A Macroeconomic Theory

of the Open Economy

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University

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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)
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Market for Loanable Funds

When NCO > 0
Net outflow of capital
Net purchase of capital overseas
Adds to the demand for domestically generated

loanable funds

When NCO < 0

Net inflow of capital
Capital resources coming from abroad
Reduce the demand for domestically generated

loanable funds
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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

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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

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Market for Loanable Funds

Higher real interest rate
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

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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
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Figure 1
The Market for Loanable Funds
Real
Interest
Rate

Supply of loanable funds

(from national saving)

Equilibrium
real interest
rate

Equilibrium
quantity

Demand for loanable

funds (for domestic
investment and net
capital outflow)
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 and foreign assets.
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Foreign-Currency Exchange
The market for foreign-currency exchange
Identity: NCO = NX
Net capital outflow = Net exports

If trade surplus, NX > 0

Exports > Imports
Net sale of goods ad services abroad
Americans use the foreign currency to buy
foreign assets
Capital is flowing abroad, NCO > 0
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Foreign-Currency Exchange
If trade deficit, NX < 0
Imports > Exports
Some of this spending - financed by
selling American assets abroad
Foreign capital is flowing into U.S.
NCO < 0

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10

Foreign-Currency Exchange
Supply of foreign-currency exchange
Net capital outflow
Quantity of dollars supplied to buy foreign

assets

Supply curve vertical

Quantity of dollars supplied for net capital

outflow
Does not depend on the real exchange rate

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Foreign-Currency Exchange
Demand for foreign-currency exchange
Net exports
Quantity of dollars demanded to 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

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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

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13

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)
Equilibrium
quantity

Quantity of Dollars Exchanged

into Foreign Currency

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
people demand to buy net exports.
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14

Equilibrium in the Open Economy

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

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15

Exhibit 3
How Net Capital Outflow Depends on the Interest Rate
Real
Interest
Rate

Net capital outflow 0 Net capital outflow Net Capital

Outflow
is negative
is positive

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.
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16

Equilibrium in the Open Economy

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
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17

Equilibrium in the Open Economy

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

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18

Equilibrium in the Open Economy

Equilibrium real exchange rate, E
Price of domestic goods and services
Relative to foreign goods and services

E and r - adjust simultaneously

To balance supply and demand
In both markets
Loanable funds
Foreign-currency exchange

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19

Equilibrium in the Open Economy

E and r - adjust simultaneously
Determine
National saving
Domestic investment
Net capital outflow
Net exports

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Figure 4
The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds
Real
Interest
Rate

Supply

(b) Net Capital Outflow

Real
Interest
Rate

r1

r1

Net capital
outflow, NCO

Demand
Quantity of
Loanable Funds
In panel (a), the supply and demand for
loanable funds determine the real interest
rate. In panel (b), the interest rate
determines net 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.

Net capital outflow

Real
Exchange
Rate

Supply

E1

Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange

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21

Government Budget Deficits

Government budget deficits
When government spending exceeds
government revenue
Negative public saving
Reduces national saving
Reduces supply of loanable funds
Increase in interest rate
Reduces net capital outflow
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22

Government Budget Deficits

Government budget deficits
Crowd-out domestic investment
Decrease in supply of foreign-currency
exchange
Currency appreciates
Net exports fall
Push the trade balance toward deficit

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23

Exhibit 5
The Effects of a Government Budget Deficit
(b) Net Capital Outflow

(a) The Market for Loanable Funds

Real
Interest
Rate

r2
r1
2. . . . which
increases the
real interest
rate . . .

1. A budget deficit reduces the

supply of loanable funds . . .

S2
B

S1

Real
Interest
Rate

r2

3. . . . which in
turn reduces net
capital outflow.

r1

Demand

Quantity of 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.

NCO
Real Exchange
Rate

E2
E1
5. . . . Which
causes the real
exchange rate
to appreciate.

Net capital outflow

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

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24

Trade Policy
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
Voluntary export restrictions

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25

Trade Policy
Macroeconomic impact of trade policy
Decrease imports
Increase in net exports
Increase in demand for dollars in the
market for foreign-currency exchange
Real exchange rate appreciates
Discourage exports

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26

Trade Policy
Macroeconomic impact of trade policy
No change in real interest rate
No change in net capital outflow
No change in net exports
Decrease in imports
Decrease in exports

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27

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

3. Net exports,
however, remain
the same.

NCO

Quantity of Loanable Funds

Net capital outflow
Real Exchange
When the U.S. government imposes a quota on the
Rate
2. . . . And causes
import of Japanese cars, nothing happens in the market
Supply
the real exchange
for loanable funds in panel (a) or to net capital outflow
rate to appreciate.
in panel (b). The only effect is a rise in net exports
E2
(exports minus imports) for any given real exchange
E1
rate. As a result, the demand for dollars in the market
for foreign-currency exchange rises, as shown by the
D2
shift from D1 to D2 in panel (c). This increase in the
1.
An
import
quota
demand for dollars causes the value of the dollar to
D1
increases
the
demand
appreciate from E1 to E2. This appreciation of the dollar
for dollars . . .
tends to reduce net exports, offsetting the direct effect
Quantity of Dollars
of the import quota on the trade balance.
(c) The Market for Foreign-Currency Exchange
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28

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

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29

Political Instability &Capital Flight

Political instability
Leads to capital flight

Capital flight
Large and sudden reduction in the
demand for assets located in a country

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30

Political Instability &Capital Flight

Mexico - capital flight affects both markets
1994, political instability
Investors capital flight
Sell Mexican assets
Buy U.S. assets, safe haven

Net-capital-outflow curve increases

Supply of pesos in the market for foreign-

currency exchange increases

Demand curve in the market for loanable

funds increases
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31

Political Instability &Capital Flight

Mexico - capital flight affects both markets
Interest rate in Mexico increases
Reduce domestic investment
Slows capital accumulations
Slows economic growth

The peso depreciates

Exports cheaper

Imports - more expensive

Trade balance moves toward surplus
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32

Figure 7
The Effects of Capital Flight
(a) The Market for Loanable Funds in Mexico
Real
Real
D2
Interest
Interest
Rate
Rate
Supply
D1
r2
r2

1. An increase
in net capital
outflow . . .

r1

r1
3. . . . Which
increases
the interest
rate.

(b) Mexican Net Capital Outflow

2. . . . increases the demand

for loanable funds . . .
Quantity of Loanable Funds

NCO1

NCO2

Net capital outflow

If people decide that Mexico is a risky place to keep their Real Exchange
4. At the same
savings, they will move their capital to safer havens such Rate
S
S
1
2 time, the increase
as the U.S., resulting in an increase in Mexican net capital
in net capital
outflow. Consequently, the demand for loanable funds in
Mexico rises from D1 to D2, as shown in panel (a), and this
outflow increases
drives up the Mexican real interest rate from r1 to r2.
the supply of
E1
Because net capital outflow is higher for any interest rate,
pesos . . .
E2
that curve also shifts to the right from NCO1 to NCO2 in
panel (b). At the same time, in the market for foreign5. . . . which
Demand
currency exchange, the supply of pesos rises from S1 to
causes the peso
S2, as shown in panel (c). This increase in the supply of
to depreciate
Quantity of Pesos
pesos causes the peso to depreciate from E1 to E2, so the
peso becomes less valuable compared to other currencies. (c) The Market for Foreign-Currency Exchange
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33

Political Instability &Capital Flight

Mexico - capital flight affects both markets
U.S. market
Fall in U.S. net capital outflow
The dollar appreciates in value
U.S. interest rates fall
Relatively small impact on the U.S. economy
Because the economy of the United States is so
large compared to that of Mexico

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34

Capital flows from China

Nation that experiences capital flight

Outflow of capital
Its currency weaken in foreign exchange
markets
Depreciation

Increases the nations net exports

Nation that experiences inflow of capital

Its currency strengthen
Appreciation

Pushes its trade balance toward deficit

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35

Capital flows from China

A nations 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
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36

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, $2.4 trillion, 2009
Including U.S. government bonds

Chinese goods - less expensive

Contributes to the U.S. trade deficit
Hurts American producers who make
products that compete with imports from
China
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37

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

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

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38

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
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39