Transcript A Macroeconomic Theory of the Open Economy

A Macroeconomic Theory
of the Open Economy
Week 9
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Pengantar Ekonomi 2
Key Macroeconomic Variables
in an Open Economy
u
The important macroeconomic
variables of an open economy include:
u
u
u
u
2
net exports
net foreign investment
nominal exchange rates
real exchange rates
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Basic Assumptions of a Macroeconomic Model of
an Open Economy
u The model takes the economy’s GDP
as given.
u The model takes the economy’s price
level as given.
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The Market for Loanable Funds
S = I + NFI
u At the equilibrium interest rate, the amount
that people want to save exactly balances
the desired quantities of investment and
net foreign investment.
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The Market for Loanable Funds
u The supply of loanable funds comes from
national saving (S).
u The demand for loanable funds comes from
domestic investment (I) and net foreign
investment (NFI).
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The Market for Loanable Funds
u
u
u
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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.
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The Market for Loanable Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate
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Demand for loanable
funds (for domestic
investment and net
foreign investment)
Equilibrium
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quantity
Quantity of
Loanable Funds
The 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.
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The Market for Foreign-Currency
Exchange
u
u
u
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The two sides of the foreign-currency exchange
market are represented by NFI and NX.
NFI represents the imbalance between the
purchases and sales of capital assets.
NX represents the imbalance between exports
and imports of goods and services.
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The Market for Foreign-Currency
Exchange
u
u
In the market for foreign-currency exchange,
U.S. dollars are traded for foreign currencies.
For an economy as a whole, NFI and NX must
balance each other out, or:
NFI = NX
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The Market for Foreign-Currency
Exchange
The price that balances the supply
and demand for foreign-currency is
the real exchange rate.
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The Market for Foreign-Currency
Exchange
u
u
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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 foreign
investment is unrelated to the real exchange
rate.
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The Market for Foreign-Currency
Exchange...
Real
Exchange
Rate
Supply of dollars
(from net foreign investment)
Equilibrium
real exchange
rate
Demand for dollars
(for net exports)
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Equilibrium
Quantity of Dollars Exchanged
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quantity
into Foreign Currency
The Market for Foreign-Currency
Exchange
u
u
14
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.
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Equilibrium in the Open Economy
u
u
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In the market for loanable funds, supply
comes from national saving and demand
comes from domestic investment and net
foreign investment.
In the market for foreign-currency exchange,
supply comes from net foreign investment
and demand comes from net exports.
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Equilibrium in the Open Economy
u Net foreign investment links the
loanable funds market and the foreigncurrency exchange market.
u
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The key determinant of net foreign
investment is the real interest rate.
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How Net Foreign Investment Depends on
the Interest rate...
Real
Interest
Rate
0
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Net foreign investment is
Net foreign investment is
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negative.
positive.
Net Foreign
Investment
Equilibrium in the Open Economy
u
u
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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.
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The Real Equilibrium in an Open Economy
Real
Interest
Rate
(a) The Market for Loanable Funds
(b) Net Foreign Investment
Real
Supply Interest
Rate
r1
r1
Net foreign
investment,
NFI
Demand
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
Supply
E1
Demand
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Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
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How Changes in Policies and Events Affect
an Open Economy
u The magnitude and variation in
important macroeconomic variables
depend on the following:
u
u
u
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Government budget deficits
Trade policies
Political and economic stability
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Government Budget Deficits
u In an open economy, government budget
deficits . . .
reduces the supply of loanable funds,
drives up the interest rate,
crowds out domestic investment,
cause net foreign investment to fall.
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The Effects of Government Budget Deficit
Real
Interest
Rate
(a) The Market for Loanable Funds
S2
(b) Net Foreign Investment
Real
Interest
Rate
r2
S1
B
r2
3. ...which in
turn reduces
net foreign
investment.
A
r1
r1
Demand
1. A budget deficit
reduces the supply
of loanable funds...
2. ...which
increases the
real interest...
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
E2
5. …which causes the
real exchange
rate to appreciate.
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NFI
E1
S2
S1
4. The decrease in
net foreign
investment
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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Effect of Budget Deficits on the Loanable
Funds Market
u A government budget deficit reduces
national saving, which . . .
. . . shifts the supply curve for loanable
funds to the left, which
. . . raises interest rates.
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Effect of Budget Deficits on Net Foreign
Investment
u Higher interest rates reduce net
foreign investment.
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Effect on the Foreign-Currency Exchange
Market
u A decrease in net foreign investment
reduces the supply of dollars to be
exchanged into foreign currency.
u This causes the real exchange rate to
appreciate.
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Trade Policy
u
u
u
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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.
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Trade Policy
u
Because they do not change national saving or
domestic investment, trade policies do not
affect the trade balance.
u
u
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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.
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Effect of an Import Quota
u
Because foreigners need dollars to buy U.S.
net exports, there is an increased demand for
dollars in the market for foreign-currency.
u
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This leads to an appreciation of the real exchange
rate.
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Effect of an Import Quota
u
u
u
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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.
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Effect of an Import Quota
u
u
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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.
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The Effects of an Import Quota
Real
Interest
Rate
(a) The Market for Loanable Funds
(b) Net Foreign Investment
Real
Interest
Rate
S1
r1
3. Net exports,
however, remain
the same.
r1
NFI
Demand
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
2. …and causes
the real exchange
rate to appreciate.
E2
Supply
1. An import
quota increases
the demand for
dollars…
E1
Demand
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Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
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Effect of an Import Quota
Trade policies do not affect
the trade balance.
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Political Instability and Capital Flight
Capital flight is a large and sudden
movement of funds out of a country,
usually due to political instability.
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Political Instability and Capital Flight
u Capital flight has its largest impact on the
country from which the capital is fleeing, but
it also affects other countries.
u If investors become concerned about the
safety of their investments, capital can quickly
leave an economy.
u Interest rates increase and the domestic
currency depreciates.
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Political Instability in Mexico and
Capital Flight
u
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When investors around the world observed
political problems in Mexico in 1994, they
sold some of their Mexican assets and used
the proceeds to buy assets of other
countries.
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Political Instability in Mexico and
Capital Flight
u
This increased Mexican net foreign
investment.
u
u
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The demand for loanable funds in the loanable
funds market increased, which increased the
interest rate.
This increased the supply of pesos in the
foreign-currency exchange market.
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The Effects of Capital Flight
Real
Interest
Rate
(a) The Market for Loanable Funds
(b) Mexican Net Foreign Investment
r2
Real
Interest
Rate
r2
r1
r1
S1
NFI1
NFI1
1. An increase in
net foreign
investment...
D2
D1
3. …which
increases
the
interest
rate.
2. …increases the
demand for
loanable funds...
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
E1
5. …which causes the
real exchange
rate to appreciate.
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S1
S2
4. At the same
time, the increase
in net foreign
investment
increases the
supply of pesos...
E2
Demand
Quantity of Pesos
(c) The Market for Foreign-Currency Exchange
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Summary
u To analyze the macroeconomics of open
economies, two markets are central – the
market for loanable funds and the market for
foreign-currency exchange.
u In the market for loanable funds, the interest
rate adjusts to balance supply for loanable
funds (from national saving) and demand for
loanable funds (from domestic investment
and net foreign investment).
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Summary
u In the market for foreign-currency
exchange, the real exchange rate adjusts to
balance the supply of dollars (for net
foreign investment) and the demand for
dollars (for net exports).
u Net foreign investment is the variable that
connects the two markets.
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Summary
u A policy that reduces national saving, such as
a government budget deficit, reduces the
supply of loanable funds and drives up the
interest rate.
u The higher interest rate reduces net foreign
investment, reducing the supply of dollars.
u The dollar appreciates, and net exports fall.
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Summary
u A trade restriction increases net exports and
increases the demand for dollars in the market
for foreign-currency exchange.
u As a result, the dollar appreciates in value,
making domestic goods more expensive
relative to foreign goods.
u This appreciation offsets the initial impact of
the trade restrictions on net exports.
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Summary
u When investors change their attitudes about
holding assets of a country, the ramifications
for the country’s economy can be profound.
u Political instability in a country can lead to
capital flight.
u Capital flight tends to increase interest rates
and cause the country’s currency to
depreciate.
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