Chapter
32
A Macroeconomic Theory
of the Open Economy
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
• Loanable funds - interpreted as
– Domestically generated flow of resources
available for capital accumulation
• Purchase of a capital asset
– 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
• Higher real interest rate
• 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
• Supply of loanable funds
– Slopes upward
• Demand of loanable funds
– Slopes downward
• At equilibrium interest rate
– 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
Demand for loanable
funds (for domestic
investment and net
capital outflow)
Equilibrium
quantity
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
6
and foreign assets.
Market for Foreign-Currency Exchange
• The market for foreign-currency exchange
– Identity: NCO = NX
– Net capital outflow = Net exports
• If trade surplus, NX > 0
– 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
• If trade deficit, NX < 0
– 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
• Supply of 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
• Demand 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
• Equilibrium real exchange rate
– 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)
Quantity of Dollars Exchanged
Equilibrium
into Foreign Currency
quantity
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
12
people demand to buy net exports.
Equilibrium in the Open Economy
• Net capital outflow: link between the two
markets
• Identities
– Market for loanable funds: S = I + NCO
– Market for foreign-currency exchange: NCO=NX
• Net-capital-outflow curve
– 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 0 Net capital outflow
is negative
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
• E and r - adjust simultaneously
– 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
(b) Net Capital Outflow
(a) The Market for Loanable Funds
Real
Interest
Rate
Supply
Real
Interest
Rate
r1
r1
Net capital
outflow, NCO
Demand
Quantity of
Loanable Funds
Net capital outflow
Real
Exchange
In panel (a), the supply and demand for
Rate
loanable funds determine the real interest rate.
In panel (b), the interest rate determines net
E1
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.
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
(b) Net Capital Outflow
(a) The Market for Loanable Funds
Real
Interest
Rate
r2
r1
1. A budget deficit reduces
the supply of loanable funds . . .
S2
B
Real
Interest
Rate
S1
A
2. . . .
which
increases
Demand
the real
interest
Quantity of
rate . . .
Loanable Funds
When the government runs a budget deficit, it
reduces the supply of loanable funds from S1 to
S2 in panel (a). The interest rate rises from r1 to r2
to balance the supply and demand for loanable
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 S1
to S2 in panel (c). This fall in the supply of dollars
causes the real exchange rate to appreciate from
E1 to E2. The appreciation of the exchange rate
pushes the trade balance toward deficit.
3. . . . which in
turn reduces
net capital
outflow.
r2
r1
NCO
Net capital outflow
Real
Exchange
Rate
E2
E1
5. . . . Which
causes the real
exchange rate
to appreciate.
S2 S1
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
• Macroeconomic impact of 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
(b) Net Capital Outflow
(a) The Market for Loanable Funds
Real
Interest
Rate
Supply
Real
Interest
Rate
r1
r1
Demand
Quantity of Loanable Funds
3. Net exports,
however, remain
the same.
NCO
Net capital outflow
Real
When the U.S. government imposes a quota on
the import of Japanese cars, nothing happens in Exchange
Supply
2. . . . And causes
Rate
the market for loanable funds in panel (a) or to net
the real exchange
capital outflow in panel (b). The only effect is a rise
E2
rate to appreciate.
in net exports (exports minus imports) for any
E1
given real exchange rate. As a result, the demand
1. An import
for dollars in the market for foreign-currency
D2 quota increases
exchange rises, as shown by the shift from D1 to
the demand for
D2 in panel (c). This increase in the demand for
D1
dollars . . .
dollars causes the value of the dollar to appreciate
from E1 to E2. This appreciation of the dollar tends
Quantity of Dollars
to reduce net exports, offsetting the direct effect of
(c) The Market for Foreign-Currency Exchange 23
the import quota on the trade balance.
How Policies & Events Affect an Open Economy
• Trade policy
• Macroeconomic impact of 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
• Political instability
– Leads to capital flight
• Capital flight
– Large and sudden reduction in the demand
for assets located in a country
25
How Policies & Events Affect an Open Economy
• Mexico - capital flight affects both markets
– 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
Real
3. . . . Which increases
D2
Interest
Interest
the interest rate.
Rate
Rate
Supply
D1
r2
r2
r1
r1
2. . . . increases the demand
for loanable funds . . .
Quantity of Loanable Funds
(b) Mexican Net Capital Outflow
1. An increase
in net capital
outflow . . .
NCO1
NCO2
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 Real
4. At the same time, the
S1
S2
as the U.S., resulting in an increase in Mexican net Exchange
increase in net capital
capital outflow. The demand for loanable funds in
Rate
outflow increases the
Mexico rises from D1 to D2, as shown in panel (a), and
supply of pesos . . .
this drives up the Mexican real interest rate from r1 to r2.
E1
Because net capital outflow is higher for any interest
5. . . . which causes
rate, that curve also shifts to the right from NCO1 to
E2
the peso to depreciate
NCO2 in panel (b). At the same time, in the market for
foreign-currency exchange, the supply of pesos rises
Demand
from S1 to S2, as shown in panel (c). This increase in the
supply of pesos causes the peso to depreciate from E1
Quantity of Pesos
to E2, so the peso becomes less valuable compared to
(c) The Market for Foreign-Currency Exchange 27
other currencies.
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