principles of macroeconomics: ch. 18 second canadian edition chapter 18 a macroeconomic theory of...

Principles of Macroeconomics: Ch. 18 Second Canadian Edition

Chapter 18

A Macroeconomic Theory

of the Open Economy

© 2002 by Nelson, a division of Thomson Canada Limited


Overview

Examine the market for loanable funds.Look at the foreign exchange market.What is equilibrium in the open

market?How policies and events affect an open

economy.


Macroeconomic Variable Determination in an Open Economy

The important macroeconomic variables of an open economy include: National Saving, Domestic Investment, Net Foreign Investment and Net Exports.

The values of these variables are determined through the interaction of: the Loanable Funds Market, the Net Foreign Investment Market, and the Market for Foreign-Currency Exchange.


The Market For Loanable FundsFinancial markets co-ordinate the

economy’s saving and investment in

The Loanable Funds MarketThe Supply of Loanable Funds comes

from national saving (S) and from net foreign investment (NFI).

The Demand for Loanable Funds comes from domestic investment (I).


Supply

Demand

RealInterest

Rate

Loanable Funds

Positive Net Foreign Investment

World

Interest

Rate

100 150

Net Foreign Investment


Supply

Demand

RealInterest

Rate

Loanable Funds

Negative Net Foreign Investment

World

Interest

Rate

90

Net Foreign Investment

130


The Market For Loanable Funds

In a small, open economy with perfect capital mobility, the interest rate is equal to the world interest rate.

National Saving represents the supply of loanable funds, while domestic investment represents demand.



Recall the identity:



Saving =Domestic

Investment +Net ForeignInvestment




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

Saving =Domestic

Investment +Net ForeignInvestment



Overview



economy.


The Equality of Net Exports and Net Foreign Investment

Net exports (NX) and net foreign investment (NFI) are closely linked. For an economy as a whole, NX and NFI balance

each other out so that: NX = NFINFI represents the quantity of dollars

supplied for the purpose of buying assets abroad. NX determines the quantity of dollars demanded for the purpose of buying foreign goods.


The Market for Foreign-Currency Exchange

The identity, NX = NFI represents the two sides of the foreign-exchange market in which Canadian dollars are traded for foreign currencies.

The price that balances the supply and demand is the “real exchange rate”, i.e. the relative price of domestic and foreign goods.


The Market for Foreign-Currency ExchangeSupply of Dollars

(NFI)

Demand for Dollars(NX)

Quantity of Dollars Exchanged into Foreign Currency

Rea

l E

xch

ang

eR

ate



The demand curve is negatively related to the real exchange rate. A higher exchange rate makes domestic goods more expensive.

The supply curve is vertical because the quantity of dollars supplied for net foreign investment is unrelated to the real exchange rate.



The real exchange rate adjusts to balance the supply and demand for

dollars. At the equilibrium 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.


The Market for Foreign-Currency ExchangeSupply of Dollars

(NFI)

Demand for Dollars(NX)

QuantityEquilibrium Quantity

Real Exchange

Rate

Equilibrium Real

ExchangeRate


Quick Quiz!

Describe the sources of supply and demand in the market for loanable funds and the market for foreign-currency exchange.


Overview



economy.


Equilibrium in the Open EconomyNet foreign investment (NFI) links the

loanable funds market with the foreign-currency exchange market. The key determinant of net foreign investment is the world interest rate.

In the market for loanable funds, NFI is a portion of demand. In the market for foreign-currency exchange, NFI is the source of supply.


The Market for Loanable FundsReal

Interest Rate

World interest

rate

Supply of loanable funds from national saving (S)

Demand for loanable funds for domestic investment (I)

Net foreign investments (S – I)

100 150 Quantity of Loanable Funds (billions of dollars)



Real Exchange

Rate

Supply of dollars (S – I)

Demand for dollars (NX)

50Quantity of Dollars

(in billions)

E1


Equilibrium in the Open Economy

The market for loanable funds and the foreign-currency exchange market determine the real exchange rate,

national saving, domestic investment, and the size of net foreign investment.


Quick Quiz!

In the model of the open economy, two markets determine one price and the value of three variables. What are the markets? What three variables are determined? What price is determined?


Overview



economy.


How Policy and Events Affect an Open Economy

The magnitude and variation in important macroeconomic variables may be illustrated by these specific events:– Increase in world interest rates– Government Budget Deficits– Government Trade Policies– Political and Economic Stability


Increase in World Interest Rates

In an open economy with perfect capital mobility, an increase in world interest rates crowds out domestic investment, causes the dollar to depreciate, and increases net exports.


Government Budget Deficits and Surpluses

In a small open economy,

- an increase in government budget deficits causes the dollar to appreciate and causes net exports to fall.

- a decrease in government budget deficits causes the dollar to depreciate and causes net exports to rise.


Government Budget Deficits: Specific Market Effects

Loanable Funds Market Effect: – Reduces national saving which...

shifts the supply curve for loanable funds to the left, which reduces net foreign investment.


The Market for Loanable FundsReal

Interest Rate

rw

Demand for loanable funds for domestic investment (I)

Supply of loanable funds from national saving (S)

1. An increase in the government budget deficit reduces national saving …

C B A

2. … which reduces net foreign invest-ment.

Quantity of Loanable Funds (billions of dollars)


Government Budget Deficits: Specific Market Effects

Foreign-Currency Exchange Market:– The decrease in net foreign investment

reduces the supply of dollars to be exchanged into foreign currency, which causes the real exchange rate to appreciate.



3. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency …

Demand for dollars (NX)

E2

E1

4. … which causes the real exchange rate to appreciate.

Quantity of Dollars (in billions)

Real Exchange

RateSupply of dollars

(S – I)2 (S – I)1


Government Trade PolicyGovernment Trade Policy Effect:

– Does not alter the trade balance because it does not alter national saving or domestic investment. For given levels of national saving and

domestic investment, the real exchange rate adjusts to keep the balance the same, regardless of the trade policies the government puts in place.

Trade policies are more microeconomic than macroeconomic.


Government Trade Policies:Specific Market Effects

Foreign-Currency Exchange Market:– Nothing happens in the loanable funds

market or to the supply of dollars in the market for foreign-currency exchange.

– The only effect is a rise in net exports for any given exchange rate. This increases the demand for dollars, which causes the value of the dollar to appreciate.


Government Trade Policies:Specific Market Effects

Net Foreign Investment Market:– Because there is no change in net foreign

investment, there will be no change in net exports.

– An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports which...

... offsets the direct increase in net exports due to import quota.


Political Instability and Capital Flight

Capital Flight is a situation in which a large and sudden movement of funds out of a country occurs due to political instability (e.g. 1994 Mexican government instability.)

When investors around the world observe political problems in one country (e.g. Mexico) they decide to sell some of their Mexican assets and use the proceeds to buy other countries’ assets.


Political Instability and Capital FlightSpecific Market Effects

Net Foreign Investment Market:– Observed political problems in Mexico in

1994 increased Mexican net foreign investment which...increased the interest rate paid on Mexican

assets which…

increased the supply of pesos in the

Foreign-Currency Exchange Market.


Quick Quiz!

Suppose that Canadians decided to spend a smaller fraction of their incomes. What would be the effect on saving, investment, interest rates, the real exchange rate and the trade balance?


Overview



economy.

principles of macroeconomics: ch. 18 second canadian edition chapter 18 a macroeconomic theory of...

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