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A Macroeconomic Theory
Of Open Economies
A Macroeconomic Theory of an
Open Economy
Open Economies
An open economy is one that interacts
freely with other economies around the
world.
A Macroeconomic Theory of an
Open Economy
 Key
Macroeconomic Variables in an
Open Economy
– net exports
– net capital outflow (NCO) (opposite of
net capital inflows)
– nominal exchange rates: EYTL/USD
– real exchange rates:
RERUS / TUR 
PTUR
EYTL /USD PUS
A Macroeconomic Model of an
Open Economy
 Basic
Assumptions of the Model
– The model takes the economy’s output
(GDP) as given. Studied factors of
output in Chapter 3.
– The model takes the economy’s price
level as given.
TWO MARKETS INTERACTING WITH
EACH OTHER:
1. The Market for Loanable Funds
2. The Market for Foreign Exchange
The Market for Loanable Funds
1. The Market for Loanable Funds is
the market where funds are traded.
S = I + NCO
 Holds at the equilibrium real
interest rate.
 Notice the equilibrium can change
when the conditions of the economy
change.
Figure 1
The Market for Loanable Funds
Real
Interest
Rate
Supply =
S
Equilibrium
real interest
rate
Demand = I
Equilibrium
quantity
+ NCO
Quantity of
Loanable Funds
The Market for Loanable Funds
 The
supply of loanable funds comes
from national saving (S).
 The demand for loanable funds
comes from domestic investment (I)
plus net capital outflows (NCO).
 For some countries such as Turkey,
NCO is negative. The model can still
work with a negative NCO.
The Market for Loanable Funds
 The
real interest rate brings the
supply and demand for loanable
funds into a balance.
 A higher real interest rate increases
saving and the quantity of loanable
funds supplied.
 So supply curve is positively related
with the real interest rate.
The Market for Loanable Funds
A
higher real interest rate
– discourages domestic investments and
borrowing because it is more costly to borrow
funds.
– encourages foreigners to buy assets from
domestic economy, and discourages domestic
residents from buying foreign assets. So, NCO
decreases.
– Then I + NCO decreases as int. rates
increases.
– So demand curve is negatively related with the
real interest rate.
The Market for Loanable Funds
 At
the equilibrium interest rate, the
amount that people want to save
(supply of funds) exactly balances
the desired quantities of domestic
investment plus NCO (demand for
funds).
The Market for Foreign Exchange
1. The Market for Foreign Exchange is
the market where domestic
currency (liras) are exchanged for
foreign currency.
NX = NCO
 Holds at the equilibrium real
exchange rate.
 Notice the equilibrium can change
when the conditions of the economy
change.
Figure 2
The Market for Foreign Exchange
Real
Exchange
Rate
Supply of liras = NCO
Equilibrium
real exchange
rate
Demand for liras =
Equilibrium
quantity
NX
Quantity of Liras Exchanged
into Foreign Currency
The Market for Foreign Exchange
 Demand
for domestic currency (liras)
comes from NX because this is the
amount of extra domestic currency
(liras) that foreigners need to buy
the extra exports from domestic
country (Turkey). Foreigners want to
sell dollars and buy NX liras. They
will use these liras to buy extra
exports of the domestic country
(Turkey).
The Market for Foreign Exchange
 Supply
of domestic currency (liras)
come from NCO because this is the
extra amount of liras that domestic
agents need to sell domestic
currency (liras) and buy foreign
currency (dollars). Domestic agents
will use these (dollars) to buy foreign
assets.
The Market for Foreign Exchange
 The
price that balances the supply
and demand for foreign currency is
the real exchange rate.
The Market for Foreign Exchange
A
higher Real Exchange Rate
RERUS/TUR makes
– domestic goods more expensive, foreign goods
cheaper. So NX decreases.
– Then quantity of domestic currency (liras)
demanded decreases. Demand curve is
downward sloping.
– Does not change net capital outflows (supply
of liras). NCO changes only with real interest
rates.
– Therefore supply curve is vertical.
The Market for Foreign Exchange
 The
real exchange rate adjusts to
balance the supply and demand for
liras.
 At the equilibrium real exchange
rate, the demand for liras to buy net
exports exactly balances the supply
of liras to be exchanged into foreign
currency to buy assets abroad.
EQUILIBRIUM IN THE OPEN
ECONOMY
 Combine
the Funds Market and
Foreign Exchange Market.
 Net capital outflow links the two
markets. NCO is the supply of liras in
Forex Market. NCO is part of the
demand for funds in Funds Market.
 Real interest rate is the key
determinant of net capital outflows.
How Net Capital Outflow Depends
on the Interest Rate
Figure 3
Real
Interest
Rate
Net capital outflow
is negative.
0
Net capital outflow
is positive.
Net Capital
Outflow
Simultaneous Equilibrium in
Two Markets
 Prices
in the Funds Market (real
interest rate) and the Foreign
Exchange Market (real exchange
rate) adjust simultaneously to
balance supply and demand in these
two markets.
 When prices come to equilibrium,
they determine the macroeconomic
variables of national saving,
domestic investment, NCO , and net
Figure 4
The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds
Real
Interest
Rate
(b) Net Capital Outflow
Real
Interest
Rate
Supply
r
r
Demand
Net capital
outflow, NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
Supply
E
Demand
Quantity of
liras
(c) The Market for Foreign-Currency Exchange
HOW POLICIES AND EVENTS
AFFECT AN OPEN ECONOMY
 Let
us analyze the following :
– Government budget deficits increase.
– Trade policies: New tariffs on imports
imposed.
– Political and economic stability
decreases.
– Saving Rate increases.
Government Budget Deficits
 In
an open economy, government
budget deficits . . .
– reduce national saving and hence the
supply of loanable funds,
– drive up the interest rate,
– decreases domestic investment,
– decreases NCO.
Figure 5 The Effects of Government
Budget Deficit
(a) The Market for Loanable Funds
Real
Interest
Rate
r2
S
1. A budget deficit reduces
(b) Net Capital Outflow
the supply of loanable funds . . .
Real
Interest
Rate
S
B
r2
A
r
2. . . . which
increases
the real
interest
rate . . .
r
3. . . . which in
turn reduces
net capital
outflow.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
E1
5. . . . which
causes the
real exchange
rate to
appreciate.
S
S
4. The decrease
in net capital
outflow reduces
the supply of liras
to be exchanged
into foreign
currency . . .
Demand
Quantity of
liras
(c) The Market for Foreign-Currency Exchange
Government Budget Deficits
 Effect
of Budget Deficits on NCO
– Higher interest rates reduce NCO.
 Effect
on the Foreign Exchange
Market
– A decrease in NCO reduces the supply
of liras. Lira will appreciate.
 This
causes the real exchange rate to
appreciate.
 Reduces NX.
Political Instability and Capital
Flight
 Capital
flight is a large and sudden
reduction in the demand for TL
denominated assets
 Happens together with a financial
crisis when a lot of banks go
bankrupt.
 Happened in Turkey in 1994 and
2001. Mexico in 1994, Argentina
2002, East Asia in 1997, Russia
1998.
Political Instability and Capital
Flight
 If
investors become concerned about
the safety of their investments,
capital can quickly leave a country.
 Interest rates increase and the
domestic currency depreciates
sharply.
Political Instability and Capital
Flight


When investors around the world observed
political problems in Turkey in 2001, they sold
their TL denominated assets and used the
proceeds to buy assets of other countries.
This increased Mexican net capital outflow.
– 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.
Figure 7 The Effects of Capital
Flight
(b) TR’s Net Capital Outflow
(a) The Market for Loanable Funds in Turkey
Real
Interest
Rate
Real
Interest
Rate
Supply
r2
r2
r1
r1
3. . . . which
increases
the interest
rate.
1. An increase
in net capital
outflow. . .
D2
D1
NCO1
Quantity of
2. . . . increases the demand
Loanable Funds
for loanable funds . . .
NCO2
Net Capital
Outflow
Real
Exchange
Rate
E
5. . . . which
causes the
peso to
depreciate.
S
S2
4. At the same
time, the increase
in net capital
outflow
increases the
supply of pesos . . .
E
Demand
Quantity of
Pesos
(c) The Market for Foreign-Currency Exchange
EFFECT OF AN İNCREASE IN
THE SAVING RATE
 What
happens to investment,
interest rates, real exchange rate,
and NX?