Mankiw: Brief Principles of
Macroeconomics, Second Edition
(Harcourt, 2001)
Ch. 13: A Macroeconomic Theory of
the Open Economy
What Is To Come?
• We will concentrate on the long run.
– Real GDP is given.
• Labor, capital, technology.
– Price level is determined by supply and demand for
money.
• Savings and investments will be matched in the
market for loanable funds.
• NFI and NX will determine the real exchange
rate.
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Dr. Ugur Aker
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The Market for Loanable Funds
• This is the complete financial system.
• All savers go here to deposit (lend) their
savings.
• All borrowers go there to get loans.
• When funds lent matches funds borrowed
an equilibrium interest rate is reached.
• Equilibrium interest rate is the return on
saving and cost of borrowing.
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Dr. Ugur Aker
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Circular Flow Equilibrium
Y = C + I + G + NX
Y=C+S+T
C + S + T = C + I + G + NX
S + (T – G) = I + NX
Private Saving + Government Saving =
Investment + Net Exports
S + (T – G) = I + NFI
National Saving = Investment + Net Foreign
Investment
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Dr. Ugur Aker
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The Market for Loanable Funds
• Each dollar saved can be used to finance to
purchase domestic capital or an asset abroad.
• The supply of loanable funds comes from
national savings [S + (T – G)].
• The demand for loanable funds comes from
domestic investment (I) and net foreign
investment (NFI).
• If NFI is negative (capital inflow), the demand
would shift left.
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Dr. Ugur Aker
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The Market for Loanable Funds
• A higher real rate of interest encourages people
to save more.
– Supply in the loanable funds market is upward
sloping.
• Demand in the loanable funds market is
downward sloping.
– A higher real interest rate discourages investment
because of higher cost of borrowing.
– A higher real interest rate at home discourages net
foreign investment.
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Dr. Ugur Aker
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The Market for Loanable Funds
S+(T-G)
At r1, the quantity of funds
demanded (Ld1) exceeds the
quantity of funds supplied (Ls1).
Real interest rate will be forced
upward. At r2, the quantity of
I+NFI funds demanded (Ld2) falls far
short of quantity of funds supplied
(Ls2). Real interest rate will be
forced downward.
r2
r1
Ld2
Ls1
Ld1 Ls2
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The Forex Market
• Participants in this market exchange USD for
foreign currency.
• When net exports is positive (trade surplus), the
quantity of USD demanded will be positive.
• When net exports is negative (trade deficit), the
quantity of USD demanded will be negative.
• When NFI is positive (capital outflow), the
quantity supplied of USD is positive.
• When NFI is negative (capital inflow), the
quantity supplied of USD is negative.
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The Forex Market
NFI
Real
Exchange
Rate
NX
As the real exchange rate drops
(our currency depreciates), our
exports will increase and our
imports will decrease. NX will
rise. Since NFI has to match NX,
given the trade deficit in the graph,
NFI is also negative, indicating a
capital inflow into US. The real
exchange rate is determined through
the interaction of NX and NFI.
0
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The Forex Market
• NFI depends on the real interest rates in our economy
and abroad.
– R is not shown on the graph; so NFI is given for the Forex
graph.
• At equilibrium real exchange rate, the demand for
dollars by foreigners arising from US net exports
exactly balances the supply of dollars from Americans
arising from US NFI.
• At equilibrium real exchange rate, the supply of
dollars by Americans arising from negative US NX
exactly balances the demand of dollars by foreigners
arising from negative US NFI.
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Net Foreign Investment
Real
Interest
rate
The higher the real interest is in
our economy, the more foreigners
and Americans would keep their
savings in the US. The lower is
the real interest rate in US
economy, the more Americans and
foreigners would like to keep
their savings abroad.
-NFI
0
+NFI
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Simultaneous Equilibrium
Real
Interest
R
S+(T-G)
Rate, R
NFI
I+NFI
Loanable Funds
Real
Exchange
Rate
NFI
NX
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Using the Double Markets
• What happens when government deficit
increases?
• What happens when government has a
surplus?
• What happens when there is a tariff
increase?
• What happens when there is capital flight?
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Government Deficit
Real
Interest
R
S+(T-G)
Rate, R
NFI
I+NFI
Loanable Funds
Real
Exchange
Rate
NFI
NX
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Tariff or Quota
Real
Interest
R
S+(T-G)
Rate, R
I+NFI
Loanable Funds
Real
Exchange
Rate
NX
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Capital Flight
R
Real
Interest
Rate, R
Loanable Funds
Real
Exchange
Rate
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Questions
1. Japan usually runs a huge trade surplus. Using the
equilibrium condition in the loanable markets,
speculate what could be the reason for it.
2. “The president was clearly determined to signal that
the United States remains solidly on a course of
deficit reduction, which should make the dollar more
attractive to investors.” (The New York Times, April
14, 1995). Is this possible?
3. Suppose that Congress passes an investment tax
credit, which subsidizes domestic investment. Show
effects on S, NFI, I, R, NX, Real exchange rate.
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More Questions
1. In 1998 the Russian government defaulted on its debt
payments, leading investors worldwide to raise their
preference for US government bonds. What effect do you
think this “flight to safety” had on the US economy?
2. Especially in the 80s Japanese savings flowed into US to
finance US investments. What would happen to the US
economy if the Japanese no longer wanted to buy
American assets (or US NFI with Japan changed from
negative to positive)?
3. Can we eliminate the trade deficit by subsidizing exports?
4. What happens when real interest rates abroad increase?
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