Chapter
19

Supply and Demand for Loanable Funds
• The market for loanable funds
– In an open economy
• S = I + NCO
• Saving = Domestic investment + Net capital outflow
– Supply of loanable funds
• From national saving (S)
– Demand for loanable funds
• From domestic investment (I)
• And net capital outflow (NCO)
2

Supply and Demand for Loanable Funds
• The market for loanable funds
•
– Domestically generated flow of resources available for capital accumulation
•
– Adds to the demand for loanable funds
• Asset – located at home: I
• Asset – located abroad: NCO
– If NCO > 0, net outflow of capital - adds to demand
– If NCO < 0, net inflow of capital - reduce the demand
3

Supply and Demand for Loanable Funds
• The market for loanable funds
•
• Encourages people to save
– Increases quantity of loanable funds supplied
• Discourages investment
– Decreases quantity of loanable funds demanded
• Discourages Americans from buying foreign assets
– Reduces U.S. net capital outflow
• Encourages foreigners to buy U.S. assets
– Reduces U.S. net capital outflow
4

Supply and Demand for Loanable Funds
• The market for loanable funds
•
– Slopes upward
•
– Slopes downward
•
– Amount that people want to save
– Exactly balances the desired quantities of domestic investment and net capital outflow
5

Figure 1
The market for loanable funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium real interest rate
Equilibrium quantity
Demand for loanable funds (for domestic investment and net capital outflow)
Quantity of
Loanable Funds
The interest rate in an open economy, as in a closed economy, is determined by the supply and demand for loanable funds. National saving is the source of the supply of loanable funds. Domestic investment and net capital outflow are the sources of the demand for loanable funds. At the equilibrium interest rate, the amount that people want to save exactly balances the amount that people want to borrow for the purpose of buying domestic capital and foreign assets.
6

Market for Foreign-Currency Exchange
• The market for foreign-currency exchange
– Identity: NCO = NX
– Net capital outflow = Net exports
•
– Foreigners - buy more U.S. goods & services
• Than Americans - buy foreign goods & services
– Americans – use foreign currency
• Buy foreign assets
– Capital is flowing abroad, NCO > 0
7

Market for Foreign-Currency Exchange
• The market for foreign-currency exchange
•
– Americans - buy more foreign goods & services
• Than foreigners - buy U.S. goods & services
– Some of this spending
• Financed by selling American assets abroad
– Foreign capital is flowing into U.S.
– NCO < 0
8

Market for Foreign-Currency Exchange
• The market for foreign-currency exchange
•
– Net capital outflow
– Quantity of dollars supplied - buy foreign assets
– Supply curve – vertical
• Quantity of dollars supplied for net capital outflow
• Does not depend on the real exchange rate
9

Market for Foreign-Currency Exchange
• The market for foreign-currency exchange
•
– Net exports
– Quantity of dollars demanded – buy U.S. net exports of goods and services
– Demand curve - downward sloping
• A higher real exchange rate
– Makes U.S. goods more expensive
– Reduces the quantity of dollars demanded to buy those goods
10

Market for Foreign-Currency Exchange
• The market for foreign-currency exchange
•
– Demand for dollars
• By foreigners
• Arising from U.S. net exports of goods & services
– Exactly balances supply of dollars
• From Americans
• Arising from U.S. net capital outflow
11

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
The real exchange rate is determined by the supply and demand for foreign-currency exchange.
The supply of dollars to be exchanged into foreign currency comes from net capital outflow.
Because net capital outflow does not depend on the real exchange rate, the supply curve is vertical. The demand for dollars comes from net exports. Because a lower real exchange rate stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net exports), the demand curve is downward sloping. At the equilibrium real exchange rate, the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports.
12

Equilibrium in the Open Economy
• Net capital outflow: link between the two markets
•
– Market for loanable funds: S = I + NCO
– Market for foreign-currency exchange: NCO=NX
•
– Link between
• Market for loanable funds
• Market for foreign-currency exchange
13

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
Because a higher domestic real interest rate makes domestic assets more attractive, it reduces net capital outflow. Note the position of zero on the horizontal axis: Net capital outflow can be positive or negative. A negative value of net capital outflow means that the economy is experiencing a net inflow of capital.
14

Equilibrium in the Open Economy
• Simultaneous equilibrium in two markets
– Market for loanable funds
• Supply: national saving
• Demand: domestic investment & net capital outflow
• Equilibrium real interest rate, r
– Net capital outflow
• Slopes downward
• Equilibrium interest rate, r
15

Equilibrium in the Open Economy
• Simultaneous equilibrium in two markets
– Market for foreign-currency exchange
• Supply: net capital outflow
• Demand: net exports
• Equilibrium real exchange rate, E
– Equilibrium real interest rate, r
• Price of goods and services in the present
– Relative to goods and services in the future
– Equilibrium real exchange rate, E
• Price of domestic goods and services
– Relative to foreign goods and services
16

Equilibrium in the Open Economy
• Simultaneous equilibrium in two markets
•
– To balance supply and demand
• In both markets
– Loanable funds
– Foreign-currency exchange
– Determine
• National saving
• Domestic investment
• Net capital outflow
• Net exports
17

Figure 4
The real equilibrium in an open economy
(a) The Market for Loanable Funds (b) Net Capital Outflow
Real
Interest
Rate
Supply
Real
Interest
Rate r
1 r
1
Demand
Net capital outflow, NCO
Quantity of
Loanable Funds
Net capital outflow
In panel (a), the supply and demand for loanable funds determine the real interest rate.
In panel (b), the interest rate determines net capital outflow, which provides the supply of dollars in the market for foreign-currency exchange.
In panel (c), the supply and demand for dollars in the market for foreign-currency exchange determine the real exchange rate.
Real
Exchange
Rate
E
1
Supply
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
18

How Policies & Events Affect an Open Economy
• Government budget deficits
• Negative public saving
• Reduces national saving
• Reduces supply of loanable funds
• Increase in interest rate
• Reduces net capital outflow
• Crowd-out domestic investment
• Decrease in supply of foreign-currency exchange
• Exchange rate appreciates
• Net exports fall
• Push the trade balance toward deficit
19

Figure 5
The effects of a government budget deficit
(a) The Market for Loanable Funds (b) Net Capital Outflow
Real
Interest
Rate r r
2
1
S
2
B
1. A budget deficit reduces the supply of loanable funds . . .
A
S
1
2. . . . which increases the real
Demand interest
Quantity of rate . . .
Loanable Funds
When the government runs a budget deficit, it reduces the supply of loanable funds from S
1 to
S
2 in panel (a). The interest rate rises from r
1 to r to balance the supply and demand for loanable
2 funds. In panel (b), the higher interest rate reduces net capital outflow. Reduced net capital outflow, in turn, reduces the supply of dollars in the market for foreign-currency exchange from S
1 to S
2 in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate from
E
1 to E
2
. The appreciation of the exchange rate pushes the trade balance toward deficit.
Real
Interest
Rate
E
E r r
2
1
Real
Exchange
Rate
2
1
5. . . . Which causes the real exchange rate to appreciate.
S
2
S
1
3. . . . which in turn reduces net capital outflow.
NCO
Net capital outflow
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
20

How Policies & Events Affect an Open Economy
• Trade policy
– Government policy
– Directly influences the quantity of goods and services
• That a country imports or exports
– Tariff
• Tax on imports
– Import quota
• Limit on quantity of imports
21

How Policies & Events Affect an Open Economy
• Trade policy
•
• Decrease imports
• Increase in net exports
• Increase in demand for foreign-currency exchange
• Real exchange rate appreciates
– Discourage exports
• No change in real interest rate
• No change in net capital outflow
• No change in net exports
22

Figure 6
The effects of an import quota
(a) The Market for Loanable Funds
Real
Interest
Rate
Supply
Real
Interest
Rate
(b) Net Capital Outflow
3. Net exports, however, remain the same.
r
1 r
1
Demand
NCO
Quantity of Loanable Funds
When the U.S. government imposes a quota on the import of Japanese cars, nothing happens in the market for loanable funds in panel (a) or to net capital outflow in panel (b). The only effect is a rise in net exports (exports minus imports) for any
Real
Exchange
Rate
E
2 given real exchange rate. As a result, the demand for dollars in the market for foreign-currency
E
1 exchange rises, as shown by the shift from D
1
D
2 to in panel (c). This increase in the demand for dollars causes the value of the dollar to appreciate from E
1 to E
2
. This appreciation of the dollar tends to reduce net exports, offsetting the direct effect of the import quota on the trade balance.
Supply
Net capital outflow
2. . . . And causes the real exchange rate to appreciate.
D
1
D
2
1. An import quota increases the demand for dollars . . .
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
23

How Policies & Events Affect an Open Economy
• Trade policy
•
– Trade policies do not affect the U.S. trade balance
• NX = NCO = S – I
– Trade policies affect specific
• Firms
• Industries
• Countries
24

How Policies & Events Affect an Open Economy
• Political instability and capital flight
•
– Leads to capital flight
•
– Large and sudden reduction in the demand for assets located in a country
25

How Policies & Events Affect an Open Economy
•
– Investors
• Sell Mexican assets & Buy U.S. assets
– Net-capital-outflow curve – increases
• Supply of pesos in the market for foreigncurrency exchange – increases
– Demand curve in the market for loanable funds – increases
– Interest rate – increases
– The peso – depreciates
26

Figure 7
The effects of capital flight
(a) The Market for Loanable Funds in Mexico
Real
Interest
Rate
D
1
D
2
3. . . . Which increases the interest rate.
Supply
Real
Interest
Rate r
2 r
2 r
1 r
1
(b) Mexican Net Capital Outflow
1. An increase in net capital outflow . . .
2. . . . increases the demand for loanable funds . . .
NCO
2
NCO
1
Quantity of Loanable Funds Net capital outflow
If people decide that Mexico is a risky place to keep their savings, they will move their capital to safer havens such rate, that curve also shifts to the right from NCO
1
NCO
2 to in panel (b). At the same time, in the market for foreign-currency exchange, the supply of pesos rises
Real as the U.S., resulting in an increase in Mexican net Exchange capital outflow. The demand for loanable funds in
Mexico rises from D
1 to D
2
, as shown in panel (a), and this drives up the Mexican real interest rate from r
1 to r
2
.
Because net capital outflow is higher for any interest
Rate
E
1
E
2 from S
1 to S
2
, as shown in panel (c). This increase in the supply of pesos causes the peso to depreciate from E
1 to E
2
, so the peso becomes less valuable compared to other currencies.
S
1
S
2
4. At the same time, the increase in net capital outflow increases the supply of pesos . . .
5. . . . which causes the peso to depreciate
Demand
Quantity of Pesos
(c) The Market for Foreign-Currency Exchange
27

Capital flows from China
• Nation that experiences capital flight
– Outflow of capital
– Its currency weaken in foreign exchange markets
• Depreciation
– Increases the nation’s net exports
• Nation that experiences inflow of capital
– Its currency strengthen
• Appreciation
– Pushes its trade balance toward deficit
28

Capital flows from China
• A nation’s government – policy:
– Encourages capital to flow to another country
• By making foreign investments itself
– Effect?
• Nation encouraging capital outflows
– Weaker currency
– Trade surplus
• For the recipient of capital flows
– Stronger currency
– Trade deficit
29

Capital flows from China
• Ongoing policy disputes: U.S. and China
– China – tried to depress its currency (renminbi) in foreign exchange markets
• Promote its export industries
• Accumulate foreign assets
– Including U.S. government bonds
– In 2007: $1.5 trillion
• Chinese goods - less expensive
• Contributes to the U.S. trade deficit
• Hurts American producers who make products that compete with imports from China
30

Capital flows from China
• Ongoing policy disputes: U.S. and China
– U.S. government
• Encouraged China to stop influencing the exchange value of its currency
– Impact of the Chinese policy on the U.S. economy
• American consumers of Chinese imports
– Benefit from lower prices
• Inflow of capital from China
– Lowers U.S. interest rates
– Increases investment in the U.S. economy
– Chinese government - financing U.S. economic growth
31

Capital flows from China
• Chinese policy of investing in U.S. economy
– Creates winners and losers among Americans
– Net impact on U.S. economy - probably small
• Motives behind the policy
– China - wants to accumulate a reserve of foreign assets
• National “rainy-day fund”
– Misguided policy
32