ETP Economics 102
Jack Wu
Key Macroeconomic Variables
 The important macroeconomic variables of an open
economy include:
 net exports
 net foreign investment
 nominal exchange rates
 real exchange rates
Net Foreign Investment
 Foreign investment includes foreign direct investment
and foreign portfolio investment.
 Direct investment: physical capital such as factory,
office, and so on.
 Portfolio investment: financial asset such as currency,
stock, bond and so on.
 Net foreign investment = outbound foreign investment
– inbound foreign investment
 Net foreign investment = Net capital outflow
Basic Assumptions
 The model takes the economy’s GDP as given.
 The model takes the economy’s price level as given.
Market for Loanable Funds
 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).
Market for Loanable Funds
 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.
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
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Equilibrium in Market for Loanable
Funds
 At the equilibrium interest rate, the amount that
people want to save exactly balances the desired
quantities of domestic investment and net foreign
investment (net capital outflow).
Foreign-Currency Exchange Market
 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
Foreign-Currency Exchange Market
 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 price that balances the supply and demand for
foreign-currency is the real exchange rate.
Foreign-Currency Exchange Market
 The demand curve for foreign currency 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.
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 Foreign-Currency
Exchange 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.
Equilibrium in 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.
Equilibrium in Open Economy
 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.
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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Equilibrium in Open Economy
 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.
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
Policies
 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.
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
Effects
 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.
Effects
 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.
Trade Policy
 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.
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
Effects
 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.
Effects
 Effect of an Import Quota
 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.
Effects
 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.
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.
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
Discussion
 Which of the following could be a consequence of an
appreciation of the U.S. real exchange rate?

a.
John, a French citizen, decides that Iowa
pork has become too expensive and cancels his order.

b.
Nick, a U.S. citizen, decides that his trip to
Nepal would be too costly and cancels his trip.

c.
Roberta, a U.S. citizen, decides to import
fewer windshield wipers for her auto parts company.

d.
All of the above are correct.
Discussion
 Which of the following is included in the supply of
dollars in the market for foreign-currency exchange in
the open-economy macroeconomic model?

a.
A retail outlet in Afghanistan wants to buy
watches from a U.S. manufacturer.

b.
A U.S. bank loans dollars to Blair, a U.S.
resident, who wants to purchase a new car made in the
United States.

c.
A U.S. based mutual fund wants to
purchase stocks issued by a Polish company.

d.
All of the above are correct.
Discussion
 In the open-economy macroeconomic model, the quantity of




dollars demanded in the foreign-currency exchange market
a.
depends on the real exchange rate. The quantity of
dollars supplied in the foreign-exchange market depends on the real
interest rate.
b.
depends on the real interest rate. The quantity of
dollars supplied in the foreign-exchange market depends on the real
exchange rate.
c.
and the quantity of dollars supplied in the foreigncurrency exchange market depend on the real exchange rate.
d.
and the quantity of dollars supplied in the foreigncurrency exchange market depend on the real interest rate.
Discussion
 Which of the following contains a list only of things
that increase when the budget deficit of the U.S.
increases?

a.
U.S. supply of loanable funds, U.S. interest
rates, U.S. domestic investment

b.
U.S. imports, U.S. interest rates, the real
exchange rate of the dollar

c.
U.S. interest rates, the real exchange rate of
the dollar, U.S. domestic investment

d.
the real exchange rate of the dollar, U.S. net
capital outflow, U.S. net exports
Discussion
 Which of the following is included in the demand for
dollars in the market for foreign-currency exchange in
the open-market macroeconomic model?

a.
A firm in Kenya wants to buy wheat from a
U.S. firm.

b.
A Japanese bank desires to purchase U.S.
Treasury securities.

c.
An U.S. citizen wants to buy a bond issued
by a Mexican corporation.

d.
All of the above are correct.
Discussion
 An increase in the U.S. real interest rate induces

a.
Americans to buy more foreign assets, which
increases U.S. net capital outflow.

b.
Americans to buy more foreign assets, which
reduces U.S. net capital outflow

c.
foreigners to buy more U.S. assets, which
reduces U.S. net capital outflow.

d.
foreigners to buy more U.S. assets, which
increases U.S. net capital outflow.
Discussion
 An increase in the interest rate causes investment to




a.
b.
c.
d.
rise and the exchange rate to appreciate.
fall and the exchange rate to depreciate.
rise and the exchange rate to depreciate.
fall and the exchange rate to appreciate.