Chapter 33 A Macroeconomic Theory of the Open Economy
Eco 202 ch 33 macroeconomic theory open economy
Jun 10, 2015
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Chapter 33 !
A Macroeconomic Theory of the
Open Economy
Key Termstrade policy capital flight
Model
Simplified version of reality
Variables
Net Exports Net Capital Outflow Real Exchange Rates
Nominal Exchange Rates
Focus
Trade Balance Exchange Rate
Two Markets
Loanable funds market Foreign currency market
Loan Market
Savers and Borrowers S = I + NCO
Savings =
Domestic Investment + Net Capital Outflow
!
Supply = Demand
Two Things
Invest at home Invest abroad
NCO > 0
Less Invest at home More Invest abroad
!
Investing more in other countries than your own
NCO < 0
More Invest at home Less Invest abroad
!
Other countries want to invest in your country
Supply and Demand of Loanable Funds
Depends on the real interest rate
Remember
Nominal Rate = Real Rate + Inflation Rate
Nominal = Real + Inflation N = R + I
Country A Country B Country C
Nominal 10% 12%
Real 8% 10%
Inflation 3% 7%2%
13%
5%
Interest RatesHigh
Encourage Savers Discourage Borrowers
Low Discourage Savers
Encourage Borrowers
Low High
Savers
Borrowers
Interest Rates
Saudi U.A.E.
Nominal Rate 10% 12%
Inflation
Real Rate
Which Investment?
4% 7%
6% 5%
Real Interest
Rate
Quantity of Loanable Funds
Equilibrium Rate
Equilibrium Quantity
Market for Loanable Funds
Demand For domestic and foreign investment
Supply From national savings
Too high More supply than demand
push rate down
Too low More demand than supply
push rate up
Foreign Currency Exchange Market
NCO = NX Net Capital Outflow = Net Exports
Foreign Currency Exchange Market
If NX > 0 Selling more than buying What to do with cash? Must buy foreign assets
Remember foreign currency is a foreign asset
Foreign Currency Exchange Market
If NX < 0 Buying more than selling Must sell domestic assets
to pay for purchases
Foreign Currency Exchange Market
At the Equilibrium Exchange Rate: Demand for currency from
foreigners from net exports = Supply of currency from citizens
from net capital outflow
Real Exchange
Rate
Quantity of Riyals Exchanged into Foreign Currency
Equilibrium Rate
Equilibrium Quantity
Market for Foreign Currency Exchange
Demand For net exports
Supply From net capital outflow Vertical - does not depend on exchange rate
Low rates stimulate exports
High rates discourage exports
Too low More demand than supply Pressure to push rate up
Too high More supply than demand
Pressure to push rate down
Linking The Loanable Funds Market
S = I + NCO with
Foreign Currency Exchange Market
NCO = NX
Where did the riyals come from?
Saudi Savers Loanable Funds Market
Where did I buy the riyals?
Foreign Currency Market
Currency Traders move funds between the
two markets
S = I + NCO demand side
!
NCO = NX supply side
Real Interest
Rate
0
Net Capital Outflow Depends on Real Interest Rate
NCO is positive NCI is negative
NCO is negative NCI is positiveCash comes in Cash goes out
LinkingReal
Interest Rate
Quantity of Loanable Funds
Equilibrium Interest
Rate
Demand
Supply
Loanable Funds Market
Real Interest
Rate
Quantity of Loanable Funds
Demand
Net Capital Outflow
Real Exchange
Rate
Quantity of Riyals
Equilibrium Exchange
Rate
Demand
Supply
Foreign Currency Exchange Market
Loanable Funds Market Interest Rate
Foreign Currency Market Exchange Rate
PolicyReal
Interest Rate
Quantity of Loanable Funds
Equilibrium Interest
Rate
Demand
Supply
Loanable Funds Market
Real Interest
Rate
Quantity of Loanable Funds
Demand
Net Capital Outflow
Real Exchange
Rate
Quantity of Riyals
Equilibrium Exchange
Rate
Demand
Supply
Foreign Currency Exchange Market
Government deficits push up interest rates
which increase exchange rates
which increase trade deficits
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