In this chapter you will build a model to explain an open economy’s trade balance and exchange rate, use the model to analyze the effects of government budget deficits, use the model to analyze the macroeconomic effects of trade policies, use the model to analyze political instability and capital flight.
A Macroeconomic Theory of the Open Economy Copyright © 2004 South-Western 32 Open Economies Anopeneconomyisonethatinteractsfreely withothereconomiesaroundtheworld. Copyright â 2004 South-Western Key Macroeconomic Variables in an Open Economy • The important macroeconomic variables of an open economy include: • • • • net exports net foreign investment nominal exchange rates real exchange rates Copyright © 2004 South-Western Basic Assumptions of a Macroeconomic Model of an Open Economy ThemodeltakestheeconomysGDPasgiven Themodeltakestheeconomyspricelevelas given Copyright â 2004 South-Western SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE • The Market for Loanable Funds S = 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 Copyright © 2004 South-Western The Market for Loanable Funds • The supply of loanable funds comes from nationalsaving(S) Thedemandforloanablefundscomesfrom domesticinvestment(I)andnetcapital outflows(NCO) Copyright â 2004 South-Western The Market for Loanable Funds • 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 Theinterestrateadjuststobringthesupplyand demandforloanablefundsintobalance Copyright â 2004 South-Western Figure The Market for Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Equilibrium real interest rate Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity Quantity of Loanable Funds Copyright©2003 Southwestern/Thomson Learning The Market for Loanable Funds • At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment Copyright © 2004 South-Western The Market for Foreign-Currency Exchange • The two sides of the foreigncurrency exchange marketarerepresentedbyNCOandNX NCOrepresentstheimbalancebetweenthe purchasesandsalesofcapitalassets NXrepresentstheimbalancebetweenexports andimportsofgoodsandservices Copyright â 2004 South-Western Trade Policy • Effect of an Import Quota • Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreigncurrency • Thisleadstoanappreciationoftherealexchangerate Copyright â 2004 South-Western Trade Policy EffectofanImportQuota Thereisnochangeintheinterestratebecause nothinghappensintheloanablefundsmarket Therewillbenochangeinnetexports. Thereisnochangeinnetforeigninvestmenteven thoughanimportquotareducesimports Copyright â 2004 South-Western Trade Policy • Effect of an Import Quota • An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports • This offsets the initial increase in net exports due to import quota Copyright © 2004 South-Western Figure The Effects of an Import Quota (a) The Market for Loanable Funds Real Interest Rate (b) Net Capital Outflow Real Interest Rate Supply r r Net exports, however, remain the same Demand NCO Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate E2 and causes the real exchange rate to appreciate Supply An import quota increases the demand for dollars E D D Quantity of Dollars (c) The Market for Foreign-Currency Exchange Copyrightâ2003 Southwestern/Thomson Learning Trade Policy EffectofanImportQuota Tradepoliciesdonotaffectthetradebalance Copyright © 2004 South-Western Political Instability and Capital Flight • Capital flight is a large and sudden reduction in the demand for assets located in a country Copyright © 2004 South-Western Political Instability and Capital Flight • 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 Copyright © 2004 South-Western Political Instability and Capital Flight • 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 Copyright © 2004 South-Western Political Instability and Capital Flight • This increased Mexican net capital outflow • The demand for loanable funds in the loanable funds market increased, which increased the interest rate • This increased the supply of pesos in the foreign currency exchange market Copyright © 2004 South-Western Figure The Effects of Capital Flight (a) The Market for Loanable Funds in Mexico Real Interest Rate (b) Mexican Net Capital Outflow Real Interest Rate Supply r2 r2 r1 r1 An increase in net capital outflow D2 which increases the interest rate D1 increases the demand for loanable funds NCO1 Quantity of Loanable Funds NCO2 Net Capital Outflow Real Exchange Rate E which E causes the peso to depreciate S S2 At the same time, the increase in net capital outflow increases the supply of pesos Demand Quantity of Pesos (c) The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning Summary • To analyze the macroeconomics of open economies, two markets are central—the market for loanable funds and the market for foreigncurrency exchange • In the market for loanable funds, the interest rate adjusts to balance supply for loanable funds (from national saving) and demand for loanable funds (from domestic investment and netcapitaloutflow) Copyright â 2004 South-Western Summary Inthemarketforforeignưcurrencyexchange, therealexchangerateadjuststobalancethe supplyofdollars(fornetcapitaloutflow)and thedemandfordollars(fornetexports) Netcapitaloutflowisthevariablethatconnects thetwomarkets Copyright â 2004 South-Western Summary Apolicythatreducesnationalsaving,suchasa governmentbudgetdeficit,reducesthesupply ofloanablefundsanddrivesuptheinterestrate Thehigherinterestratereducesnetcapital outflow,reducingthesupplyofdollars Thedollarappreciates,andnetexportsfall Copyright â 2004 South-Western Summary • A trade restriction increases net exports and increases the demand for dollars in the market for foreigncurrency exchange. • As a result, the dollar appreciates in value, making domestic goods more expensive relativetoforeigngoods Thisappreciationoffsetstheinitialimpactof thetraderestrictionsonnetexports Copyright â 2004 South-Western Summary When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound • Political instability in a country can lead to capital flight • Capital flight tends to increase interest rates and cause the country’s currency to depreciate Copyright © 2004 South-Western ... affect the trade balance • For a given level of national saving and domestic investment,therealexchangerateadjuststokeep thetradebalancethesame Tradepolicieshaveagreatereffecton microeconomicthanonmacroeconomic... Southwestern/Thomson Learning The Market for Foreign-Currency Exchange Therealexchangerateadjuststobalancethe supplyanddemandfordollars Attheequilibriumrealexchangerate ,the demandfordollarstobuynetexportsexactly... Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate E2 E1 which causes the real exchange rate to appreciate S S The decrease in net capital outflow reduces the supply of dollars