Transcript A Macroeconomic Theory of the Open Economy

A Macroeconomic Theory of
the Open-Economy
Outline:
 Develop a model to study forces that
determine the open economy
variables (NX, NFI, RER)
 How are these variables related to
one another?
Assumptions
 Real GDP is determined by factor
supplies and level of technology
 Economy’s price level is given
 Real interest rate equals world
interest rate due to perfect capital
mobility.
Supply and demand in the open
economy
 Market for loanable funds
 Market for foreign currency exchange
Market for loanable funds
 S=I+NFI
 Supply of loanable funds comes from
comes from national savings
 Demand for loanable funds comes
from domestic investment
 The difference between S and I at
world interest rate is the NFI
(savings by foreigners).
Market for loanable funds:
Conclusions
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Open economy
Interest rate =
world interest rate
NFI exists
because S is not
equal to I
NX is also
determined by the
difference in S
and I
• Closed economy
• Interest rate is
determined by
demand and
supply of loanable
funds
• S=I, NFI=0
• NX=0
The Market for Foreign-Currency
Exchange
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NFI=NX
S-I=NX
Imbalances on both sides of the equation
are equal
Positive NFI is the source for supply of
domestic currency (Canadian$) in the
foreign currency exchange market
Positive NX is the source of demand for
domestic currency (Canadian$) in the
foreign currency exchange market
The Market for Foreign-Currency
Exchange
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Real Exchange Rate (RER) adjusts to
balance the demand and supply of
domestic currency (Can$).
At the equilibrium RER, the demand for $
to buy net exports exactly balances the
supply of $ to be exchanged into foreign
currency to buy assets abroad.
What if the NFI is negative?
Simultaneous equilibrium in the
two markets
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We have studied coordination between 4
macro variables: S, I, NFI, and NX
NFI is the variable that links the two
markets together
 In the loanable funds market it is the
difference in the supply of loanable funds (S)
and demand for loanable funds (I) at the world
interest rate
 In the foreign currency exchange market
positive NFI determines the supply of domestic
currency.
Simultaneous equilibrium in the
two markets
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In the loanable funds market we
determine S and I, which are determined
by world interest rate and we determine
NFI.
In the foreign currency market we
determine the real exchange rate (= price)
which balances supply and demand for
domestic currency.
Together we have determined S, I, NFI,
and RER.
Policies affecting an open economy
 Increase in world interest rates:
Crowds out domestic investment and
increases NFI
Increases supply of domestic currency in
the foreign currency exchange market
RER depreciates, increasing NX.
Policies affecting an open economy
 Increase in government budget
deficit:
 Reduces supply of loanable funds and
crowds out domestic investment
 Decrease in NFI reduces the supply of
domestic currency in foreign-currency
exchange market
 RER appreciates and NX fall.
 What happens if there is a reduction in
budget deficit?
Policies affecting an open economy
 Increase in government budget
deficit: Impact
 Depreciation in domestic currency
benefits exporters and hurts importers
Policies affecting an open economy
 Trade policy:
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Trade policy is a government policy that
directly influences the quantity of goods
and services that a country imports or
exports.
Restrictive trade policy: Imposition of an
import quota
 Objective: to improve trade balance
Policies affecting an open economy
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Restrictive trade policy: Imposition of an
import quota
 No impact on loanable fund market. No
change in NFI.
 Import quota restricts imports and increases
NX for any given RER.
 Increase in demand for domestic currency
causes RER to appreciate.
 NX decline, canceling out the earlier increase.
Therefore, no change in NX.
 Trade policies do not affect trade balance.
Policies affecting an open economy
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Restrictive trade policy: Imposition of an
import quota
 Trade policies do not affect trade balance.
 Trade policies have microeconomic rather than
macroeconomic effects.
 Trade restrictions reduce gains from trade and
economic well-being.
Policies affecting an open economy
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Political instability and capital flight:
 Capital flight is a large and sudden reduction
in the demand for assets located in a country.
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Implications for the economy experiencing
capital flight:
 Savers to save the same amount of funds as
before (to capital flight) must receive a risk
premium in order to hold the domestic debt
 Borrowers must pay the risk premium in
addition to the world interest rate to halt capital
flight
 Supply of loanable funds remains same and
demand decreases, increasing NFI before sale of
domestic assets has been halted.
Policies affecting an open economy
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Political instability and capital flight
(continued):
Implications for the economy experiencing
capital flight:
 Increase in NFI, increases supply of domestic
currency (though in this case, a large portion of
the supply of domestic currency comes from
sale of domestic assets).
 RER depreciates.
 Capital flight from a country increases the
domestic interest rates and depreciates the
value of the domestic currency.