PowerPoint Presentations for
Principles of Macroeconomics
Sixth Canadian Edition
by Mankiw/Kneebone/McKenzie
Adapted for the
Sixth Canadian Edition by
Marc Prud’homme
University of Ottawa
A MACROECONOMIC
THEORY OF THE
SMALL OPEN
ECONOMY
Chapter 13
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A MACROECONOMIC THEORY OF
THE SMALL OPEN ECONOMY
 The goal of the model in this chapter is to
highlight the forces that determine the
economy’s trade balance and exchange rate.
 To understand what factors determine a
country’s trade balance and how government
policies can affect it, we need a
macroeconomic theory of the small open
economy.
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A MACROECONOMIC THEORY OF
THE SMALL OPEN ECONOMY
Assumptions for our small open economy
model:
1. The level of GDP is a given.
2. The price level is fixed.
3. The real interest rate is equal to the world
interest rate and is taken as given.
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SUPPLY AND DEMAND FOR LOANABLE FUNDS
AND FOR FOREIGN-CURRENCY EXCHANGE
The focus is on supply and demand on
two markets to understand the forces at
work in an open economy:
Market for loanable funds
Market for foreign currency exchange
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The Market for Loanable Funds
 The place to start to understand the market for
loanable funds in a small open economy is with
this identity:
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The Market for Loanable Funds
 Recall that in a small open economy with perfect
capital mobility (e.g., Canada), the domestic interest
rate will equal the world interest rate.
 The market for loanable funds in a small open
economy with perfect capital mobility is different
from that in a closed economy.
 The interest rate is no longer determined by the
demand and supply of loanable funds.
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FIGURE 13.1:
The Market for Loanable Funds
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The Market for Loanable Funds
 The quantity of loanable funds made available by the
savings of Canadians does not have to equal the
quantity of loanable funds demanded for domestic
investment.
 The difference between these two amounts is net
capital outflow.
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The Market for Foreign-Currency Exchange
 The market for foreign exchange exists
because people want to trade goods, services,
and financial assets with people in other
countries, but they want to be paid for these
things in their own currency.
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The Market for Foreign-Currency Exchange
 To understand the market for foreign-currency
exchange …
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The Market for Foreign-Currency Exchange
 We can view the two sides of this identity as representing
the two sides of the market for foreign-currency exchange.
 The difference between national saving and domestic
investment represents net capital outflow.
 This difference, then, represents the quantity of dollars
supplied in the market for foreign-currency exchange for
the purpose of buying foreign assets.
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The Market for Foreign-Currency Exchange
 What price balances the supply and demand
in the market for foreign-currency exchange?
 The real exchange rate
 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.
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FIGURE 13.2:
The Market for Foreign-Currency Exchange
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The Market for Foreign-Currency Exchange
 The division of transactions between “supply”
and “demand” in this model is somewhat
artificial.
 In our model, net exports are the source of the
demand for dollars, and net capital outflow is
the source of the supply.
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QuickQuiz
Describe the sources of supply and
demand in the market for loanable funds
and the market for foreign-currency
exchange.
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EQUILIBRIUM IN
THE SMALL OPEN ECONOMY
 Let’s now consider how the market for
loanable funds and the market for foreigncurrency exchange are related to each other.
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Net Capital Outflow:
The Link Between the Two Markets
 So far, we have discussed how the economy
coordinates four important macroeconomic
variables:
1.
2.
3.
4.
National saving (S)
Domestic investment (I)
Net capital outflow (NCO)
Net exports (NX)
 NCO is the variable that links these two markets.
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FIGURE 13.3:
The Real Equilibrium in a Small Open Economy
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QuickQuiz
In the model of the small open economy
just developed, two markets determine one
price and the value of three variables.
What are the markets?
What three variables are determined?
What price is determined?
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Active Learning
The Budget Deficit, Exchange Rate, and NX
 Initially, the government budget is balanced
and trade is balanced (NX = 0).
 Suppose the government runs a budget
deficit. As we saw earlier, r rises and NCO falls.
 How does the budget deficit affect the
Canadian real exchange rate? The balance
of trade?
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Active Learning
Answers
The budget deficit
reduces NCO and
the supply of dollars.
Market for foreign-currency exchange
E
The real exchange
rate appreciates,
reducing net
exports.
S2 =
NCO2
S1 =
NCO1
E2
E1
Since NX = 0 initially,
the budget deficit
causes a trade
deficit (NX < 0).
D=
NX
Dollars
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HOW POLICIES AND EVENTS
AFFECT A SMALL OPEN ECONOMY
 When using the model to analyze any event,
we can apply the same three steps outlined in
Chapter 4.
1. Determine which of the supply and demand
curves the event affects.
Xin Qiu/Shutterstock
2. Determine which way the curves shift.
3. Use the supply-and-demand diagrams to
examine how these shifts alter the
economy’s equilibrium.
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Increase in World Interest Rates
 Canadians have good reason to closely watch
movements in world interest rates. Why?
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FIGURE 13.4:
The Effects of an Increase in the World Interest Rate
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Government Budget
Deficits and Surpluses
 In a closed economy, a government budget
deficit reduces the supply of loanable funds,
drives up the domestic interest rate, and
crowds out investment.
 What is the effect of a government budget
deficit in an open economy?
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FIGURE 13.5:
The Effects of an Increase in the Government Budget Deficit
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Government Budget
Deficits and Surpluses
 In a small open economy with perfect capital
mobility, a decrease in government budget
deficits causes the dollar to depreciate and
causes net exports to rise.
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Trade Policy
 Trade policy: a government policy that directly
influences the quantity of goods and services that a
country imports or exports
 Tariff: a tax on goods produced abroad and sold
domestically
 Import quota: a limit on the quantity of a good that is
produced abroad and sold domestically
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FIGURE 13.6:
The Effects of an Import Quota
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Trade Policy
Trade policies do not affect the trade
balance.
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Political Instability and Capital Flight
Capital flight: a large
and sudden
reduction in the
demand for assets
located in a country
Thinkstock
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FIGURE 13.7:
The Effects of Capital Flight
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Political Instability and Capital Flight
 Capital flight from Mexico increases Mexican interest rates
and decreases the value of the Mexican peso in the market
for foreign-currency exchange.
 These price changes that result from capital flight influence
some key macroeconomic quantities.
 Exports become cheaper
 Imports become more expensive
 Net exports increase.
 The interest rate increases.
 Capital accumulation slows
 Economic growth slows.
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QuickQuiz
Suppose that Canadians decided to spend
a smaller fraction of their incomes.
What would be the effect on saving,
domestic investment, net capital outflow,
the real exchange rate, and the trade
balance?
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Classroom Activity
•
•
•
•
•
Open Economy Article
Find an article in a recent newspaper or magazine illustrating a
change that will affect net capital outflow or net exports.
Explain how and why net capital outflow or net exports would
shift.
Use the market open-economy model (the market for loanable
funds and the market for foreign-currency exchange) to analyze
this change.
Graph the world real interest rate showing net capital outflow
and real exchange rate before the change. Then show how the
change will affect these variables.
Turn in a copy of the article along with your explanation.
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THE END
Chapter 13
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