Chapter 19 A Macroeconomic Theory of the Open Economy 1 Market for Loanable Funds Open Economy o S I NCO o Saving Domestic Investment Supply of Loanable Funds o From national saving S Demand for Loanable Funds o From domestic investment I NCO NCO O Net Outflow of Capital o Net purchases of capital overseas NCO 0 Net Outflow of Capital o Capital resources from abroad Loanable Funds accumulation Purchase of a capital asset o Adds to the demand for loanable funds o Asset located at home I abroad NCO Higher real interest rate o Encourages Adds to demand for domestically generated loanable funds Reduces demand for domestically generated loanable funds o Domestically generated flow of resources available for capital people to save Inc Q of loanable funds supplied foreigners to buy U S assets reduces U S NCO o Discourages Investment Dec Q loanable funds demanded Ams from buying foreign assets Reduces U S NCO Chapter 19 A Macroeconomic Theory of the Open Economy 2 Foreign Currency Exchange o Market for foreign currency exchange o NCO NX o Trade Surplus NX 0 o Exports imports o Net sale of G S abroad o Foreign currency is used to buy foreign assets Capital flow abroad NCO 0 o Trade Deficit NX 0 o Imports exports o Some of spending is financed by selling Am Assets abroad Foreign capital flowing into U S NCO 0 o Supply of foreign currency exchange o NCO Q of dollars supplied to buy foreign assets o Vertical supply curve Q of dollars supplied for NCO Independent of real exchange rate o Demand for foreign currency exchange o Net exports Q of dollars demanded to buy U S net exports of G S o Higher real exchange rate Makes U S goods more expensive reduces Q of dollars demanded to buy goods o E real exchange rate o Demand for dollars by foreigners o Arising from U S net exports of G S o Exactly balances supply of dollars Arising from U S NCO Chapter 19 A Macroeconomic Theory of the Open Economy 3 E in the Open Economy o Net capital outflow curve links o Market for Loanable funds S I NCO o Market for foreign currency exchange NCO NX Chapter 19 A Macroeconomic Theory of the Open Economy 4 o Market for loanable funds o Supply national saving o Demand Domestic I NCO o E real interest rate r o NCO o downward sloping o E real interest rate r o Market for foreign currency exchange o Supply NCO o Demand net exports o E real exchange rate E o E real interest rate r o Prices of G S in the present relative to G S in future o E real exchange rate E o Price of domestic G S o E r adjust simultaneously Relative to foreign goods services o To balance supply demand o In Loanable Funds foreign currency exchange o Determine National saving domestic investment NCO NX Chapter 19 A Macroeconomic Theory of the Open Economy 5 Government Budget Deficit o Govt spending exceeds govt revenue o Neg public saving o Less national saving o Less supply of loanable funds o less NCO o int rate o crowd out domestic investment o dec in supply of foreign currency exchange o currency appreciates o net exports fall o trade deficit Trade Policy o Trade policy o govt policy o directly influences Q of G S imported exported o tariff tax on imports o import quota limit on Q of imports o Voluntary export restrictions o Macroecon impact of trade policy Chapter 19 A Macroeconomic Theory of the Open Economy 6 o Dec imports o net exports o demand for dollars in market of for foreign exchange o real exchange rate appreciates discourages exports o NO CHANGE in o Real int rate NCO NX dec imports dec exports o Trade policies do not affect the U S trade balance o NX NCO S I o Trade policies affect specific firms industries countries Political Stability Capital Flight o Political instability capital flight o Capital Flight large sudden reduction in the demand for assets located in a country o Mexico capital flight affects both markets o 1994 political instability o investors capital flight sell Mexican assets Chapter 19 A Macroeconomic Theory of the Open Economy 7 Supply of pesos in market for foreign currency exchange inc buy U S assets safe haven o NCO curve increases o Demand curve in market for loanable funds inc o Interest rate in Mexico inc Reduces dom Investmet Slows capital accumulations Slows econ Growth o Peso depreciates Exports cheaper Trade balance moves toward surplus Imports more expensive o Mexico capital flight affects both markets o U S market U S NCO interest rate falls appreciates relatively small impact on U S economy larger econ Compared to Mexico Chapter 19 A Macroeconomic Theory of the Open Economy 8 Capital flows from China o Nation experiences capital flight o Capital outflow o currency depr In foreign exchange markets o Nation exp Inflow of capital o Currency appreciates o Pushes trade toward deficit o A Nation s Govt Policy o Encourages capital to flow to another country w foreign investment o Effect Nation encourages capital outflows Weaker currency Trade surplus For the recipient of capital flows Stronger currency trade deficit o Ongoing policy disputes U S China o China tried to depress currency in foreign exchange markets Promoted export industries Accumulate foreign assets 3 trillion 2012 Including U S govt bonds Chinese goods less expensive Contributes to the U S trade deficit Hurts U S producers who make products which compete with imports from China o U S govt Encouraged China to stop influecncing exchange value of its currency U S consumers of Chinese imports benefit from lower prices Inflow of capital from China Lowers U S interest rates Inc investment in the U S economy o Chinese policy of investing in U S economy Creates winners losers amongst Ams Small net impact on U S economy o Motives behind policy China wants to accumulate a reserve of foereign assets national rainy day fund Misguided policy