chapter 32- a macro economic theory of the open economy

8/2/2019 Chapter 32- A Macro Economic Theory of the Open Economy

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Chapter

A Macroeconomic Theoryof the Open Economy

32



Supply and Demand for Loanable Funds

• The market for loanable funds

– In an open economy

• S = I + NCO

• Saving = Domestic investment + Net capital

outflow

– Supply of loanable funds

• From national saving (S)

– Demand for loanable funds

• From domestic investment (I)

• And net capital outflow (NCO)

2





• Loanable funds - interpreted as

– Domestically generated flow of resources

available for capital accumulation• Purchase of a capital asset

– Adds to the demand for loanable funds

•Asset – located at home: I

• Asset – located abroad: NCO

– If NCO > 0, net outflow of capital - adds to demand

– If NCO < 0, net inflow of capital - reduce the demand

3





• Higher real interest rate

• Encourages people to save

– Increases quantity of loanable funds supplied

• Discourages investment

– Decreases quantity of loanable funds demanded

• Discourages Americans from buying foreign

assets – Reduces U.S. net capital outflow

• Encourages foreigners to buy U.S. assets

– Reduces U.S. net capital outflow4





• Supply of loanable funds

– Slopes upward

•

Demand of loanable funds – Slopes downward

• At equilibrium interest rate

– Amount that people want to save

– Exactly balances the desired quantities of

domestic investment and net capital outflow

5



Figure

RealInterest

Rate

The market for loanable funds

1

6

Quantity of

Loanable Funds

Equilibriumreal interest

rate

Supply of loanable funds(from national saving)

Demand for loanablefunds (for domesticinvestment and netcapital outflow)

Equilibrium

quantity

The interest rate in an open economy, as in a closed economy, is determined by the supplyand demand for loanable funds. National saving is the source of the supply of loanablefunds. Domestic investment and net capital outflow are the sources of the demand forloanable funds. At the equilibrium interest rate, the amount that people want to save exactly

balances the amount that people want to borrow for the purpose of buying domestic capitaland foreign assets.



Market for Foreign-Currency Exchange

• The market for foreign-currency exchange

– Identity: NCO = NX

– Net capital outflow = Net exports

•

If trade surplus, NX > 0 – Foreigners - buy more U.S. goods & services

• Than Americans - buy foreign goods & services

– Americans – use foreign currency• Buy foreign assets

– Capital is flowing abroad, NCO > 0

7





• If trade deficit, NX < 0

– Americans - buy more foreign goods &

services

• Than foreigners - buy U.S. goods & services

– Some of this spending

•

Financed by selling American assets abroad – Foreign capital is flowing into U.S.

– NCO < 0

8





• Supply of foreign-currency exchange

– Net capital outflow

–

Quantity of dollars supplied - buy foreignassets

– Supply curve – vertical

•

Quantity of dollars supplied for net capitaloutflow

• Does not depend on the real exchange rate

9





• Demand for foreign-currency exchange

– Net exports

–

Quantity of dollars demanded – buy U.S. netexports of goods and services

– Demand curve - downward sloping

•

A higher real exchange rate – Makes U.S. goods more expensive

– Reduces the quantity of dollars demanded to buy

those goods

10





• Equilibrium real exchange rate

– Demand for dollars

•

By foreigners• Arising from U.S. net exports of goods & services

– Exactly balances supply of dollars

•

From Americans• Arising from U.S. net capital outflow

11



Figure

The market for foreign-currency exchange

2

12

RealExchangeRate

Quantity of Dollars Exchangedinto Foreign Currency

Equilibrium realexchange rate

Supply of dollars(from net capital outflow)

Demand for dollars(for net exports)

Equilibriumquantity

The real exchange rate is determined by the supply and demand for foreign-currency exchange.The supply of dollars to be exchanged into foreign currency comes from net capital outflow.Because net capital outflow does not depend on the real exchange rate, the supply curve isvertical. The demand for dollars comes from net exports. Because a lower real exchange ratestimulates net exports (and thus increases the quantity of dollars demanded to pay for these netexports), the demand curve is downward sloping. At the equilibrium real exchange rate, the

number of dollars people supply to buy foreign assets exactly balances the number of dollarspeople demand to buy net exports.



Equilibrium in the Open Economy

• Net capital outflow: link between the two

markets

• Identities

–

Market for loanable funds: S = I + NCO – Market for foreign-currency exchange: NCO=NX

• Net-capital-outflow curve

– Link between• Market for loanable funds

• Market for foreign-currency exchange

13



Figure

How net capital outflow depends on the interest rate

3

14

RealInterestRate

Net CapitalOutflow

Because a higher domestic real interest rate makes domestic assets more attractive, itreduces net capital outflow. Note the position of zero on the horizontal axis: Net capitaloutflow can be positive or negative. A negative value of net capital outflow means that the

economy is experiencing a net inflow of capital.

0 Net capital outflowis positive

Net capital outflowis negative




• Simultaneous equilibrium in two markets

– Market for loanable funds

• Supply: national saving

• Demand: domestic investment & net capital

outflow

• Equilibrium real interest rate, r

– Net capital outflow

• Slopes downward

• Equilibrium interest rate, r

15





– Market for foreign-currency exchange

• Supply: net capital outflow

• Demand: net exports

• Equilibrium real exchange rate, E

– Equilibrium real interest rate, r

• Price of goods and services in the present

– Relative to goods and services in the future

– Equilibrium real exchange rate, E

• Price of domestic goods and services

– Relative to foreign goods and services 16





• E and r - adjust simultaneously

– To balance supply and demand

•

In both markets – Loanable funds

– Foreign-currency exchange

– Determine

• National saving

• Domestic investment

• Net capital outflow

• Net exports 17

i 4



Figure

The real equilibrium in an open economy

4

18

Real

InterestRate

Supply

Demand

Quantity of

Loanable Funds

(a) The Market for Loanable Funds

Real

Interest

Rate

Net capital

outflow, NCO

Net capital outflow

(b) Net Capital Outflow

r1 r1

Real

Exchange

Rate

Supply

Demand

Quantity of Dollars(c) The Market for Foreign-Currency Exchange

E1

In panel (a), the supply and demand for

loanable funds determine the real interest rate.In panel (b), the interest rate determines net

capital outflow, which provides the supply of

dollars in the market for foreign-currencyexchange.

In panel (c), the supply and demand for dollars

in the market for foreign-currency exchangedetermine the real exchange rate.



How Policies & Events Affect an Open Economy

• Government budget deficits

• Negative public saving

• Reduces national saving

• Reduces supply of loanable funds

• Increase in interest rate

• Reduces net capital outflow

• Crowd-out domestic investment

• Decrease in supply of foreign-currency exchange

• Exchange rate appreciates

• Net exports fall

• Push the trade balance toward deficit 19

Fi 5



Figure

The effects of a government budget deficit

5

20

Real

InterestRate

S1

Demand

Quantity of

Loanable Funds


Real

Interest

Rate

NCO

Net capital outflow


r1

Real

Exchange

Rate

S1

Demand


E1

When the government runs a budget deficit, itreduces the supply of loanable funds from S1 to

S2 in panel (a). The interest rate rises from r1 to r2to balance the supply and demand for loanablefunds. In panel (b), the higher interest rate

reduces net capital outflow. Reduced net capital

outflow, in turn, reduces the supply of dollars inthe market for foreign-currency exchange from S1

to S2 in panel (c). This fall in the supply of dollars

causes the real exchange rate to appreciate from

E1 to E2. The appreciation of the exchange ratepushes the trade balance toward deficit.

S2

r1

A

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

r2B

2. . . .

whichincreases

the real

interest

rate . . .

r23. . . . which in

turn reduces

net capital

outflow.

S2

4. The decrease

in net capital

outflow reducesthe supply of dollars

to be exchangedinto foreign

currency . . .

E2

5. . . . Which

causes the real

exchange rate

to appreciate.




• Trade policy

– Government policy

– Directly influences the quantity of goods and

services

• That a country imports or exports

– Tariff

• Tax on imports

– Import quota

• Limit on quantity of imports

21




• Trade policy

• Macroeconomic impact of trade policy

• Decrease imports

• Increase in net exports

• Increase in demand for foreign-currency

exchange

• Real exchange rate appreciates

– Discourage exports

• No change in real interest rate

• No change in net capital outflow

•No change in net exports 22

Fi 6



Figure

The effects of an import quota

6

23

Real

InterestRate

Supply

Demand

Quantity of Loanable Funds


Real

Interest

Rate

NCO

Net capital outflow


r1 r1

RealExchange

RateSupply

D1


E1

When the U.S. government imposes a quota on

the import of Japanese cars, nothing happens inthe market for loanable funds in panel (a) or to net

capital outflow in panel (b). The only effect is a risein net exports (exports minus imports) for anygiven real exchange rate. As a result, the demand

for dollars in the market for foreign-currency

exchange rises, as shown by the shift from D1 to

D2 in panel (c). This increase in the demand for

dollars causes the value of the dollar to appreciate

from E1 to E2. This appreciation of the dollar tends

to reduce net exports, offsetting the direct effect of

the import quota on the trade balance.

D2

1. An import

quota increasesthe demand for

dollars . . .

E2

2. . . . And causes

the real exchange

rate to appreciate.

3. Net exports,however, remain

the same.




• Trade policy

• Macroeconomic impact of trade policy

– Trade policies do not affect the U.S. trade

balance

• NX = NCO = S – I

– Trade policies affect specific

• Firms

• Industries

• Countries

24




• Political instability and capital flight

• Political instability

– Leads to capital flight

•

Capital flight – Large and sudden reduction in the demand

for assets located in a country

25




• Mexico - capital flight affects both markets

– Investors

• Sell Mexican assets & Buy U.S. assets

– Net-capital-outflow curve – increases

• Supply of pesos in the market for foreign-

currency exchange – increases

– Demand curve in the market for loanable

funds – increases

– Interest rate – increases

– The peso – depreciates26

Figure 7



Figure

The effects of capital flight

7

27

Real

InterestRate

SupplyD1

Quantity of Loanable Funds

(a) The Market for Loanable Funds in Mexico

Real

Interest

Rate

NCO1

Net capital outflow

(b) Mexican Net Capital Outflow

r1 r1

Real

Exchange

Rate

S1

Demand

Quantity of Pesos(c) The Market for Foreign-Currency Exchange

E1

If people decide that Mexico is a risky place to keep theirsavings, they will move their capital to safer havens suchas the U.S., resulting in an increase in Mexican netcapital outflow. The demand for loanable funds inMexico rises from D1 to D2, as shown in panel (a), andthis drives up the Mexican real interest rate from r1 to r2.Because net capital outflow is higher for any interestrate, that curve also shifts to the right from NCO1 toNCO2 in panel (b). At the same time, in the market forforeign-currency exchange, the supply of pesos risesfrom S1 to S2, as shown in panel (c). This increase in thesupply of pesos causes the peso to depreciate from E1

to E2, so the peso becomes less valuable compared toother currencies.

NCO2

1. An increase

in net capital

outflow . . .

D2

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

r2

3. . . . Which increasesthe interest rate.

r2

S2

E2

4. At the same time, the

increase in net capital

outflow increases thesupply of pesos . . .

5. . . . which causes

the peso to depreciate

C it l fl f Chi



• Nation that experiences capital flight

– Outflow of capital

– Its currency weaken in foreign exchange markets

• Depreciation

– Increases the nation’s net exports

• Nation that experiences inflow of capital

– Its currency strengthen

• Appreciation

– Pushes its trade balance toward deficit

Capital flows from China

28

C it l fl f Chi



• A nation’s government – policy:

– Encourages capital to flow to another country

• By making foreign investments itself

– Effect?

• Nation encouraging capital outflows – Weaker currency

– Trade surplus

• For the recipient of capital flows

– Stronger currency – Trade deficit


29

Capital flo s from China



• Ongoing policy disputes: U.S. and China

– China – tried to depress its currency (renminbi) in

foreign exchange markets

• Promote its export industries

• Accumulate foreign assets – Including U.S. government bonds

– In 2007: $1.5 trillion

• Chinese goods - less expensive

• Contributes to the U.S. trade deficit• Hurts American producers who make products that

compete with imports from China


30




• Ongoing policy disputes: U.S. and China

– U.S. government

• Encouraged China to stop influencing the exchange value

of its currency

–Impact of the Chinese policy on the U.S. economy• American consumers of Chinese imports

– Benefit from lower prices

• Inflow of capital from China

– Lowers U.S. interest rates – Increases investment in the U.S. economy

– Chinese government - financing U.S. economic

growth


31




• Chinese policy of investing in U.S. economy

– Creates winners and losers among Americans

– Net impact on U.S. economy - probably small

• Motives behind the policy

– China - wants to accumulate a reserve of foreign

assets

• National “rainy-day fund”

– Misguided policy


32

chapter 32- a macro economic theory of the open economy

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