OPEN ECONOMY THEORY OF MACROECONOMIC Supply and Demand for Equilibrium in the Open Economy How Policies & Events affect an open economy Loanable funds Foreign Currency Exchange S = I + NCO All savers[.]
All savers go to this market to deposit their saving, and all borrowers go to this market to get their loans Supply: National Saving (S) Demand: Domestic Investment (I) + Net Capital Outflow (NCO) Loanable funds Real Interest Rate: higher Supply: Increase Demand: I: Decrease NCO: Decrease Real Interest Rate: lower Supply: Decrease Demand: I: Increase NCO: Increase S = I + NCO Quantity demanded and supplied depend on the Real Interest Rate Equilibrium Interest Rate: the amount people want to save = the amount people want to borrow to buy to buy Domestic Investment & Foreign assets Supply and Demand for The budget deficit and the trade deficit are often called the twin deficits Participants in this market trade U.S dollars in exchange for foreign currencies T-G National Saving decrease S (Loanable Funds) shift to left => Real Interest Rate increase => Net Capital Outflow (NCO) decrease => S (Foreign-Currency Exchange) increase => Net Exports (NX) decrease Supply: Net Capital Outflow (NCO) Demand: Net Export (NX) Government Budget Deficit Real Exchange Rate (U.S.) appreciates, U.S goods become more expensive relative to foreign goods, exports lower and imports more => reduce the quantity of dollars demanded Trade deficit Foreign - Currency Exchange Government policy that directly influences the quantity of goods and services that a country imports or exports Quotas have no effect on the market for loanable funds => The real interest rate will be unaffected Tariffs (taxes on imported goods) Import quotas (limits on the quantity of goods produced abroad that can be sold domestically) common types Quotas lower import => NX increase => D1 shifts to D2 NCO = NX Real Exchange Rate: appreciates In the end, the quota reduces both imports and exports but net exports remain the same Trade policy How Policies & Events affect an open economy OPEN ECONOMY - THEORY OF MACROECONOMIC Supply: Net Capital Capital Outflow: unchanged Demand: Decrease Quantity demanded and supplied depend on Real Exchange Rate => Real Exchange Rate increase => Export decrease => NX decrease Trade policies have effects on specific firms, industries, and countries But these effects are more microeconomic than macroeconomic The key determinant of NCO is the Real Interest Rate => Real Exchange Rate changes, there will be no change in NCO Real Exchange Rate: deppreciates Supply: unchanged Demand: Increase Trade policies not affect the trade balance Equilibrium Exchange Rate: the demand for dollars to buy net exports exactly = the supply of dollars to be exchanged into foreign currency to buy assets abroad NX = S – I Because trade policies not affect S or I => cannot affect net exports Capital flight: a large and sudden reduction in the demand for assets located in a country Capital Flight => NCO (Mexican) increase => D (LF) increase => Real Interest Rate increase => Real Exchange Rate decrease => Value of Peso decrease Political Instability and Capital Flight *NCO is the link between markets Real Interest Rate - higher: NCO decrease - lower: NCO increase Equilibrium in the Open Economy Real Interest Rate & Real Exchange Rate determine: National Saving (S), Domestic investment (I), Net Capital Outflow (NCO), Net Exports (NX)