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A Macroeconomic Theory of the Open Economy Week 9 1 Pengantar Ekonomi 2 Key Macroeconomic Variables in an Open Economy u The important macroeconomic variables of an open economy include: u u u u 2 net exports net foreign investment nominal exchange rates real exchange rates Pengantar Ekonomi 2 Basic Assumptions of a Macroeconomic Model of an Open Economy u The model takes the economy’s GDP as given. u The model takes the economy’s price level as given. 3 Pengantar Ekonomi 2 The Market for Loanable Funds S = I + NFI u At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net foreign investment. 4 Pengantar Ekonomi 2 The Market for Loanable Funds u The supply of loanable funds comes from national saving (S). u The demand for loanable funds comes from domestic investment (I) and net foreign investment (NFI). 5 Pengantar Ekonomi 2 The Market for Loanable Funds u u u 6 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. Pengantar Ekonomi 2 The Market for Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Equilibrium real interest rate 7 Demand for loanable funds (for domestic investment and net foreign investment) Equilibrium Pengantar Ekonomi 2 quantity Quantity of Loanable Funds The Market for Loanable 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. 8 Pengantar Ekonomi 2 The Market for Foreign-Currency Exchange u u u 9 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. Pengantar Ekonomi 2 The Market for Foreign-Currency Exchange u u 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 10 Pengantar Ekonomi 2 The Market for Foreign-Currency Exchange The price that balances the supply and demand for foreign-currency is the real exchange rate. 11 Pengantar Ekonomi 2 The Market for Foreign-Currency Exchange u u 12 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. Pengantar Ekonomi 2 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) 13 Equilibrium Quantity of Dollars Exchanged Pengantar Ekonomi 2 quantity into Foreign Currency The Market for Foreign-Currency Exchange u u 14 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. Pengantar Ekonomi 2 Equilibrium in the Open Economy u u 15 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. Pengantar Ekonomi 2 Equilibrium in the Open Economy u Net foreign investment links the loanable funds market and the foreigncurrency exchange market. u 16 The key determinant of net foreign investment is the real interest rate. Pengantar Ekonomi 2 How Net Foreign Investment Depends on the Interest rate... Real Interest Rate 0 17 Net foreign investment is Net foreign investment is Pengantar Ekonomi 2 negative. positive. Net Foreign Investment Equilibrium in the Open Economy u u 18 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. Pengantar Ekonomi 2 The Real Equilibrium in an Open Economy Real Interest Rate (a) The Market for Loanable Funds (b) Net Foreign Investment Real Supply Interest Rate r1 r1 Net foreign investment, NFI Demand Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate Supply E1 Demand 19 Quantity of Dollars (c) The Market for Foreign-Currency Exchange Pengantar Ekonomi 2 How Changes in Policies and Events Affect an Open Economy u The magnitude and variation in important macroeconomic variables depend on the following: u u u 20 Government budget deficits Trade policies Political and economic stability Pengantar Ekonomi 2 Government Budget Deficits u 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. 21 Pengantar Ekonomi 2 The Effects of Government Budget Deficit Real Interest Rate (a) The Market for Loanable Funds S2 (b) Net Foreign Investment Real Interest Rate r2 S1 B r2 3. ...which in turn reduces net foreign investment. A r1 r1 Demand 1. A budget deficit reduces the supply of loanable funds... 2. ...which increases the real interest... Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate E2 5. …which causes the real exchange rate to appreciate. 22 NFI E1 S2 S1 4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency… Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange Pengantar Ekonomi 2 Effect of Budget Deficits on the Loanable Funds Market u A government budget deficit reduces national saving, which . . . . . . shifts the supply curve for loanable funds to the left, which . . . raises interest rates. 23 Pengantar Ekonomi 2 Effect of Budget Deficits on Net Foreign Investment u Higher interest rates reduce net foreign investment. 24 Pengantar Ekonomi 2 Effect on the Foreign-Currency Exchange Market u A decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency. u This causes the real exchange rate to appreciate. 25 Pengantar Ekonomi 2 Trade Policy u u u 26 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. Pengantar Ekonomi 2 Trade Policy u Because they do not change national saving or domestic investment, trade policies do not affect the trade balance. u u 27 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. Pengantar Ekonomi 2 Effect of an Import Quota u Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency. u 28 This leads to an appreciation of the real exchange rate. Pengantar Ekonomi 2 Effect of an Import Quota u u u 29 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. Pengantar Ekonomi 2 Effect of an Import Quota u u 30 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. Pengantar Ekonomi 2 The Effects of an Import Quota Real Interest Rate (a) The Market for Loanable Funds (b) Net Foreign Investment Real Interest Rate S1 r1 3. Net exports, however, remain the same. r1 NFI Demand Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate 2. …and causes the real exchange rate to appreciate. E2 Supply 1. An import quota increases the demand for dollars… E1 Demand 31 Quantity of Dollars (c) The Market for Foreign-Currency Exchange Pengantar Ekonomi 2 Effect of an Import Quota Trade policies do not affect the trade balance. 32 Pengantar Ekonomi 2 Political Instability and Capital Flight Capital flight is a large and sudden movement of funds out of a country, usually due to political instability. 33 Pengantar Ekonomi 2 Political Instability and Capital Flight u Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries. u If investors become concerned about the safety of their investments, capital can quickly leave an economy. u Interest rates increase and the domestic currency depreciates. 34 Pengantar Ekonomi 2 Political Instability in Mexico and Capital Flight u 35 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. Pengantar Ekonomi 2 Political Instability in Mexico and Capital Flight u This increased Mexican net foreign investment. u u 36 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. Pengantar Ekonomi 2 The Effects of Capital Flight Real Interest Rate (a) The Market for Loanable Funds (b) Mexican Net Foreign Investment r2 Real Interest Rate r2 r1 r1 S1 NFI1 NFI1 1. An increase in net foreign investment... D2 D1 3. …which increases the interest rate. 2. …increases the demand for loanable funds... Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate E1 5. …which causes the real exchange rate to appreciate. 37 S1 S2 4. At the same time, the increase in net foreign investment increases the supply of pesos... E2 Demand Quantity of Pesos (c) The Market for Foreign-Currency Exchange Pengantar Ekonomi 2 Summary u To analyze the macroeconomics of open economies, two markets are central – the market for loanable funds and the market for foreign-currency exchange. u 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). 38 Pengantar Ekonomi 2 Summary u 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). u Net foreign investment is the variable that connects the two markets. 39 Pengantar Ekonomi 2 Summary u A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate. u The higher interest rate reduces net foreign investment, reducing the supply of dollars. u The dollar appreciates, and net exports fall. 40 Pengantar Ekonomi 2 Summary u A trade restriction increases net exports and increases the demand for dollars in the market for foreign-currency exchange. u As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods. u This appreciation offsets the initial impact of the trade restrictions on net exports. 41 Pengantar Ekonomi 2 Summary u When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound. u Political instability in a country can lead to capital flight. u Capital flight tends to increase interest rates and cause the country’s currency to depreciate. 42 Pengantar Ekonomi 2