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Macroeconomics in an Open
Economy CH 13
 The important macroeconomic variables
of an open economy include: National
Saving, Domestic Investment, Net Capital
Outflow and Net Exports.
 The values of these variables are determined
through the interaction of: the Loanable Funds
Market and the Market for Foreign-Currency
Exchange. –FX--The market where people
exchange the domestic currency for the currency
of other countries. 2 markets.
Objectives-ch. 13
 Develop SOE model to explain: Trade
balance and exchange rates
 Use the model to analyze a series of
related variables.
 The model takes as given-real GDP and
the price level.
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 capital outflow
(NCO)
 The Demand for Loanable Funds comes from
domestic investment (I).
 In an open economy the amount that a nation saves
does not have to equal the amount it spends to
purchase domestic capital.
Market for Loanable Funds
 If the amount of national saving exceeds the
amount needed to finance the purchase of
domestic capital, net capital outflow (NCO)
is positive.
 If the national saving is insufficient to
finance the purchase of domestic capital,
the NCO is negative.
The Market for Loanable Funds
 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.
 At the equilibrium interest rate, the amount that
people want to save exactly balances the desired
quantities of domestic investment and net foreign
investment.
Loanable Funds –closed
economy-domestic interest rate is 5%
Loanable Funds-SOE
 In a small open economy with perfect capital
mobility, like Canada, the domestic interest rate
will equal the world interest rate.
 As a result, the quantity of loanable funds made
available by the savings of Canadians does not
have to equal the quantity of loanable funds
demanded for domestic investment.
 The difference between these two amounts is net
capital outflow (NCO)
RealPositive
Interest
Rate
Net Capital Outflow
Net
Capital
Outflow
Supply
World
Interest
Rate
Demand--I
100
150 Loanable Funds
Negative
Net
Capital
Outflow:
Inflow
Real
Supply
Interest
Rate
World
Interest
Rate
Net Capital
Outflow
90
Demand
130 Loanable Funds
The Market For Loanable Funds
 In a small, open economy with perfect
capital mobility, the Canadian interest rate is
equal to the world interest rate.
 National Saving represents the supply of
loanable funds, while domestic investment
represents demand.
The Market For Loanable Funds
Recall
the identity:
Domestic
Saving =
Investment
+
Net Capital
Outflow
 At the equilibrium interest rate, the amount
that people want to save, exactly balances
the desired quantities of investment and net
capital outflow.
 NCO can be positive or negative.
The Market for Foreign-Currency
Exchange
 The market for foreign-currency exchange exists
because people want to trade with people in other
countries, but they want to be paid in their own
currency.
– The two sides of the foreign-currency exchange
market are represented by NCO and NX.
– NCO represents the imbalance between the
purchases and sales of capital assets.
– NX represents the imbalance between exports
and imports of goods and services.
The Equality of Net Exports and
Net Capital Outflow
 Net exports (NX) and net capital outflow (NCO) are
closely linked. For an economy as a whole, NX and
NCO balance each other out so that: NX
= NCO
 NCO 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.
The Market for Foreign-Currency
Exchange
 The identity, NX = NCO 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.
Market for Foreign-Currency Exchange
Real
Exchange
Rate
Supply of Dollars
(NCO)
Demand for Dollars
(NX)
Quantity of Dollars Exchanged into
Foreign Currency
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 capital
outflow is unrelated to the real exchange
rate.
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.
Market for Foreign-Currency Exchange
Real
Exchange
Rate
Equilibrium
Real
Exchange
Rate
Supply of Dollars
(NCO)
Demand for Dollars
(NX)
Equilibrium Quantity
Quantity
Equilibrium in the Open Economy
 Net capital outflow (NCO) links the loanable
funds market with the foreign-currency
exchange market. The key determinant of
NCO is the world interest rate.
 In the market for loanable funds, NCO is a
portion of demand. In the market for foreigncurrency exchange, NCO is the source of
supply.
TUTORIAL GROUP B09
 Tutorial was cancelled today due to TA
illness. Apologies.
 Hand in Assignments to me today.
 Next meeting is March 17
Equilibrium in the Open Economy
The market for loanable funds and the foreigncurrency exchange market determine the
real exchange rate, national saving,
domestic investment, net exports and the
size of net capital outflow.
LF: S, I, NCO
FX: RER and NX--------Using NCO
2 Markets—LF and FX
FX market-NCO from LF
Figure 13.2
LF AND FX MARKETS
 1The real interest rate (r) is determined in the market for
loanable funds by rw.
 2This real interest rate determines the level of NCO.
3NCO must be paid for with foreign currency so the
quantity of NCO determines the supply of dollars.
4The equilibrium real exchange rate brings into balance the
quantity of dollars supplied and the quantity of dollars
demanded.
5The real interest rate and the real exchange rate adjust
simultaneously to balance supply and demand in the two
markets. As they do so, they determine the levels of
national S, domestic I, NCO and NX.
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-Greece, Egypt--
Assessing Policies and Events
 Three steps in using the model to analyze
these events
– Determine which of the supply and
demand curves each event affects
– Determine which way the curves shift
– Examine how these shifts alter the
economy’s equilibrium.
– Like Micro
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.
World Interest Rates Go Up13.4
G Budget deficits
 Because a government budget deficit
represents negative public saving, it reduces
national saving, and therefore reduces. . .
– the supply of loanable funds,
– net capital outflow
– the supply of Canadian dollars in the
market for foreign-currency exchange
Government Budget Deficits
 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
First 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 NCO.
Government Budget Deficits:
Specific Market Effects
 Foreign-Currency Exchange Market:
–
The decrease in NCO reduces the supply of
dollars to be exchanged into foreign currency,
which causes the real exchange rate to
appreciate.
G deficits
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.
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.
Government Trade Policies:
Specific Market Effects
 NCO Market:
–
–
Because there is no change in NCO, 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.
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 Mexico, 2011
Egypt: 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.
 Interest rates increase in Mexico and the domestic
currency depreciates.
Political Instability and Capital Flight
Specific Market Effects
 NCO Market:
–
–
–
–
Observed political problems in Mexico in 1994
increased Mexican interest rates (r+risk).
To save the same amount Mexican savers must
get r+risk so Slf shifts upwards. NCO gets bigger.
This increase in NCO increases the supply of
pesos in the foreign-currency exchange market.
The peso depreciates. Due to instability.
Principles of Macroeconomics:
Capital flight
Summary
 To analyze the macroeconomics of open economies, two
markets are central—the market for loanable funds and the
market for foreign-currency exchange. SOE
 LF market: the interest rate adjusts to balance supply for
loanable funds (from national saving) and demand for
loanable funds (from domestic investment and net capital
outflow).
 In the market for foreign-currency exchange,
– the real exchange rate adjusts to balance the supply of
dollars (for net capital outflow) and the demand for
dollars (for net exports).
 NCO is the variable that connects the two markets.