1. No category

A Macroeconomic Theory
of the Open Economy
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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1
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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2
Market for Loanable Funds
• When NCO > 0
– Net outflow of capital
– Net purchase of capital overseas
• Adds to the demand for domestically generated
loanable funds
• When NCO < 0
– Net inflow of capital
– Capital resources coming from abroad
• Reduce the demand for domestically generated
loanable funds
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3
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
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4
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
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5
Market for Loanable Funds
• Higher real interest rate
– Discourages Americans from buying
foreign assets
• Reduces U.S. net capital outflow
– Encourages foreigners to buy U.S. assets
• Reduces U.S. net capital outflow
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6
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 1
The Market for Loanable Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate
Equilibrium
quantity
Demand for loanable
funds (for domestic
investment and net
capital outflow)
Quantity of
Loanable Funds
The interest rate in an open economy, as in a closed economy, is determined by the
supply and demand for loanable funds. National saving is the source of the supply of
loanable funds. Domestic investment and net capital outflow are the sources of the
demand for loanable 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 capital and foreign assets.
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8
Foreign-Currency Exchange
• The market for foreign-currency exchange
– Identity: NCO = NX
– Net capital outflow = Net exports
• If trade surplus, NX > 0
– Exports > Imports
– Net sale of goods ad services abroad
– Americans use the foreign currency to buy
foreign assets
• Capital is flowing abroad, NCO > 0
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9
Foreign-Currency Exchange
• If trade deficit, NX < 0
– Imports > Exports
– Some of this spending - financed by
selling American assets abroad
• Foreign capital is flowing into U.S.
• NCO < 0
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10
Foreign-Currency Exchange
• Supply of foreign-currency exchange
– Net capital outflow
• Quantity of dollars supplied to buy foreign
assets
– Supply curve – vertical
• Quantity of dollars supplied for net capital
outflow
• Does not depend on the real exchange rate
(by assumption)
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11
Foreign-Currency Exchange
• Demand for foreign-currency exchange
– Net exports
• Quantity of dollars demanded to buy U.S. net
exports 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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12
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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13
Figure 2
The Market for Foreign-Currency Exchange
Real
Exchange
Rate
Supply of dollars
(from net capital outflow)
Equilibrium real
exchange rate
Demand for dollars
(for net exports)
Equilibrium
quantity
Quantity of Dollars Exchanged
into Foreign Currency
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 is
vertical. The demand for dollars comes from net exports. Because a lower real exchange rate
stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net
exports), 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 dollars
people demand to buy net exports.
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14
Equilibrium in the Open Economy
• 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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15
Exhibit 3
How Net Capital Outflow Depends on the Interest Rate
Real
Interest
Rate
Net capital outflow 0 Net capital outflow Net Capital
Outflow
is negative
is positive
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.
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16
Equilibrium in the Open Economy
• 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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17
Equilibrium in the Open Economy
• 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
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18
Equilibrium in the Open Economy
• Equilibrium real exchange rate, E
– Price of domestic goods and services
• Relative to foreign goods and services
• E and r - adjust simultaneously
– To balance supply and demand
• In both markets
– Loanable funds
– Foreign-currency exchange
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19
Equilibrium in the Open Economy
• E and r - adjust simultaneously
– Determine
• National saving
• Domestic investment
• Net capital outflow
• Net exports
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20
Figure 4
The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds
Real
Interest
Rate
Supply
(b) Net Capital Outflow
Real
Interest
Rate
r1
r1
Net capital
outflow, NCO
Demand
Quantity of
Loanable Funds
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-currency exchange. In panel (c),
the supply and demand for dollars in the
market for foreign-currency exchange
determine the real exchange rate.
Net capital outflow
Real
Exchange
Rate
Supply
E1
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
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21
Government Budget Deficits
• Government budget deficits
– When government spending exceeds
government revenue
– Negative public saving
– Reduces national saving
– Reduces supply of loanable funds
– Increase in interest rate
– Reduces net capital outflow
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22
Government Budget Deficits
• Government budget deficits
– Crowd-out domestic investment
– Decrease in supply of foreign-currency
exchange
– Currency appreciates
– Net exports fall
– Push the trade balance toward deficit
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23
Exhibit 5
The Effects of a Government Budget Deficit
(b) Net Capital Outflow
(a) The Market for Loanable Funds
Real
Interest
Rate
r2
r1
2. . . . which
increases the
real interest
rate . . .
1. A budget deficit reduces the
supply of loanable funds . . .
S2
B
S1
Real
Interest
Rate
r2
A
3. . . . which in
turn reduces net
capital outflow.
r1
Demand
Quantity of Loanable Funds
When the government runs a budget deficit, it
reduces the supply of loanable funds from S1 to S2
in panel (a). The interest rate rises from r1 to r2 to
balance the supply and demand for loanable funds.
In panel (b), the higher interest rate reduces net
capital outflow. Reduced net capital outflow, in turn,
reduces the supply of dollars in the 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 rate pushes the trade
balance toward deficit.
NCO
Real Exchange
Rate
E2
E1
5. . . . Which
causes the real
exchange rate
to appreciate.
Net capital outflow
S2 S1
4. The decrease in net
capital outflow reduces
the supply of dollars to
be exchanged into
foreign currency . . .
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
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24
Trade Policy
• 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
– Voluntary export restrictions
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25
Trade Policy
• Macroeconomic impact of trade policy
– Decrease imports
– Increase in net exports
– Increase in demand for dollars in the
market for foreign-currency exchange
– Real exchange rate appreciates
• Discourage exports
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26
Trade Policy
• Macroeconomic impact of trade policy
– No change in real interest rate
– No change in net capital outflow
– No change in net exports
• Decrease in imports
• Decrease in exports
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27
Figure 6
The Effects of an Import Quota
(b) Net Capital Outflow
(a) The Market for Loanable Funds
Real
Interest
Rate
Supply
Real
Interest
Rate
r1
r1
Demand
3. Net exports,
however, remain
the same.
NCO
Quantity of Loanable Funds
Net capital outflow
Real Exchange
When the U.S. government imposes a quota on the
Rate
2. . . . And causes
import of Japanese cars, nothing happens in the market
Supply
the real exchange
for loanable funds in panel (a) or to net capital outflow
rate to appreciate.
in panel (b). The only effect is a rise in net exports
E2
(exports minus imports) for any given real exchange
E1
rate. As a result, the demand for dollars in the market
for foreign-currency exchange rises, as shown by the
D2
shift from D1 to D2 in panel (c). This increase in the
1.
An
import
quota
demand for dollars causes the value of the dollar to
D1
increases
the
demand
appreciate from E1 to E2. This appreciation of the dollar
for dollars . . .
tends to reduce net exports, offsetting the direct effect
Quantity of Dollars
of the import quota on the trade balance.
(c) The Market for Foreign-Currency Exchange
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28
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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29
Political Instability &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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30
Political Instability &Capital Flight
• Mexico - capital flight affects both markets
– 1994, political instability
– Investors – capital flight
• Sell Mexican assets
• Buy U.S. assets, “safe haven”
– 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
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31
Political Instability &Capital Flight
• Mexico - capital flight affects both markets
– Interest rate in Mexico – increases
• Reduce domestic investment
• Slows capital accumulations
• Slows economic growth
– The peso depreciates
• Exports – cheaper
• Imports - more expensive
• Trade balance moves toward surplus
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32
Figure 7
The Effects of Capital Flight
(a) The Market for Loanable Funds in Mexico
Real
Real
D2
Interest
Interest
Rate
Rate
Supply
D1
r2
r2
1. An increase
in net capital
outflow . . .
r1
r1
3. . . . Which
increases
the interest
rate.
(b) Mexican Net Capital Outflow
2. . . . increases the demand
for loanable funds . . .
Quantity of Loanable Funds
NCO1
NCO2
Net capital outflow
If people decide that Mexico is a risky place to keep their Real Exchange
4. At the same
savings, they will move their capital to safer havens such Rate
S
S
1
2 time, the increase
as the U.S., resulting in an increase in Mexican net capital
in net capital
outflow. Consequently, the demand for loanable funds in
outflow increases
Mexico rises from D1 to D2, as shown in panel (a), and this
drives up the Mexican real interest rate from r1 to r2.
the supply of
E1
Because net capital outflow is higher for any interest rate,
pesos . . .
E2
that curve also shifts to the right from NCO1 to NCO2 in
panel (b). At the same time, in the market for foreign5. . . . which
Demand
currency exchange, the supply of pesos rises from S1 to S2, causes the peso
as shown in panel (c). This increase in the supply of pesos to depreciate
Quantity of Pesos
causes the peso to depreciate from E1 to E2, so the peso
(c) The Market for Foreign-Currency Exchange
becomes less valuable compared to other currencies.
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33
Political Instability &Capital Flight
• Mexico - capital flight affects both markets
– U.S. market
• Fall in U.S. net capital outflow
• The dollar appreciates in value
• U.S. interest rates fall
• Relatively small impact on the U.S. economy
– Because the economy of the United States is so
large compared to that of Mexico
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34
Capital flows from China
• 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
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35
Capital flows from China
• 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
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36
Capital flows from China
• 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, $2.4 trillion, 2009
– Including U.S. government bonds
• Chinese goods - less expensive
• Contributes to the U.S. trade deficit
• Hurts American producers who make
products that compete with imports from
China
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37
Capital flows from China
• Ongoing policy disputes: U.S. and China
– U.S. government
• Encouraged China to stop influencing the
exchange value of its currency
– 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
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38
Capital flows from China
• 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
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39