LECTURE 10 : A MACROECONOMIC THEORY OF THE OPEN ECONOMY
Model that identifies the forces that determine net exports, net capital outflows, exchange rates.
How government policies and other events can affect them.
We build our previous analisys in two important ways:
We take GDP as given
GDP determined by the supplies of factor of production.
We take prices as given
Price level adjusts to bring money supply and money demand in equilibrium.
A SIMPLE MODEL
Goal of the model: To highlight the forces that determine the economy´s trade balance and exchange rate.
Need to look simultaneously at two markets:
1. The market for loanable funds, which coordinates investment, savings and NCO.
2. The market for foreign currency, which coordinates people who want to exchange the domestic for foreign
currency.
The Market for Loanable Funds
As we discussed, the following identity is true in an open economy: S = I + NCO
The two sides of this identity represent the two sides of the market for national savings:
The supply of loanable funds comes from national saving (S).
The demand for loanable funds comes from domestic investment (I) and net capital outflow
(NCO).
Demand and supply of loanable funds depend on the real interest rate:
A higher real interest rate encourages people to save and thus raises supply.
A higher interest rate makes borrowing to finance capital projects more costly, discouraging investment and
reducing demand.
A higher real interest rate in a country will also lower net capital outflow. All else equal, a higher domestic
interest rate implies that purchases of foreign assets by domestic residents will fall and purchases of
domestic assets by foreigners will rise.
The real interest rate adjusts to bring the supply and demand for loanable funds into balance.
The Market for Foreign Currency
The market for foreign currency exchange is the market where the domestic currency is traded for foreign currencies
For the economy as a whole: NCO = NX
Net capital outflow (NCO) represents the quantity of pounds supplied for the purpose of buying assets
abroad.
Net exports (NX) represent the quantity of pounds demanded for the purpose of buying U.K. net exports of
goods and services.
The real exchange rate is the price that balances the supply and demand in the market for foreign currency
exchange.
When the domestic real exchange rate appreciates, domestic exports decrease and imports rise.
Thus, an increase in the real exchange rate will reduce the quantity of domestic currency demanded.
The key determinant of net capital outflow is the real interest rate. Thus, as the real exchange rate changes, there
will be no change in net capital outflow.
Net Capital Outflow: The Link between the Two Markets
Net capital outflow is
One of the sources of demand in the market for loanable funds.
The source of supply in the foreign currency exchange market.
The key determinant of net capital outflow is the real interest rate:
When the real interest rate is high, owning domestic assets is more attractive and net capital outflow is low.
EQUILIBRIUM IN THE OPEN ECONOMY
Prices in the loanable funds market and the foreign currency exchange market adjust simultaneously to balance
supply and demand in these two markets.
The real interest rate, which is determined in the market for loanable funds, determines the level of NCO.
Given the level of NCO, the real exchange rate brings the equilibrium in the market for foreign currency
exchange.
As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign
investment, and net exports.
HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY
How do changes in policy and other events affect the economys equilibrium?:
1. Government budget deficits
2. Trade policies
3. Political and economic stability
It may be useful to proceed in three steps:
a) Determine which of the supply and demand curves the event affects.
b) Determine in which way the curves shift.
c) Use S&D to determine how these shifts alter the economy´s equilibrium.
Government Budget Deficits
Effect of Budget Deficits on the Loanable Funds Market:
A government budget deficit reduces national saving, which . . .
Shifts the supply curve for loanable funds to the left, which . . .
Raises interest rates and crowds out domestic investment.
Effect of Budget Deficits on Net Foreign Investment:
Higher interest rates reduce net foreign investment.
Effect on the Foreign Currency Exchange Market:
A decrease in net foreign investment reduces the supply of pounds to be exchanged into foreign currency.
This causes the real exchange rate to appreciate
Trade Policy
A trade policy is a government policy that directly influences the quantity of goods and services that a country
imports or exports.
Tariff: A tax on an imported good.
Import quota: A limit on the quantity of a good produced abroad and sold domestically.
Example: the EU imposes a quota on the number of cars imported from Japan.
Note that the quota will have no effect on the market for loanable funds. Thus, the real interest rate will be
unaffected.
The quota lower imports and thus increase net exports, increasing the demand for pounds.
The real exchange rate rise, making goods from the domestic economy relatively more expensive than
foreign goods. Exports fall, imports rise, and net exports fall.
In the end, the quota reduces both imports and exports but net exports remain the same.
Thus, trade policies do not affect the trade balance.
Recall that NX = NCO. Also remember that S = I + NCO.
Rewriting, we get: NCO = S - I = NX
Since trade policies do not affect national saving or domestic investment, they cannot affect net exports.
Trade policies do have effects on firms, industries, and countries. But these effects are more microeconomic
than macroeconomic.
Political Instability and Capital Flight
A capital flight is a large and sudden reduction in the demand for assets located in a country.
Capital flight often occurs because investors feel that the country is unstable, due to either economic or political
problems.
Example: the "Tequila Crisis" in Mexico in 1994.
When investors around the world observed political problems in Mexico in 1994, they sold some of their
Mexican assets and used the proceeds to buy assets of other countries.
This increased Mexican net capital outflow.
Other examples: Asian crisis 1997, Russian crisis 1998
Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries.
If investors become concerned about the safety of their investments, capital can quickly leave an economy.
Interest rates increase and the domestic currency depreciates.
