Chapter 13 Class macroeconomic

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Chapter 13: a macro theory ofChapter 13: a macro theory of

the open economythe open economy

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In this chapter,

look for the answers to these

questions: In an open economy, what determines the realinterest rate? The real exchange rate?

How are the markets for loanable funds and

foreign-currency exchange connected?

How do government budget deficits affect the

exchange rate and trade balance?

How do other policies or events affect the

interest rate, exchange rate, and trade balance?


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Introduction

The previous chapter explained the basic

concepts and vocabulary of the open economy:

net exports NX !, net capital outflow NCO!,

and exchange rates"

This chapter ties these concepts together into atheory of the open economy"

#e will use this theory to see how govt policies

and various events affect the trade balance,exchange rate, and capital flows"

#e start with the loanable funds market$

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The Market for Loanable unds

%n identity from the preceding chapter:

S & I ' NCO

(aving)omestic

investment

*et capital

outflow

(upply of loanable funds & saving"

% dollar of saving can be used to finance

+ the purchase of domestic capital+ the purchase of a foreign asset



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The supply and demand for loanable fundsdepend on the real interest rate"

% higher real interest rate encourages people tosave and raises the uantity of loanable funds

supplied"

The interest rate adusts to bring the supply anddemand for loanable funds into balance"

%t the euilibrium interest rate, the amount thatpeople want to save exactly balances the desireduantities of domestic investment and net foreigninvestment"



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In a small open economy with perfect capitalmobility, like .anada, the domestic interest rate

will eual the world interest rate"

%s a result, the uantity of loanable funds madeavailable by the savings of .anadians does not

have to eual the uantity of loanable funds

demanded for domestic investment"

The difference between these two amounts is

net capital outflow *./!



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The Market for orei!n"Currency#$chan!e

The market for foreign-currency exchange exists

because people want to trade with people in

other countries, but they want to be paid in their

own currency"

+ The two sides of the foreign-currencyexchange market are represented by NCO

and NX "

+NCO

represents the imbalance between thepurchases and sales of capital assets"

+ NX represents the imbalance between exportsand imports of goods and services"

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The Market for orei!n"Currency

#$chan!e %nother identity from the preceding chapter:

NCO & NX

*et exports*et capital

outflow

In the market for foreign-currency exchange,

+ NX is the demand for dollars:0oreigners need dollars to buy .anadian net exports"

+ NCO is the supply of dollars:.anadian residents sell dollars to obtain the foreign

currency they need to buy foreign assets"



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S & NCO

%n increase in E makes

.anadian goods more

expensive to foreigners,

reduces foreign demand

for .anadian goods 1and dollars"

The Market for orei!n"Currency#$chan!e

E

Dollars

D & NX

E 1

%n increase in E

has no effect on

saving or investment,so it does not affect

NCO or the supply of

dollars"

E adusts to balance

supply and demand for

dollars in the market for

foreign- currency

exchange"



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%isentan!lin! &upply and %emand#hen a .anadian resident buys imported goods,

does the transaction affect supply or demandin the foreign exchange market? Two views:

1. The supply of dollars increases.

The person needs to sell her dollars to obtain the

foreign currency she needs to buy the imports"

2. The demand for dollars decreases.

The increase in imports reduces NX ,

which we think of as the demand for dollars"

(o, NX is really the net demand for dollars"!

2oth views are euivalent" 0or our purposes,

it3s more convenient to use the second"



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%isentan!lin! &upply and %emand#hen a foreigner buys a .anadian asset,

does the transaction affect supply or demandin the foreign exchange market? Two views:

1. The demand for dollars increases.

The foreigner needs dollars in order to purchase

the .anadian asset"

2. The supply of dollars falls.

The transaction reduces NCO, which we think of

as the supply of dollars"

(o, NCO is really the net supply of dollars"!

%gain, both views are euivalent" #e will use the

second"



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Initially, the government budget is balanced and

trade is balanced NX & 4!"

(uppose the government runs a budget deficit"

How does the budget deficit affect the .anadianreal exchange rate? The balance of trade?

A C T I V E L E A R N I N G 2

The bud!et de'cit, e$chan!e

rate, and ()


# ilib i i h *


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#quilibrium in the *pen#conomy

*et capital outflow is the variable that links these

two markets

S & I + NCO

NCO & NX



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&imultaneous #quilibrium inthe Two Markets



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&imultaneous #quilibrium inthe Two Markets



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+ow olicies and #-ents ./ectan *pen #conomy

The magnitude and variation in important

macroeconomic variables depend on the

following:

+ Increase in world interest rates+ 5overnment budget deficits and surpluses+ Trade policies

+ 6olitical and economic stability



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The #/ects of an Increase in0orld Interest ates

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The #/ects of an Increase in0orld Interest ates



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The #/ects of an Increase inthe 2o-ernment ud!et %e'cit



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Trade olicy

% trade policytrade policy is a government policy that directly

influences the uantity of goods and services

that a country imports or exports"

+ Tariff: % tax on an imported good"

+ Import uota: % limit on the uantity of a goodproduced abroad and sold domestically"



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The #/ects of an Import 4uota



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The #/ects of an Import 4uota


olitical Instability and Capital


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olitical Instability and Capitalli!ht

.apital flight

is a large and sudden reduction in the demandfor assets located in a country"

has its largest impact on the country from which

the capital is fleeing, but it also affects othercountries"

If investors become concerned about the safety of

their investments, capital can uickly leave an

economy"

Interest rates increase and the domestic

currency depreciates"



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The #/ects of Capital li!ht



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The #/ects of Capital li!ht



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C+.T# &5MM.6

In an open economy, the real interest rate adusts tobalance the supply of loanable funds saving! with

the demand for loanable funds domestic investment

and net capital outflow!"

In the market for foreign-currency exchange,

the real exchange rate adusts to balance the supply

of dollars net capital outflow! with the demand for

dollars net exports!"

*et capital outflow is the variable that connects

these markets"


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C+.T# &5MM.6

% budget deficit reduces national saving, drives upinterest rates, reduces net capital outflow, reduces

the supply of dollars in the foreign exchange

market, appreciates the exchange rate, and

reduces net exports"

% policy that restricts imports does not affect net

capital outflow, so it cannot affect net exports or

improve a country3s trade deficit" Instead, it drivesup the exchange rate and reduces exports as well

as imports"


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C+.T# &5MM.6

6olitical instability may cause capital flight,as nervous investors sell assets and pull their

capital out of the country" %s a result, interest rates

rise and the country3s exchange rate falls"

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Chapter 13 Class macroeconomic