Download LF and FEM

The Theory of the Open Economy: A
Complete Logical Flow
• The theory relates and determines r, NCO, EP/P*, and NX
• It begins with conditions in the loanable funds market and
then the foreign exchange market.
• In each market, the demand and supply are analyzed, put
together to determine equilibrium, and then the effects of
shifts in demand and supply are analyzed.
• The two markets are linked together and r, NCO, EP/P*,
and NX are jointly determined.
• Different policies and situations are then analyzed and
their affect on r, NCO, EP/P*, and NX identified.
The Loanable Funds Market
• The supply and demand in the loanable
funds market determines the real interest
rate {r}
– Closed Economy: S=I only domestic borrowing
and lending are allowed.
– Open Economy: S=I+NCO this allows trade
and borrowing and lending from the ROW (rest
of the world)
• National Saving: S → SLF is positively related to
r↓(↑) → SLF ↓(↑)
• Investment and Net Capital Flow:
I+NCO → DLF is negatively related to
r ↓(↑) → DLF ↑(↓)
– r ↓(↑) I ↑(↓)
• r↓(↑) PV ↑(↓) of future returns
– r ↓(↑) NCO ↑(↓)
• rUS ↓(↑) US increases (decreases) demand for ROW assets and
ROW decreases (increases) demand for US assets
• The equilibrium r in the LF market brings national
saving = investment +net capital outflow or
S=I+NCO.
• Supply-side shocks to LF
– S↓ (income taxes↑ or budget →deficit), then r↑→LF↓
– S↑ (income taxes↓ or budget →surplus), then r↓→LF↑
• Demand-side shocks to LF
– I↓ (tax credits↑ or expected Y↑), then r↑→LF↑
– I↑ (tax credits↓ or expected Y↓), then r↓→LF↓
– NCO↓ (political instability abroad↑), then r↑→LF↑ [US
holds fewer ROW assets and ROW holds more US assets]
– NCO↑ (political stability abroad↑), then r↓→LF↓[US
holds more ROW assets and ROW holds less US assets]
• We have now fully described the LF market and the
determination of r
The Foreign Exchange Market
• The supply and demand in the foreign
exchange market determines the real
interest exchange rate EP/P*
– Closed Economy: no trading, NX, or EP/P*.
– Open Economy: NX=NCO this allows trade
and borrowing and lending from the ROW (rest
of the world)
• Net Capital Outflow - NCO: S → S$
↓
– If NCO↑, US is supplying more dollars, on net,
to purchase foreign assets
– If NCO↓, US is supplying fewer dollars, on net,
to purchase fewer foreign assets
– NCO is determined by r in the loanable funds
markets and is not related to EP/P*.
– As EP/P*↓(↑), NCO remains the same
• Net Exports - NX: → D$ is negatively related to
EP/P*↓(↑)
– If EP/P*↓, NX↑, D$↑ - US goods become cheaper, net
exports increase, and ROW needs more US dollars to
purchase more goods and services
– If EP/P*↑, NX↓, D$↓ - US goods become more
expensive, net exports decrease, and ROW needs fewer
US dollars to purchase fewer goods and services
• Equilibrium in the foreign exchange market occurs
when the EP/P* equates the D$ with the S$ or
NX=NCO .
Linking the Loanable Funds and Foreign
Exchange Market
•
•
•
•
•
•
NCO link the two markets together
Step 1: S=I+NCO or SLF=DLF →r
Step 2: r →NCO
Step 3: NCO →S$
Step 4: NX →D$
Step 5: D$=S$ →EP/P* and NX=NCO
Examples of Transmission of LF
and FEM Shocks
• Loanable Funds Shocks:
–
–
–
–
S↓, SLF↓, r↑,NCO↓,S$↓, EP/P*↑,NX↓
S↑, SLF↑, r↓,NCO↑,S$↑, EP/P*↓,NX↑
I↑, DLF↑, r↑,NCO↓,S$↓, EP/P*↑,NX↓
I↓, DLF↓, r ↓,NCO↑,S$↑, EP/P*↓,NX↑
• Exchange Rate Shocks
– D$↑, S$ is constant from NCO, EP/P*↑, until quantity of
D$↓, but NX are constant, r is constant
– D$↓, S$ is constant from NCO, EP/P*↓, until quantity of
D$↑, but NX are constant, r is constant