A Macroeconomic Theory of the Open Economy. Macroeconomic Variables in an Open Economy An open economy is one that interacts freely with other economies.

A Macroeconomic Theory of the Open Economy

Macroeconomic Variables in an Open Economy

• An open economy is one that interacts freely with other economies around the world.

• The important macroeconomic variables of an open economy include:– net exports (NX)– net capital outflow (NCO)– nominal exchange rates (e)– real exchange rates (eP/P*)– real interest rates (r)– Loanable funds (LF=I=S)

• Theory helps us to link these variables together; however, to simplify the analysis we will make some assumptions.

Basic Assumptions

• The model takes the economy’s GDP as given. Y = Y-bar (like the quantity theory)

• The model takes the economy’s price level as given. P = P-bar (unlike the quantity theory)

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 used, 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)

SUPPLY AND DEMAND FOR LOANABLE FUNDS: OPEN ECONOMY

• The Market for Loanable FundsS = I + NCO

– At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net capital outflows.

• The supply of loanable funds comes from national saving (S).

• The demand for loanable funds comes from domestic investment (I) and net capital outflows (NCO).

• 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.

• 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

Figure 3 How Net Capital Outflow Depends on the Interest Rate

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0 Net CapitalOutflow

Net capital outflowis negative.

Net capital outflowis positive.

RealInterest

Rate

• 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

Figure 1 The Market for Loanable Fund

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Quantity ofLoanable Funds

RealInterest

RateSupply of loanable funds

(from national saving)

Demand for loanablefunds (for domesticinvestment and net

capital outflow)

Equilibriumquantity

Equilibriumreal interest

rate

The Market for Foreign-Currency Exchange

• 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.

• In the market for foreign-currency exchange, U.S. dollars are traded for foreign currencies.

• For an economy as a whole, NCO and NX must balance each other out, or:

NCO = NX

The Market for Foreign-Currency Exchange

• The price that balances the supply and demand for foreign-currency is the real exchange rate.

• The demand curve for dollars 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 capital outflow is unrelated to the real exchange rate. It is related to the real interest rate and comes from the loanable funds market.

• 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.

• For example, if the US has a trade surplus, foreigners are demanding US dollars to buy the net exports. At the same time, US dollars are being supplied to buy the foreign assets from the resulting net capital outflow (US receipt of foreign assets).

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$

– 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 .

• Foreign Exchange Shocks– D$↑, S$ is constant from NCO, EP/P*↑, until quantity of D$↓ and equals

the quantity of S$

– D$↓, S$ is constant from NCO, EP/P*↓, until quantity of D$↑ and equals the quantity of S$

Figure 2 The Market for Foreign-Currency Exchange

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Quantity of Dollars Exchangedinto Foreign Currency

RealExchange

RateSupply of dollars

(from net capital outflow)

Demand for dollars(for net exports)

Equilibriumquantity

Equilibriumreal exchange

rate

EQUILIBRIUM IN THE OPEN ECONOMY

• In the market for loanable funds, supply comes from national saving and demand comes from domestic investment and net capital outflow.

• In the market for foreign-currency exchange, supply comes from net capital outflow and demand comes from net exports.

• Net capital outflow links the loanable funds market and the foreign-currency exchange market.– The key determinant of net capital outflow is the real

interest rate.

• 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. WOW!

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↑

• Foreign Exchange 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

Figure 4 The Real Equilibrium in an Open Economy

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(a) The Market for Loanable Funds (b) Net Capital Outflow

Net capitaloutflow, NCO

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign-Currency Exchange

Quantity ofDollars

Quantity ofLoanable Funds

Net CapitalOutflow

RealExchange

Rate

Supply

Supply

Demand

Demand

r r

E

HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY

• The magnitude and variation in important macroeconomic variables depend on the following:– Government budget deficits– Trade policies– Political and economic stability

Government Budget Deficits

• In an open economy, government budget deficits . . . – reduce the supply of loanable funds,– drive up the interest rate,– crowd out domestic investment,– cause net foreign investment to fall.

Figure 5 The Effects of Government Budget Deficit

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(a) The Market for Loanable Funds (b) Net Capital Outflow

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign-Currency Exchange

Quantity ofDollars

Quantity ofLoanable Funds

Net CapitalOutflow

RealExchange

Rate

Demand

Demand

r2

NCO

SS

S S

r2B

E1

r rA

1. A budget deficit reducesthe supply of loanable funds . . .

2. . . . which increasesthe real interestrate . . .

4. The decreasein net capitaloutflow reducesthe supply of dollarsto be exchangedinto foreigncurrency . . .

5. . . . which causes thereal exchange rate toappreciate.

3. . . . which inturn reducesnet capitaloutflow.

E2

• Effect of Budget Deficits on the Loanable Funds Market– A government budget deficit reduces national saving, which . .

.• shifts the supply curve for loanable funds to the left, which . . .• raises interest rates

• Effect of Budget Deficits on Net Foreign Investment– Higher interest rates reduce net foreign investment.

• Effect on the Foreign-Currency Exchange Market– A decrease in net foreign investment reduces the supply of

dollars to be exchanged into foreign currency.– This causes the real exchange rate to appreciate.

Trade Policy• 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.

• Because they do not change national saving or domestic investment, trade policies do not affect the trade balance.– 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.

Trade Policy

• Effect of an Import Quota– Because foreigners need dollars to buy U.S. net

exports, there is an increased demand for dollars in the market for foreign-currency.

• This leads to an appreciation of the real exchange rate.

– 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.

• Effect of an Import Quota– 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.

– Trade policies do not affect the trade balance.

Figure 6 The Effects of an Import Quota

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(a) The Market for Loanable Funds (b) Net Capital Outflow

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign-Currency Exchange

Quantity ofDollars

Quantity ofLoanable Funds

Net CapitalOutflow

RealExchange

Rate

r r

Supply

Supply

DemandNCO

D

D

3. Net exports,however, remainthe same.

2. . . . and causes thereal exchange rate to appreciate.

E

E2

1. An importquota increasesthe demand fordollars . . .

Political Instability and Capital Flight

• Capital flight is a large and sudden reduction in the demand for assets located in a country.

• Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries.

• If investors become concerned about the safety of their investments, capital can quickly leave an economy.

• Interest rates increase and the domestic currency depreciates.

• 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.

• 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

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(a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign-Currency Exchange

Quantity ofPesos

Quantity ofLoanable Funds

Net CapitalOutflow

RealExchange

Rate

r1 r1

D1

D2

E

Demand

S S2

Supply

NCO2NCO1

1. An increase in net capitaloutflow. . .

3. . . . which increasesthe interestrate.

2. . . . increases the demandfor loanable funds . . .

4. At the sametime, the increasein net capitaloutflowincreases thesupply of pesos . . .

5. . . . which causes thepeso todepreciate.

r2 r2

E

Summary

• To analyze the macroeconomics of open economies, two markets are central—the market for loanable funds and the market for foreign-currency exchange.

• 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 capital outflow).

Summary

• 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).

• Net capital outflow is the variable that connects the two markets.

Summary

• A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate.

• The higher interest rate reduces net capital outflow, reducing the supply of dollars.

• The dollar appreciates, and net exports fall.

Summary

• A trade restriction increases net exports and increases the demand for dollars in the market for foreign-currency exchange.

• As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods.

• This appreciation offsets the initial impact of the trade restrictions on net exports.

Summary

• When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound.

• Political instability in a country can lead to capital flight.

• Capital flight tends to increase interest rates and cause the country’s currency to depreciate.