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Chapter 33
A Macroeconomic Theory of the
Open Economy
Key Termstrade policycapital flight
Model
Simplified version of reality
Variables
Net ExportsNet Capital OutflowReal Exchange Rates
Nominal Exchange Rates
Focus
Trade BalanceExchange Rate
Two Markets
Loanable funds marketForeign currency market
Loan Market
Savers and BorrowersS = I + NCO
Savings =
Domestic Investment + Net Capital Outflow
Supply = Demand
Two Things
Invest at homeInvest abroad
NCO > 0
Less Invest at homeMore Invest abroad
Investing more in other countries than your own
NCO < 0
More Invest at homeLess Invest abroad
Other countries want to invest in your country
Supply and Demandof Loanable Funds
Depends on the real interest rate
Remember
Nominal Rate = Real Rate + Inflation Rate
Nominal = Real + InflationN = R + I
Country A Country B Country C
Nominal 10% 12%
Real 8% 10%
Inflation 3% 7%2%
13%
5%
Interest RatesHigh
Encourage SaversDiscourage Borrowers
LowDiscourage 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%
RealInterest
Rate
Quantity of Loanable Funds
EquilibriumRate
EquilibriumQuantity
Market for Loanable Funds
DemandFor domestic and foreigninvestment
SupplyFrom national savings
Too highMore supply than demand
push rate down
Too lowMore demand than supply
push rate up
Foreign Currency Exchange Market
NCO = NXNet Capital Outflow = Net Exports
Foreign Currency Exchange Market
If NX > 0Selling more than buyingWhat to do with cash? Must buy foreign assets
Remember foreign currency is a foreign asset
Foreign Currency Exchange Market
If NX < 0Buying more than sellingMust 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
RealExchange
Rate
Quantity of Riyals Exchanged into Foreign Currency
EquilibriumRate
Equilibrium Quantity
Market for Foreign Currency Exchange
DemandFor net exports
SupplyFrom net capital outflowVertical - does not depend on exchange rate
Low rates stimulate exports
High rates discourage exports
Too lowMore demand than supplyPressure to push rate up
Too highMore supply than demand
Pressure to push rate down
Linking The Loanable Funds Market
S = I + NCOwith
Foreign Currency Exchange Market
NCO = NX
Where did the riyals come from?
Saudi SaversLoanable Funds Market
Where did I buy the riyals?
Foreign Currency Market
Currency Tradersmove funds between the
two markets
S = I + NCOdemand side
NCO = NXsupply side
RealInterest
Rate
0
Net Capital OutflowDepends on Real Interest Rate
NCO is positiveNCI is negative
NCO is negativeNCI is positiveCash comes in Cash goes out
LinkingReal
InterestRate
Quantity of Loanable Funds
EquilibriumInterest
Rate
Demand
Supply
Loanable Funds Market
RealInterest
Rate
Quantity of Loanable Funds
Demand
Net Capital Outflow
RealExchange
Rate
Quantity of Riyals
EquilibriumExchange
Rate
Demand
Supply
Foreign Currency Exchange Market
Loanable Funds MarketInterest Rate
Foreign Currency MarketExchange Rate
PolicyReal
InterestRate
Quantity of Loanable Funds
EquilibriumInterest
Rate
Demand
Supply
Loanable Funds Market
RealInterest
Rate
Quantity of Loanable Funds
Demand
Net Capital Outflow
RealExchange
Rate
Quantity of Riyals
EquilibriumExchange
Rate
Demand
Supply
Foreign Currency Exchange Market
Government deficitspush up interest rates
which increase exchange rates
which increase trade deficits
