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Chapter 32 A Macroeconomic Theory of the Open Economy

Chapter 32 A Macroeconomic Theory of the Open Economy. Open Economies. An open economy is one that interacts freely with other economies around the world. Key Macroeconomic Variables in an Open Economy. The important macroeconomic variables of an open economy include: net exports

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Chapter 32 A Macroeconomic Theory of the Open Economy

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  1. Chapter 32 A Macroeconomic Theory of the Open Economy

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

  3. Key Macroeconomic Variables in an Open Economy • The important macroeconomic variables of an open economy include: • net exports • net foreign investment • nominal exchange rates • real exchange rates

  4. Basic Assumptions of a Macroeconomic Model of an Open Economy • The model takes the economy’s GDP as given. • The model takes the economy’s price level as given.

  5. 32.1 SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE • The Market for Loanable Funds S = 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.

  6. 32.1.1 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) and net capital outflows (NCO).

  7. 32.1.1 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.

  8. Supply of loanable funds (from national saving) Equilibrium real interest rate Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity Figure 1 The Market for Loanable Funds Real Interest Rate Quantity of Loanable Funds

  9. 32.1.1 The Market for Loanable Funds • At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment.

  10. 32.1.2 The Market for Foreign-Currency Exchange • The two sides of the foreign-currency exchange market are represented by NCO and NX. NCO = NX Net capital outflow = Net exports. • NCOrepresents the imbalance between the purchases and sales of capital assets. • NX represents the imbalance between exports and imports of goods and services.

  11. 32.1.2 The Market for Foreign-Currency Exchange • 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

  12. 32.1.2 The Market for Foreign-Currency Exchange • Net capital outflow represents the quantity of dollars supplied for the purpose of buying foreign assets. • For example, when a U.S. mutual fund wants to buy a Japanese government bond, it needs to change dollars into yen, so it supplies dollars in the market for foreign-currency exchange.

  13. 32.1.2 The Market for Foreign-Currency Exchange • Net exports represents the quantity of dollars demanded for the purpose of buying U.S. net exports of goods and services. • For example, when a Japanese airline wants to buy a plane made by Boeing, it needs to change its yen into dollars, so it demands dollars in the market for foreign-currency exchange. • The price that balances the supply and demand for foreign-currency is the real exchange rate.

  14. 32.1.2 The Market for Foreign-Currency Exchange • The demand curve for foreign currency 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.

  15. Supply of dollars (from net capital outflow) Equilibrium real exchange rate Demand for dollars (for net exports) Equilibrium quantity Figure 2 The Market for Foreign-Currency Exchange Real Exchange Rate Quantity of Dollars Exchanged into Foreign Currency

  16. 32.1.2 The Market for Foreign-Currency Exchange • 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.

  17. 32.2 EQUILIBRIUM IN THE OPEN ECONOMY

  18. 32.2.1 Net Capital Outflow: The Link between the two Markets • 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.

  19. 32.2.1 Net Capital Outflow: The Link between the two Markets • Net capital outflow links the loanable funds market and the foreign-currency exchange market. • In the market for loanable funds, net capital outflow is a piece of demand. A person who wants to buy an asset abroad must finance this purchase by obtaining resources in the market for loanable funds.

  20. 32.2.1 Net Capital Outflow: The Link between the two Markets • In the market for foreign-currency exchange, net capital outflow is the source of supply. A person who wants to buy an asset in another country must supply dollars in order to exchange for them for the currency of that country. • The key determinant of net capital outflow is the real interest rate. When the U.S. interest rate is high, owning U.S.assets is more attractive, and U.S. net capital outflow is low.

  21. Net capital outflow Net capital outflow is negative. is positive. Figure 3 How Net Capital Outflow Depends on the Interest Rate Real Interest Rate Net Capital 0 Outflow

  22. 32.2.2 Simultaneous Equilibrium in Two Markets • 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.

  23. 32.2.2 Simultaneous Equilibrium in Two Markets • Panel (a) of the figure shows the market for loanable funds. As before, national saving is the source of the supply of loanable funds. Domestic investment and net capital outflow are the source of the demand for loanable funds. The equilibrium real interest rate(r1) brings the quantity of loanable funds supplied and the quantity of loanable funds demanded into balance. • Panel (b) of the figure shows net capital outflow.It shows how the interest rate from panel (a) determines net capital outflow. A higher interest rate at home makes domestic assets more attractive, and this in turn reduces net capital outflow. Therefore, the net capital outflow curve in panel (b) slopes downward.

  24. 32.2.2 Simultaneous Equilibrium in Two Markets • Panel (c) of the figure shows the market for foreign-currency exchange.Because foreign assets must be purchased with foreign currency, the quantity of net capital outflow from panel (b) determines the supply of dollars to be exchanged into foreign currencies. The real exchange rate does not affect net capital outflow, so the supply curve is vertical. The demand for dollars come from net exports. Because a depreciation of the real exchange rate increases net exports, the demand curve for foreign-currency exchange slopes downward.

  25. Supply r r Demand Net capital outflow, NCO Supply E Demand Figure 4 The Real Equilibrium in an Open Economy (a) The Market for Loanable Funds (b) Net Capital Outflow Real Real Interest Interest Rate Rate Quantity of Net Capital Loanable Funds Outflow Real Exchange Rate Quantity of Dollars (c) The Market for Foreign-Currency Exchange

  26. 32.3 HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY

  27. 32.3 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

  28. 32.3.1 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 (NCO) to fall, • Cause the currency to appreciate, • Push the trade balance toward deficit.

  29. 1. A budget deficit reduces the supply of loanable funds . . . S B r2 r2 A r r 3. . . . which in 2. . . . which turn reduces increases net capital the real outflow. interest rate . . . S 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged E2 into foreign currency . . . E1 5. . . . which causes the real exchange rate to appreciate. Figure 5 The Effects of Government Budget Deficit (a) The Market for Loanable Funds (b) Net Capital Outflow Real Real Interest Interest S Rate Rate Demand NCO Quantity of Net Capital Loanable Funds Outflow Real S Exchange Rate Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange

  30. 32.3.1 Government Budget Deficits • 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.

  31. 32.3.1 Government Budget Deficits • Effect of Budget Deficits on Net Foreign Outflow: • Panel (b) shows that the increase in the interest rate from r1 to r2reduces net capital outflow. • Because saving kept at home now earns higher rates of return, investing abroad is less attractive, and domestic residents buy fewer foreign assets. Higher interest rates also attract foreign investors, who want to earn the higher returns on US. Assets. • Thus, when budget deficits raise interest rates, both domestic and foreign behavior cause US. Net capital outflow to fall.

  32. 32.3.1 Government Budget Deficits • 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.

  33. 32.3.2 Trade Policy • A trade policyis 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.

  34. 32.3.2 Trade Policy • 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.

  35. 32.3.2 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.

  36. 32.3.2 Trade Policy • 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.

  37. r r 3. Net exports, however, remain the same. 1. An import quota increases the demand for E2 dollars . . . 2. . . . and causes the real exchange rate to D appreciate. Figure 6 The Effects of an Import Quota (a) The Market for Loanable Funds (b) Net Capital Outflow Real Real Interest Interest Supply Rate Rate Demand NCO Quantity of Net Capital Loanable Funds Outflow Real Supply Exchange Rate E D Quantity of Dollars (c) The Market for Foreign-Currency Exchange

  38. 32.3.2 Trade Policy • Effect of an Import Quota • 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.

  39. 32.3.2 Trade Policy • Effect of an Import Quota: Trade policies do not affect the trade balance. • That is, policies that directly influence exports or imports do not alter net exports. This conclusion seems less surprising if one recalls the accounting identity: NX = NCO = S – I

  40. 32.3.2 Trade Policy NX = NCO = S – I • Net exports equal net capital outflow, which equals national saving minus domestic investment. Trade policies do not alter the trade balance because they do not alter national saving or domestic investment. • For given levels of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same, regardless of the trade policies the government puts in place. • Although trade policies do not affect a country’s overall trade balance, these policies do affect specific firms , industries, and countries.

  41. 32.3.3 Political Instability and Capital Flight • In 1994 political instability in Mexico, including the assassination of a prominent political leader, made would financial markets nervous. People began to view Mexico as a much less stable country than they had previously thought. They decided to pull some of their assets out of Mexico in order to move these funds to the U.S. and other “safe heaven”. Such a large and sudden movement of funds out of a country is called capital flight.

  42. 32.3.3 Political Instability and Capital Flight • Capital flight资本外逃 is a large and sudden reduction in the demand for assets located in a country.

  43. 32.3.3 Political Instability and Capital Flight • 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.

  44. 32.3.3 Political Instability and Capital Flight • This increased Mexican net capital outflow. • The demand for loanable funds in the loanable funds marketincreased, which increased the interest rate. • This increased the supply of pesos in the foreign-currency exchange market. • Decreases the value of the Mexican peso in the market for foreign-currency exchange.

  45. 32.3.3 Political Instability and Capital Flight • To see the effects of capital flight on the economy,we compare the old and new equilibria. • Panel (a) of Figure 7 shows that the increased demand for loanable funds causes the interest rate in Mexico to rise from r1 to r2. • Panel (b) shows that Mexican net capital outflow increases. (Although the rise in the interest rate does make Mexican assets more attractive, this only partly offsets the impact of capital flight on net capital outflow.)

  46. 32.3.3 Political Instability and Capital Flight • Panel (c ) shows that the increase in net capital outflow raises the supply of pesos in the market for foreign-currency exchange from S1 to S2. That is, as people try to get out of Mexican assets, there is a large supply of pesos to be converted into dollars.This increase in supply causes the peso to depreciate from E1 to E2. • Thus, capital flight from Mexico increases Mexican interest rates and decreases the value of the Mexican peso in the market for foreign-currency exchange.

  47. 32.3.3 Political Instability and Capital Flight • This is exactly what was observed in 1994. From November 1994 to March 1995, the interest rate on short-term Mexican government bonds rose from 14 percent to 70 percent, and the peso depreciated in value from 29 to 15 U.S. cents per peso.

  48. 1. An increase in net capital outflow. . . r2 r2 D2 3. . . . which increases the interest rate. NCO2 2. . . . increases the demand for loanable funds . . . S2 4. At the same time, the increase in net capital outflow increases the E supply of pesos . . . 5. . . . which E causes the peso to depreciate. Figure 7 The Effects of Capital Flight (a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow Real Real Supply Interest Interest Rate Rate r1 r1 D1 NCO1 Quantity of Net Capital Loanable Funds Outflow Real S Exchange Rate Demand Quantity of Pesos (c) The Market for Foreign-Currency Exchange

  49. 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).

  50. 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.

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