A Macro Theory of
the Open Economy
Copyright © 2004 South-Western
32
Open Economies
• An open economy is one that interacts with
other economies around the world.
• The key macro variables:
•
•
•
•
net exports：NX
net foreign investment (net capital outflow：NCO)
nominal exchange rates：e
real exchange rates： (P/ePF).
Copyright © 2004 South-Western
A Macro Model of an Open Economy:
Basic Assumptions
• A simplified but workable model
• Takes GDP (Y and YF) as given:
(補充：exogenous 外生變數：模型外決定的變數)
排除Y對IM的影響，排除YF對EX的影響
• Takes price level (P and PF) as given:
Nominal and Real exchange rate: 1-1對應
eg, 台幣升值 e↓ <＝> (P/ePF) ↑
(△foreign goods/△domestic goods)↑
Copyright © 2004 South-Western
Two markets:
Markets for Loanable Funds
and for Foreign-Currency Exchange
1. The Market for Loanable Funds (LF)
S = I + NCO
• Supply of LF：SLF＝S
Demand for LF：DLF＝I+NCO
domestic investment and net capital outflows
(net foreign investment).
• The price in LF market is the real interest rate,
r=R-π.
Copyright © 2004 South-Western
Market for Loanable Funds
• SLF =S： (+)vely-slpoed，
Assume SE >IE, so r ↑→ S ↑
• DLF=I+NCO： (-) vely-slpoed，
As r ↑, I↓, NCO↓(r↑ relative rF , Fig 32.3)
• Market equilibrium:
The interest rate adjusts to bring supply and
demand for loanable funds into balance.
Copyright © 2004 South-Western
Fig 32.3
How Net Capital Outflow Depends on the Interest Rate
Real
Interest
Rate
NCO
Net capital outflow
is negative.
0
Net capital outflow
is positive.
Net Capital
Outflow
Copyright
© 2004 South-Western
Copyright©2003
Southwestern/Thomson
Learning
Figure 32.1 The Market for Loanable Funds
Real
Interest
Rate
SLF=S
r*
DLF=I+NCO
LF*
Quantity of
Loanable Funds
Copyright©2003 Southwestern/Thomson Learning
Market for Foreign-Currency Exchange
2. Market for Foreign-Currency Exchange (FE)
Assume FE =U.S. dollars
• Ch31: For an economy as a whole,
NCO = NX
 equilibrium condition of FE market
The price in FE market is the real exchange rate
(P/ePF).
• 課本圖形為對美金（本國貨幣）供需，
在此採用該圖形則為本國貨幣「台幣」的供需
Copyright © 2004 South-Western
The Market for Foreign-Currency Exchange
• DE= NX： (-) vely-slpoed ，
As (P/ePF) ↓, EX↑, IM↓, NX↑
NX↑: demand for NT$↑ in terms of US$
( 出口賺美金，將美金兌換為台幣，為台幣需求)
• SE =NCO： vertical，
NCO：由 r 與 rF 差異決定，
unrelated to the real exchange rate.
( 為購買美國資產，將台幣兌換為美金，為台幣供給)
• Market Equilibrium:
The real exchange rate adjusts to balance supply and demand
for dollars.
Copyright © 2004 South-Western
Figure 32.2
The Market for Foreign-Currency Exchange
Real
Exchange
Rate
Supply of NT dollars＝NCO
Equilibrium
(P/ePF)*
Demand for NT dollars
＝NX
Q*NT
Quantity of NT Dollars
In terms of US dollar
Copyright©2003 Southwestern/Thomson Learning
The Market for Foreign-Currency Exchange
• At (P/ePF)*, 同時決定 e* ( given P and PF)
DNT from net exports exactly balances
SNT to be exchanged into foreign currency to buy
assets abroad.
• Alternative(補充)：
也可以以外匯（美金）供需做圖，最終推論相同。
美金供需決定美金價格（匯率）
一體兩面：對台幣需求＝對美金供給
對台幣供給＝對美金需求
Consider NX↑ : D-S analysis  (P/ePF)*↑ and e*↓
Copyright © 2004 South-Western
Figure 32.2 Alternative representation (不採用):
The Market for Foreign-Currency Exchange
Nominal
Exchange rate
(e)
Demand for US dollars
(NCO)
Supply of US dollars
(NX)
Equilibrium
e*
Equilibrium
quantity
Quantity of FE
(US dollars)
Copyright
© 2004 South-Western
Copyright©2003
Southwestern/Thomson
Learning
Equilibrium in the Open Economy
Fig 32.4: Equilibrium in the Open Economy
• NCO links LF market and FE market. (圖b)
• r in LF market (圖a) and
(P/ePF) in FE market (圖c)
adjust simultaneously to achieve equilibrium
in these two markets.
• As they do, they determine the macro variables of S, I,
NX, and NCO.
補充：r, e, S, I, NX, NCO：endogenous 內生變數，
模型內決定的變數
Copyright © 2004 South-Western
Figure 32.4 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
Comparative Statics
• The magnitude and variation in open macro
variables depend on:
1. Government budget deficits
2. Trade policies
3. Political and economic stability
Copyright © 2004 South-Western
1. Government Budget Deficits: Sg < 0
(Fig 32.5)
(圖a) In an open economy, government budget deficits
(Sg < 0) reduce the supply of LF market：
S↓ SLF ↓  r*↑
I↓ and NCO↓
(圖b) Movement along with NCO curve
(圖c) Effect on FE Market
NCO↓ SE ↓: shifts to the left
 real exchange rate↑（課本符號 E↑）：升值
and also e*↓ (升值，P, PF as given )
E↑  NX↓
eg, Twin deficits (1980s US: Sg<0 and NX<0)
Copyright © 2004 South-Western
Fig 32.5 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
r
3. . . . which in
turn reduces
NCO
2. . . . which
Increases r
D
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 NCO reduces
the supply of dollars
to be exchanged
into foreign
currency . . .
D
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
2. Trade Policy 貿易政策
• A trade policy is a government policy that
directly influences the quantity of goods and
services that a country imports or exports.
• Tariff 關稅: A tax on an imported good.
• Import quota 進口配額: A limit on the quantity of
a good produced abroad and sold domestically.
Copyright © 2004 South-Western
Trade Policy: Effect of an Import Quota
(Fig 32.6)
Effect of an Import Quota
(圖a, b) S , I, and NCO: unaffected  r*：the same
(圖c) Initial IM↓  NX↑= DE↑: shifts to the right
 the real exchange rate to appreciate.
 NX↓( movement along DE2) = initial NCO
This offsets the initial increase in net exports due to
import quota.
• Trade policies do not affect the trade balance.
Trade policies have a greater effect on microeconomic
than on macroeconomic markets.
Copyright © 2004 South-Western
Fig 32.6 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. NX
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
D fo NT
dollars . . .
E
D
D
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
3. Political Instability and Capital Flight
資金外逃金融危機 (Fig 32.7)
• When an economy faces political instability,
capital flight may happen:
a large/ sudden reduction in D for the country’s assets .
eg, 1994 Capital Flight in Mexico
1997 Capital Flight in East Asia
 Capital is fleeing：NCO↑
(圖b, a) NCO↑ DLF↑ r*↑
(圖b ,c) NCO↑ SE↑ real exchange rate↓ e*↑
(the domestic currency depreciates.貨幣大幅貶值)
Copyright © 2004 South-Western
Fig 32.7 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 NCO
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 NCO
increases the
supply of pesos . . .
E
Demand
Quantity of
Pesos
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
Summary
Open Macro: two markets are central
1. The Market for Loanable Funds (LF)
S = I + NCO
2.The Market for Foreign-Currency Exchange (FE)
NCO = NX
Equilibrium in the Open Economy
• NCO links the LF market and FE market.
• r and real exchange rate adjust simultaneously to
achieve equilibrium in these two markets and they
determine the macro variables of S, I, NX, and NCO.
• Comparative Statics
Copyright © 2004 South-Western