quota: A limit on the quantity of a
good produced abroad and sold
domestically.
Trade Policy
 Because they do not change national saving
or domestic investment, trade policies do not
affect the trade balance.
 For a given level of national saving and domestic
investment, the real exchange rate adjusts to
keep the trade balance the same.
 Trade policies have a greater effect on
microeconomic than on macroeconomic
markets.
Effect of an Import Quota
 Because foreigners need dollars to buy

U.S. net exports, there is an increased
demand for dollars in the market for
foreign-currency.
 This leads to an appreciation of the real
exchange rate.
 There is no change in the interest rate

because nothing happens in the loanable
funds market.
 There will be no change in net exports.
 There is no change in net foreign
investment even though an import quota
reduces imports.
 An appreciation of the dollar in the

foreign exchange market encourages
imports and discourages exports.
 This offsets the initial increase in net
exports due to import quota.
The Effects of an Import Quota
Real Real
Interest S1 Interest
Rate Rate
3. Net exports,
however, remain
r1 r1 the same.
Demand NFI

Real
Exchange Supply
Rate 1. An import
quota increases
E2 the demand for
2. …and causes dollars…
the real exchange
rate to appreciate. E1
Demand
Quantity of Dollars
Trade policies do not

affect the trade balance.
Political Instability and Capital
Flight
Capital flight is a large and sudden

movement of funds out of a country,
usually due to political instability.
Political Instability and Capital
Flight
 Capital flight has its largest impact on the
country from which the capital is fleeing,
but it also affects other countries.
 If investors become concerned about the
safety of their investments, capital can
quickly leave an economy.
 Interest rates increase and the domestic
currency depreciates.
Political Instability in Mexico
and Capital Flight
 When investors around the world

observed political problems in Mexico in
1994, they sold some of their Mexican
assets and used the proceeds to buy assets
of other countries.
Political Instability in Mexico
and Capital Flight
 This increased Mexican net foreign

investment.
 The demand for loanable funds in the
loanable funds market increased, which
increased the interest rate.
 This increased the supply of pesos in the
foreign-currency exchange market.
The Effects of Capital Flight
(a) The Market for Loanable Funds (b) Mexican Net Foreign Investment
Real Real
Rate NFI1 NFI1
Rate 1. An increase in
r2 r2 net foreign
investment...
r1 r1
D2
D1

2. …increases Loanable Funds Investment
the demand for
3. …which loanable funds... Real 4. At the same
increases S1 S2 time, the
Exchange
the increase in net
Rate foreign
interest
rate. investment
E1 increases the
supply of
5. …which causes the pesos...
real exchange E2
rate to appreciate.
Demand
Quantity of Pesos
Summary
 To analyze the macroeconomics of open
economies, two markets are central – the
market for loanable funds and the market for
foreign-currency exchange.
 In the market for loanable funds, the
interest rate adjusts to balance supply for
loanable funds (from national saving) and
demand for loanable funds (from domestic
investment and net foreign investment).
Summary
 In the market for foreign-currency
exchange, the real exchange rate adjusts
to balance the supply of dollars (for net
foreign investment) and the demand for
dollars (for net exports).
 Net foreign investment is the variable
that connects the two markets.
Summary
 A policy that reduces national saving, such
as a government budget deficit, reduces the
supply of loanable funds and drives up the
interest rate.
 The higher interest rate reduces net foreign
investment, reducing the supply of dollars.
 The dollar appreciates, and net exports fall.
Summary
 A trade restriction increases net exports and
increases the demand for dollars in the
market for foreign-currency exchange.
 As a result, the dollar appreciates in value,
making domestic goods more expensive
relative to foreign goods.
 This appreciation offsets the initial impact of
the trade restrictions on net exports.
Summary
 When investors change their attitudes
about holding assets of a country, the
ramifications for the country’s economy
can be profound.
 Political instability in a country can lead to
capital flight.
 Capital flight tends to increase interest
rates and cause the country’s currency to
depreciate.
Graphical
Review
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate Demand for loanable
funds (for domestic
investment and net
foreign investment)
Equilibrium Quantity
quantity Loanable
of Funds
The Market for Foreign-Currency
Exchange...
Real
Exchange
Rate
Supply of dollars
(from net foreign investment)
Equilibrium
real exchange
rate
Demand for dollars

(for net exports)
Equilibrium Quantity of Dollars Exchanged

quantity into Foreign Currency
How Net Foreign Investment
Depends on the Interest rate...
Real
Interes
t Rate
Net Foreign
0 Investment
Net foreign investment is Net foreign investment is
negative. positive.
The Real Equilibrium in an Open Economy
Real Real
Interest Supply Interest
Rate Rate
r1 r1
Net foreign
investment,
Demand NFI

Real
Exchange Supply
Rate
E1
Demand
Quantity of Dollars
The Effects of Government Budget Deficit
Real Real
Interest S2 S1 Interest
Rate Rate
B
r2 r2
3. ...which in
A turn reduces
r1 r1 net foreign
investment.
Demand
NFI
1. A budget deficit Loanable Funds Investment
reduces the supply
of loanable funds... Real 4. The decrease in
S2 S1 net foreign
Exchange
investment
2. ...which Rate reduces the
increases the supply of dollars
real interest... to be exchanged
E2
into foreign
5. …which causes the E1 currency…
real exchange
rate to appreciate.
Demand
Quantity of Dollars
The Effects of an Import Quota
Real Real
Rate Rate
3. Net exports,
however, remain
r1 r1 the same.
Demand NFI

Real
Exchange Supply
Rate 1. An import
quota increases
E2 the demand for
2. …and causes dollars…
the real exchange
rate to appreciate. E1
Demand
Quantity of Dollars
The Effects of Capital Flight
(a) The Market for Loanable Funds (b) Mexican Net Foreign Investment
Real Real
Rate NFI1 NFI1
Rate 1. An increase in
r2 r2 net foreign
investment...
r1 r1
D2
D1

2. …increases Loanable Funds Investment
the demand for
3. …which loanable funds... Real 4. At the same
increases S1 S2 time, the
Exchange
the increase in net
Rate foreign
interest
rate. investment
E1 increases the
supply of
5. …which causes the pesos...
real exchange E2
rate to appreciate.
Demand
Quantity of Pesos

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Chap_30 - Macroeconomics Theory of the Open Economy

Uploaded by

Copyright:

Available Formats

A Macroeconomic

Theory of the Open

Copyright © 2001 by Harcourt, Inc.

 The model takes the economy’s

 The supply of loanable funds comes from

 The supply and demand for loanable

At the equilibrium interest rate, the

 In the market for foreign-currency exchange,

The price that balances the supply

Demand for dollars

Equilibrium Quantity of Dollars Exchanged

 Net foreign investment links the

Quantity of Net Foreign

 The magnitude and variation in

 In an open economy, government budget

 A government budget deficit reduces

 Higher interest rates reduce net

 A decrease in net foreign investment

 Because foreigners need dollars to buy

 There is no change in the interest rate

 An appreciation of the dollar in the

Quantity of Net Foreign

Trade policies do not

Capital flight is a large and sudden

 When investors around the world

 This increased Mexican net foreign

Quantity of Net Foreign

Demand for dollars

Equilibrium Quantity of Dollars Exchanged

Quantity of Net Foreign

Quantity of Net Foreign

Quantity of Net Foreign

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