A Macroeconomic Theory of the Open EconomyMacroeconomic Variables in an Open EconomyBasic AssumptionsThe Theory of the Open Economy: A Complete Logical FlowThe Loanable Funds MarketSUPPLY AND DEMAND FOR LOANABLE FUNDS: OPEN ECONOMYSlide 7Slide 8Figure 3 How Net Capital Outflow Depends on the Interest RateSlide 10Figure 1 The Market for Loanable FundThe Market for Foreign-Currency ExchangeSlide 13Slide 14The Foreign Exchange MarketSlide 16Slide 17Figure 2 The Market for Foreign-Currency ExchangeEQUILIBRIUM IN THE OPEN ECONOMYSlide 20Linking the Loanable Funds and Foreign Exchange MarketExamples of Transmission of LF and FEM ShocksFigure 4 The Real Equilibrium in an Open EconomyHOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMYGovernment Budget DeficitsFigure 5 The Effects of Government Budget DeficitSlide 27Trade PolicyTrade PolicySlide 30Figure 6 The Effects of an Import QuotaPolitical Instability and Capital FlightSlide 33Figure 7 The Effects of Capital FlightSummarySlide 36Slide 37Slide 38Slide 39A Macroeconomic Theory of the Open EconomyMacroeconomic Variables in an Open Economy•An open economy is one that interacts freely with other economies around the world. •The important macroeconomic variables of an open economy include:–net exports (NX)–net capital outflow (NCO)–nominal exchange rates (e)–real exchange rates (eP/P*)–real interest rates (r)–Loanable funds (LF=I=S)•Theory helps us to link these variables together; however, to simplify the analysis we will make some assumptions.Basic Assumptions•The model takes the economy’s GDP as given. Y = Y-bar (like the quantity theory)•The model takes the economy’s price level as given. P = P-bar (unlike the quantity theory)The Theory of the Open Economy: A Complete Logical Flow•The theory relates and determines r, NCO, EP/P*, and NX•It begins with conditions in the loanable funds market and then the foreign exchange market.•In each market, the demand and supply are used, put together to determine equilibrium, and then the effects of shifts in demand and supply are analyzed.•The two markets are linked together and r, NCO, EP/P*, and NX are jointly determined.• Different policies and situations are then analyzed and their affect on r, NCO, EP/P*, and NX identified.The Loanable Funds Market•The supply and demand in the loanable funds market determines the real interest rate {r}–Closed Economy: S=I only domestic borrowing and lending are allowed.–Open Economy: S=I+NCO this allows trade and borrowing and lending from the ROW (rest of the world)SUPPLY AND DEMAND FOR LOANABLE FUNDS: OPEN ECONOMY•The Market for Loanable FundsS = 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.•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).•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•At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment.•National Saving: S → SLF is positively related to r↓(↑) → SLF ↓(↑)•Investment and Net Capital Flow: I+NCO → DLF is negatively related to r ↓(↑) → DLF ↑(↓)–r ↓(↑) I ↑(↓) •r↓(↑) PV ↑(↓) of future returns–r ↓(↑) NCO ↑(↓)•rUS ↓(↑) US increases (decreases) demand for ROW assets and ROW decreases (increases) demand for US assetsFigure 3 How Net Capital Outflow Depends on the Interest RateCopyright©2003 Southwestern/Thomson Learning0Net CapitalOutflowNet capital outflowis negative.Net capital outflowis positive.RealInterestRate•The equilibrium r in the LF market brings national saving = investment +net capital outflow or S=I+NCO.•Supply-side shocks to LF–S↓ (income taxes↑ or budget →deficit), then r↑→LF↓–S↑ (income taxes↓ or budget →surplus), then r↓→LF↑•Demand-side shocks to LF–I↑ (tax credits↑ or expected Y↑), then r↑→LF↑–I↓ (tax credits↓ or expected Y↓), then r↓→LF↓–NCO↓ (political instability abroad↑), then r↓→LF↓ [US holds fewer ROW assets and ROW holds more US assets]–NCO↑ (political stability abroad ↓), then r↑→LF↑ [US holds more ROW assets and ROW holds less US assets]•We have now fully described the LF market and the determination of rFigure 1 The Market for Loanable FundCopyright©2003 Southwestern/Thomson LearningQuantity ofLoanable FundsRealInterestRateSupply of loanable funds(from national saving)Demand for loanablefunds (for domesticinvestment and netcapital outflow)EquilibriumquantityEquilibriumreal interestrateThe Market for Foreign-Currency Exchange•The two sides of the foreign-currency exchange market are represented by NCO and NX.•NCO represents the imbalance between the purchases and sales of capital assets.•NX represents the imbalance between exports and imports of goods and services.•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 = NXThe Market for Foreign-Currency Exchange•The price that balances the supply and demand for foreign-currency is the real exchange rate.•The demand curve for dollars 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. It is related to the real interest rate and comes from the loanable funds market.•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.•For example, if the US has a trade surplus, foreigners are demanding US dollars to buy the net exports. At the same time, US dollars are being supplied to buy the foreign assets from the resulting net capital outflow (US receipt of foreign assets).The Foreign Exchange