Download How policies and events affect an open economy.

Chapter 18
A Macroeconomic Theory
of the Open Economy
© 2002 by Nelson, a division of Thomson Canada Limited
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Overview
Examine
the market for loanable funds.
Look at the foreign exchange market.
What is equilibrium in the open
market?
How policies and events affect an open
economy.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Macroeconomic Variable
Determination in an Open Economy
 The
important macroeconomic variables of
an open economy include: National Saving,
Domestic Investment, Net Foreign
Investment and Net Exports.
 The values of these variables are
determined through the interaction of: the
Loanable Funds Market, the Net Foreign
Investment Market, and the Market for
Foreign-Currency Exchange.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Market For Loanable Funds
Financial
markets co-ordinate the
economy’s saving and investment in
The Loanable Funds Market
The Supply of Loanable Funds comes
from national saving (S) and from net
foreign investment (NFI).
The Demand for Loanable Funds
comes from domestic investment (I).
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Positive Net Foreign Investment
Real
Interest
Rate
Net
Foreign
Investment
Supply
World
Interest
Rate
Demand
100
Principles of Macroeconomics: Ch. 18
150 Loanable Funds
Second Canadian Edition
Negative Net Foreign Investment
Real
Interest
Rate
Supply
World
Interest
Net Foreign
Investment
Demand
Rate
90
Principles of Macroeconomics: Ch. 18
130 Loanable Funds
Second Canadian Edition
The Market For Loanable Funds
In
a small, open economy with perfect
capital mobility, the interest rate is
equal to the world interest rate.
National Saving represents the supply
of loanable funds, while domestic
investment represents demand.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Market For Loanable Funds
Recall
the identity:
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Market For Loanable Funds

Recall the identity:
Domestic
Saving =
Investment
Principles of Macroeconomics: Ch. 18
+
Net Foreign
Investment
Second Canadian Edition
The Market For Loanable Funds
Recall
the identity:
Domestic
Saving =
Investment
+
Net Foreign
Investment
 At
the equilibrium interest rate, the amount
that people want to save, exactly balances
the desired quantities of investment and net
foreign investment.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Overview
 Examine
the market for loanable funds.
Look at the foreign exchange market.
What is equilibrium in the open
market?
How policies and events affect an open
economy.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Equality of Net Exports and Net
Foreign Investment
 Net
exports (NX) and net foreign
investment (NFI) are closely linked. For an
economy as a whole, NX and NFI balance
each other out so that: NX
= NFI
 NFI
represents the quantity of dollars
supplied for the purpose of buying assets
abroad. NX determines the quantity of
dollars demanded for the purpose of
buying foreign goods.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Market for Foreign-Currency
Exchange
identity, NX = NFI represents the
two sides of the foreign-exchange
market in which Canadian dollars are
traded for foreign currencies.
The price that balances the supply and
demand is the “real exchange rate”,
i.e. the relative price of domestic and
foreign goods.
The
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Market for Foreign-Currency Exchange
Real
Exchange
Rate
Supply of Dollars
(NFI)
Demand for Dollars
(NX)
Quantity of Dollars Exchanged into
Foreign Currency
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Market for Foreign-Currency
Exchange
The
demand curve is negatively related
to the real exchange rate. 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.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Market for Foreign-Currency
Exchange
The real exchange rate adjusts to
balance the supply and demand for
dollars. At the equilibrium 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.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Market for Foreign-Currency Exchange
Real
Exchange
Rate
Equilibrium
Real
Exchange
Rate
Supply of Dollars
(NFI)
Demand for Dollars
(NX)
Equilibrium Quantity
Principles of Macroeconomics: Ch. 18
Quantity
Second Canadian Edition
Quick Quiz!
Describe
the
sources of supply
and demand in the
market for loanable
funds and the
market for foreigncurrency exchange.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Overview
 Examine
the market for loanable funds.
 Look at the foreign exchange market.
What is equilibrium in the open
market?
How policies and events affect an open
economy.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Equilibrium in the Open Economy
Net
foreign investment (NFI) links the
loanable funds market with the foreigncurrency exchange market. The key
determinant of net foreign investment
is the world interest rate.
In the market for loanable funds, NFI is
a portion of demand. In the market for
foreign-currency exchange, NFI is the
source of supply.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Market for Loanable Funds
Real
Interest
Rate
Net foreign
investments (S – I)
Supply of loanable funds
from national saving (S)
World
interest
rate
Demand for
loanable funds
for domestic
investment (I)
100
Principles of Macroeconomics: Ch. 18
150
Quantity of Loanable
Funds (billions of dollars)
Second Canadian Edition
The Market for Foreign-Currency
Exchange
Real
Exchange
Rate
Supply of dollars (S – I)
E1
Demand for
dollars (NX)
50
Principles of Macroeconomics: Ch. 18
Quantity of Dollars
(in billions)
Second Canadian Edition
Equilibrium in the Open Economy
The market for loanable funds and the
foreign-currency exchange market
determine the real exchange rate,
national saving, domestic investment,
and the size of net foreign investment.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Quick Quiz!
 In
the model of the open
economy, two markets
determine one price and
the value of three
variables. What are the
markets? What three
variables are determined?
What price is determined?
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Overview
 Examine
the market for loanable funds.
 Look at the foreign exchange market.
 What is equilibrium in the open
market?
How policies and events affect an open
economy.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
How Policy and Events Affect an Open
Economy
The
magnitude and variation in
important macroeconomic variables
may be illustrated by these specific
events:
Increase in world interest rates
– Government Budget Deficits
– Government Trade Policies
– Political and Economic Stability
–
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Increase in World Interest Rates

In an open economy with perfect
capital mobility, an increase in world
interest rates crowds out domestic
investment, causes the dollar to
depreciate, and increases net exports.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Government Budget Deficits
and Surpluses
In a small open economy,
- an increase in government budget
deficits causes the dollar to appreciate
and causes net exports to fall.
- a decrease in government budget
deficits causes the dollar to depreciate
and causes net exports to rise.

Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Government Budget Deficits:
Specific Market Effects
Loanable
–
Funds Market Effect:
Reduces national saving which...
shifts the supply curve for loanable
funds to the left, which reduces net
foreign investment.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Market for Loanable Funds
Real
Interest
Rate
rw
Supply of loanable
funds from national
saving (S)
C
2. …
which
reduces
net
foreign
investment.
Principles of Macroeconomics: Ch. 18
B
A
1. An increase in
the government
budget deficit
reduces national
saving …
Demand for loanable
funds for domestic
investment (I)
Quantity of Loanable
Funds (billions of dollars)
Second Canadian Edition
Government Budget Deficits:
Specific Market Effects
Foreign-Currency
–
Exchange Market:
The decrease in net foreign investment
reduces the supply of dollars to be
exchanged into foreign currency, which
causes the real exchange rate to
appreciate.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
The Market for Foreign-Currency
Exchange
Real
Exchange
Rate
E2
E1
4. … which
causes the
real
exchange
rate to
appreciate.
Principles of Macroeconomics: Ch. 18
Supply of dollars
(S – I)2 (S – I)1
3. The decrease
in net foreign
investment
reduces the
supply of
dollars to be
exchanged into
foreign
currency …
Demand for
dollars (NX)
Quantity of Dollars
(in billions)
Second Canadian Edition
Government Trade Policy
Government
–
Trade Policy Effect:
Does not alter the trade balance because
it does not alter national saving or
domestic investment.
For
given levels of national saving and
domestic investment, the real exchange rate
adjusts to keep the balance the same,
regardless of the trade policies the
government puts in place.
Trade policies are more microeconomic than
macroeconomic.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Government Trade Policies:
Specific Market Effects
Foreign-Currency
Exchange Market:
Nothing happens in the loanable funds
market or to the supply of dollars in the
market for foreign-currency exchange.
– The only effect is a rise in net exports for
any given exchange rate. This increases
the demand for dollars, which causes the
value of the dollar to appreciate.
–
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Government Trade Policies:
Specific Market Effects
Net
Foreign Investment Market:
Because there is no change in net foreign
investment, there will be no change in net
exports.
– An appreciation of the dollar in the
foreign exchange market encourages
imports and discourages exports which...
... offsets the direct increase in net
exports due to import quota.
–
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Political Instability and Capital Flight
 Capital
Flight is a situation in which a large
and sudden movement of funds out of a
country occurs due to political instability
(e.g. 1994 Mexican government instability.)
 When investors around the world observe
political problems in one country (e.g.
Mexico) they decide to sell some of their
Mexican assets and use the proceeds to
buy other countries’ assets.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Political Instability and Capital Flight
Specific Market Effects
Net
–
Foreign Investment Market:
Observed political problems in Mexico in
1994 increased Mexican net foreign
investment which...
increased the interest rate paid on Mexican
assets which…
increased the supply of pesos in the
Foreign-Currency Exchange Market.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Quick Quiz!
Suppose
that Canadians
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?
Principles of Macroeconomics: Ch. 18
Second Canadian Edition
Overview
 Examine
the market for loanable funds.
 Look at the foreign exchange market.
 What is equilibrium in the open
market?
 How policies and events affect an open
economy.
Principles of Macroeconomics: Ch. 18
Second Canadian Edition