A Macroeconomic Theory of the
Open Economy
Macroeconomic Variables in an
Open Economy
• An open economy is one that interacts freely with other
economies around the world.
• The important macroeconomic variables of an open
economy include:
–
–
–
–
–
–
net exports (NX)
net capital outflow (NCO)
nominal exchange rates (e)
real exchange rates (eP/P*)
real interest rates (r)
Loanable funds (LF=I=S)
• Theory helps us to link these variables together; however,
to simplify the analysis we will make some assumptions.
Basic Assumptions
• The model takes the economy’s GDP as
given. Y = Y-bar (like the quantity theory)
• The model takes the economy’s price level
as given. P = P-bar (unlike the quantity
theory)
The Theory of the Open Economy: A
Complete Logical Flow
• The theory relates and determines r, NCO, EP/P*, and NX
• It begins with conditions in the loanable funds market and
then the foreign exchange market.
• In each market, the demand and supply are used, put
together to determine equilibrium, and then the effects of
shifts in demand and supply are analyzed.
• The two markets are linked together and r, NCO, EP/P*,
and NX are jointly determined.
• Different policies and situations are then analyzed and
their affect on r, NCO, EP/P*, and NX identified.
The Loanable Funds Market
• The supply and demand in the loanable
funds market determines the real interest
rate {r}
– Closed Economy: S=I only domestic borrowing
and lending are allowed.
– Open Economy: S=I+NCO this allows trade
and borrowing and lending from the ROW (rest
of the world)
SUPPLY AND DEMAND FOR LOANABLE
FUNDS: OPEN ECONOMY
• 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.
• The supply of loanable funds comes from national
saving (S).
• The demand for loanable funds comes from
domestic investment (I) and net capital outflows
(NCO).
• 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.
• The interest rate adjusts to bring the supply and
demand for loanable funds into balance
• At the equilibrium interest rate, the amount that
people want to save exactly balances the desired
quantities of domestic investment and net foreign
investment.
• National Saving: S → SLF is positively related to
r↓(↑) → SLF ↓(↑)
• Investment and Net Capital Flow:
I+NCO → DLF is negatively related to
r ↓(↑) → DLF ↑(↓)
– r ↓(↑) I ↑(↓)
• r↓(↑) PV ↑(↓) of future returns
– r ↓(↑) NCO ↑(↓)
• rUS ↓(↑) US increases (decreases) demand for ROW assets and
ROW decreases (increases) demand for US assets
Figure 3 How Net Capital Outflow Depends on
the Interest Rate
Real
Interest
Rate
Net capital outflow
is negative.
0
Net capital outflow
is positive.
Net Capital
Outflow
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• The equilibrium r in the LF market brings national saving = investment
+net capital outflow or S=I+NCO.
• Supply-side shocks to LF
– S↓ (income taxes↑ or budget →deficit), then r↑→LF↓
– S↑ (income taxes↓ or budget →surplus), then r↓→LF↑
•
Demand-side shocks to LF
– I↑ (tax credits↑ or expected Y↑), then r↑→LF↑
– I↓ (tax credits↓ or expected Y↓), then r↓→LF↓
– NCO↓ (political instability abroad↑), then r↓→LF↓ [US
holds fewer ROW assets and ROW holds more US assets]
– NCO↑ (political stability abroad ↓), then r↑→LF↑ [US
holds more ROW assets and ROW holds less US assets]
• We have now fully described the LF market and the determination of r
Figure 1 The Market for Loanable Fund
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 Foreign-Currency
Exchange
• The two sides of the foreign-currency exchange market are
represented by NCO and NX.
• NCO represents the imbalance between the purchases and
sales of capital assets.
• NX represents the imbalance between exports and imports
of goods and services.
• In the market for foreign-currency exchange, U.S. dollars
are traded for foreign currencies.
• For an economy as a whole, NCO and NX must balance
each other out, or:
NCO = NX
The Market for Foreign-Currency
Exchange
• The price that balances the supply and demand for
foreign-currency is the real exchange rate.
• The demand curve for dollars is downward
sloping because a higher exchange rate makes
domestic goods more expensive.
• The supply curve is vertical because the quantity
of dollars supplied for net capital outflow is
unrelated to the real exchange rate. It is related to
the real interest rate and comes from the loanable
funds market.
• The real exchange rate adjusts to balance the
supply and demand for dollars.
• At the equilibrium real exchange rate, the demand
for dollars to buy net exports exactly balances the
supply of dollars to be exchanged into foreign
currency to buy assets abroad.
• For example, if the US has a trade surplus,
foreigners are demanding US dollars to buy the
net exports. At the same time, US dollars are
being supplied to buy the foreign assets from the
resulting net capital outflow (US receipt of
foreign assets).
The Foreign Exchange Market
• The supply and demand in the foreign
exchange market determines the real
interest exchange rate EP/P*
– Closed Economy: no trading, NX, or EP/P*.
– Open Economy: NX=NCO this allows trade
and borrowing and lending from the ROW (rest
of the world)
• Net Capital Outflow - NCO → S$
↓
– If NCO↑, US is supplying more dollars, on net,
to purchase foreign assets
– If NCO↓, US is supplying fewer dollars, on net,
to purchase fewer foreign assets
– NCO is determined by r in the loanable funds
markets and is not related to EP/P*.
– As EP/P*↓(↑), NCO remains the same
• Net Exports - NX → D$ is negatively related to
EP/P*
– If EP/P*↓, NX↑, D$↑ - US goods become cheaper, net
exports increase, and ROW needs more US dollars to
purchase more goods and services
– If EP/P*↑, NX↓, D$↓ - US goods become more
expensive, net exports decrease, and ROW needs fewer
US dollars to purchase fewer goods and services
• Equilibrium in the foreign exchange market occurs
when the EP/P* equates the D$ with the S$ or
NX=NCO .
• Foreign Exchange Shocks
– D$↑, S$ is constant from NCO, EP/P*↑, until quantity of
D$↓ and equals the quantity of S$
– D$↓, S$ is constant from NCO, EP/P*↓, until quantity
of D$↑ and equals the quantity of S$
Figure 2 The Market for Foreign-Currency
Exchange
Real
Exchange
Rate
Supply of dollars
(from net capital outflow)
Equilibrium
real exchange
rate
Demand for dollars
(for net exports)
Equilibrium
quantity
Quantity of Dollars Exchanged
into Foreign Currency
Copyright©2003 Southwestern/Thomson Learning
EQUILIBRIUM IN THE OPEN
ECONOMY
• In the market for loanable funds, supply comes
from national saving and demand comes from
domestic investment and net capital outflow.
• In the market for foreign-currency exchange,
supply comes from net capital outflow and
demand comes from net exports.
• Net capital outflow links the loanable funds
market and the foreign-currency exchange market.
– The key determinant of net capital outflow is the real
interest rate.
• Prices in the loanable funds market and the
foreign-currency exchange market adjust
simultaneously to balance supply and
demand in these two markets.
• As they do, they determine the
macroeconomic variables of national
saving, domestic investment, net foreign
investment, and net exports. WOW!
Linking the Loanable Funds and Foreign
Exchange Market
•
•
•
•
•
•
NCO link the two markets together
Step 1: S=I+NCO or SLF=DLF →r
Step 2: r →NCO
Step 3: NCO →S$
Step 4: NX →D$
Step 5: D$=S$ →EP/P* and NX=NCO
Examples of Transmission of LF
and FEM Shocks
• Loanable Funds Shocks:
–
–
–
–
S↓, SLF↓, r↑,NCO↓,S$↓, EP/P*↑,NX↓
S↑, SLF↑, r↓,NCO↑,S$↑, EP/P*↓,NX↑
I↑, DLF↑, r↑,NCO↓,S$↓, EP/P*↑,NX↓
I↓, DLF↓, r↓,NCO↑,S$↑, EP/P*↓,NX↑
• Foreign Exchange Shocks
– D$↑, S$ is constant from NCO, EP/P*↑, until quantity of
D$↓, but NX are constant, r is constant
– D$↓, S$ is constant from NCO, EP/P*↓, until quantity of
D$↑, but NX are constant, r is constant
Figure 4 The Real Equilibrium in an Open
Economy
(a) The Market for Loanable Funds
Real
Interest
Rate
(b) Net Capital Outflow
Real
Interest
Rate
Supply
r
r
Demand
Net capital
outflow, NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
Supply
E
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
HOW POLICIES AND EVENTS AFFECT
AN OPEN ECONOMY
• The magnitude and variation in important
macroeconomic variables depend on the
following:
– Government budget deficits
– Trade policies
– Political and economic stability
Government Budget Deficits
• In an open economy, government budget
deficits . . .
–
–
–
–
reduce the supply of loanable funds,
drive up the interest rate,
crowd out domestic investment,
cause net foreign investment to fall.
Figure 5 The Effects of Government Budget
Deficit
(a) The Market for Loanable Funds
Real
Interest
Rate
r2
S
1. A budget deficit reduces
(b) Net Capital Outflow
the supply of loanable funds . . .
Real
Interest
Rate
S
B
r2
A
r
2. . . . which
increases
the real
interest
rate . . .
r
3. . . . which in
turn reduces
net capital
outflow.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
E1
5. . . . which
causes the
real exchange
rate to
appreciate.
S
S
4. The decrease
in net capital
outflow reduces
the supply of dollars
to be exchanged
into foreign
currency . . .
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
• 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
• 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 dollars 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.
• Because they do not change national saving or
domestic investment, trade policies do not affect
the trade balance.
– For a given level of national saving and domestic
investment, the real exchange rate adjusts to keep the
trade balance the same.
• Trade policies have a greater effect on
microeconomic than on macroeconomic markets.
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 foreign-currency.
• This leads to an appreciation of the real exchange rate.
– There is no change in the interest rate because nothing
happens in the loanable funds market.
– There will be no change in net exports.
– There is no change in net foreign investment even
though an import quota reduces imports.
• 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.
– Trade policies do not affect the trade balance.
Figure 6 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
3. Net exports,
however, remain
the same.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
2. . . . and
causes the
real exchange
rate to
appreciate.
Supply
1. An import
quota increases
the demand for
dollars . . .
E
D
D
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
Political Instability and Capital Flight
• Capital flight is a large and sudden reduction in
the demand for assets located in a country.
• 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.
• 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.
– The demand for loanable funds in the loanable funds
market increased, which increased the interest rate.
– This increased the supply of pesos in the foreigncurrency exchange market.
Figure 7 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
3. . . . which
increases
the interest
rate.
1. An increase
in net capital
outflow. . .
D2
D1
NCO1
Quantity of
2. . . . increases the demand
Loanable Funds
for loanable funds . . .
NCO2
Net Capital
Outflow
Real
Exchange
Rate
E
5. . . . which
causes the
peso to
depreciate.
S
S2
4. At the same
time, the increase
in net capital
outflow
increases the
supply of pesos . . .
E
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 net capital
outflow).
Summary
• In the market for foreign-currency
exchange, the real exchange rate adjusts to
balance the supply of dollars (for net capital
outflow) and the demand for dollars (for net
exports).
• Net capital outflow is the variable that
connects the two markets.
Summary
• A policy that reduces national saving, such
as a government budget deficit, reduces the
supply of loanable funds and drives up the
interest rate.
• The higher interest rate reduces net capital
outflow, reducing the supply of dollars.
• The dollar appreciates, and net exports fall.
Summary
• A trade restriction increases net exports and
increases the demand for dollars in the
market for foreign-currency exchange.
• As a result, the dollar appreciates in value,
making domestic goods more expensive
relative to foreign goods.
• This appreciation offsets the initial impact
of the trade restrictions on net exports.
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.