Vocab Trade Policy Capital Flight Tariff Import quota Notes A government policy that directly influences the quantity of goods and services that a country imports or exports A large and sudden reduction in the demand for assets located in a country a tax on imported goods a limit on the quantity of a good produced abroad that can be sold domestically The market for loanable funds in an open economy NCO 0 the country is experiencing a net outflow of capital o the net purchase of capital overseas adds to the demand for domestically generated loanable funds NCO 0 the country is experiencing a net inflow of capital o the capital resources coming from abroad reduce the demand for domestically generated loanable funds In the market for loanable funds the quantity of loanable funds supplied and the quantity of loanable funds demanded depend on the real interest rate A higher real interest rate encourages people to save and therefore raises the quantity of loanable funds supplied A higher interest rate also makes borrowing to finance capital projects more costly thus it discourages investment and reduces the quantity of loanable funds demanded In addition to influencing national saving and domestic investment the real interest rate in a country affects that country s net capital outflow Higher interest rate increases the quantity of loanable funds supplied and the demand curve slopes downward because a higher interest rate decreases the quantity of loanable funds demanded The interest rate adjusts to bring the supply and demand for loanable funds into balance If the interest rate were below the equilibrium level the quantity of loanable funds supplied would be less than the quantity demanded The resulting shortage of loanable funds would push the interest rate upward If the interest rate were above the equilibrium level the quantity of loanable funds supplied would exceed the quantity demanded The surplus of loanable funds would drive the interest rate downward At the equilibrium interest rate the supply of loanable funds exactly balances the demand That is at the equilibrium interest rate the amount that people want to save exactly balances the desired quantities of domestic investment and net capital outflow This identity states that the imbalance between the purchase and sale of capital assets abroad NCO equals the imbalance between exports and imports of goods and services NX In a trade surplus NX 0 foreigners are buying more U S goods and services than Americans are buying foreign goods and services If the United States is running a trade deficit NX 0 Americans are spending more on foreign goods and services than they are earning from selling abroad When the U S real exchange rate appreciates U S goods become more expensive relative to foreign goods making U S goods less attractive to consumers both at home and abroad o As a result exports from the United States fall and imports into the United States rise For both reasons net exports fall o Hence an appreciation of the real exchange rate reduces the quantity of dollars demanded in the market for foreign currency exchange A higher real exchange rate makes U S goods more expensive and reduces the quantity of dollars demanded to buy those goods The supply curve is vertical because the quantity of dollars supplied for net capital outflow does not depend on the real exchange rate Net capital outflow depends on the real interest rate A higher exchange value of the U S dollar not only makes foreign goods less expensive for American buyers but also makes foreign assets less expensive In the market for loanable funds supply comes from national saving S demand comes from domestic investment I and net capital outflow NCO and the real interest rate balances supply and demand In the market for foreign currency exchange supply comes from net capital outflow NCO demand comes from net exports NX and the real exchange rate balances supply and demand Net capital outflow is the variable that links these two markets The real exchange rate does not affect net capital outflow so the supply curve is vertical A government budget deficit reduces the supply of loanable funds drives up the interest rate and crowds out investment In an open economy government budget deficits raise real interest rates crowd out domestic investment cause the currency to appreciate and push the trade balance toward deficit An import quota reduces both imports and exports but net exports exports minus imports are unchanged Trade policies do not affect the trade balance NX NCO S I Trade restrictions interfere with these gains from trade and thus reduce overall economic well being Capital flight from Mexico increases Mexican interest rates and decreases the value of the Mexican peso in the market for foreign currency exchange The depreciation of the currency makes exports cheaper and imports more expensive pushing the trade balance toward surplus At the same time the increase in the interest rate reduces domestic investment which slows capital accumulation and economic growth Capital flight has its largest impact on the country from which capital is fleeing but it also affects other countries Capital Flight Rising interest rates and falling currency
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