Transcript Chapter18

Chapter 18 A Macroeconomic Theory Of the
Open Economy
• Supply and Demand for loanable funds and
for foreign-currency exchange
• Equilibrium in the Open Economy
• How Policies and events affect an open
economy
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Supply and Demand for loanable funds and for foreigncurrency exchange
1, The market for loanable funds, which coordinates the
economy’s saving and investment
• Recall the identity : S = I + NFI
• Saving = Domestic investment + Net foreign investment
• In a small open economy with perfect capital mobility, like
Canada, the domestic real interest rate is equal to the world
real interest rate.
• The Supply of Loanable Funds comes from national saving
(S) and from net foreign investment (NFI).
• The Demand for Loanable Funds comes from domestic
investment (I).
• At the equilibrium interest rate, the amount that people want
to save, exactly balances the desired quantities of
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investment and net foreign investment.
• See Figure 18-1
• In panel (a), at the world interest rate, the difference
between domestic investment and national saving, is net
foreign assets purchased by Canadian. It is a positive NFI.
• In panel (b), net foreign investment is negative, indicating
that foreigners are purchasing more Canadian assets than
Canadian are purchasing foreign assets.
• Recall another identity from the preceding chapter:
• NFI = NX (Net foreign investment = Net exports)
• Therefore, we get S = I + NX.
• Net exports are determined by the difference between the
supply of loanable funds due to national saving (S) and the
demand for loanable funds (I) at the world interest rate.
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2, The market for foreign-currency exchange
• Recall the identity: S = I + NX, we can rearrange it to
be: S - I = NX ( Saving – Domestic investment = Net
exports)
• This new identity states that the imbalance between the
domestic supply of loanable funds that is due to national
saving (S) and the demand for loanable funds for domestic
investment (I) must equal the imbalance between exports
and imports (NX).
• We can view the two sides of this identity as representing
the two sides of the market for foreign-currency exchange.
• Left hand side, S – I, represents the quantity of dollars
supplied in the market for foreign-currency exchange for the
purpose of buying foreign assets.
• Net exports represent the quantity of dollars demanded in
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that market for the purpose of buying Canadian net exports
of goods and services.
• The price that balances the supply and demand is the “real
exchange rate”, i.e. the relative price of domestic and
foreign goods.
• See Figure 18-2. The supply curve is vertical because
neither savings nor investment depends on the real
exchange rate. A higher exchange rate makes domestic
goods more expensive. The demand curve is downward
sloping because a lower real exchange rate stimulates net
exports (and thus increases the quantity of dollars demanded
to pay for these net exports).
• The real exchange rate adjusts to balance the supply and
demand for dollars. At the equilibrium 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
• Net foreign investment (NFI) links the loanable funds
market with the foreign-currency exchange market.The key
determinant of net foreign investment is the world interest
rate.
• In the market for loanable funds, NFI is a portion of
demand. In the market for foreign-currency exchange, NFI
is the source of supply.
• See Figure 18-3. This figure shows how the market for
loanable funds and the market for foreign-currency
exchange jointly determine the important variables of an
open economy.
• In panel (a), the real interest rate is determined by the world
real interest rate. At the world interest rate, national saving
(S) exceeds the demand for loanable funds for domestic
investment (I). Because national saving is more than 6
sufficient to provide loanable funds for domestic
• investment, the excess is used to buy foreign assets. This is
net foreign investment.
• When Canadian purchase foreign currency, they must sell
Canadian dollars in the market for foreign exchange. For
this reason, the quantity of net foreign investment from
panel (a) determines the supply of dollars to be exchanged
into foreign currencies.
• The equilibrium real exchange rate (E1) brings into balance
the quantity of dollars supplied and the quantity of dollars
demanded in the market for foreign-currency exchange.
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How Policy and Events Affect an Open Economy
• The magnitude and variation in important macroeconomic
variables may be illustrated by these specific events:
– Increase in world interest rates
– Government Budget Deficits and surpluses
– Trade Policy
– Political instability and capital flight
Case 1 Increase in world interest rates
• See Figure 18-4
• In panel (a), when the world interest rate increases, it
increases the supply of loanable funds made available by the
savings of Canadians and reduces the quantity of loanable
funds demanded for domestic investment. For both of these
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reasons, net foreign investment increases.
• In panel (b), the increase in net foreign investment shifts the
curve that measure the supply of dollars to be exchanged in
the market for foreign currency exchange to the right.
• The increased supply of dollars causes the real exchange
rate to depreciate form E1 to E2. That is, the dollar becomes
less valuable relative to other currencies.
• Hence, in a small open economy with perfect capital
mobility, an increase in world interest rates crowds out
domestic investment, causes the dollar to depreciate, and
increases net exports.
• An increase in world interest rates, by causing the Canadian
dollar to depreciate, benefits exporters by making goods
priced in Canadian dollars cheaper to foreigners. At the
same time, the depreciation of the dollar hurts Canadian
importers by making goods priced in foreign currencies
more expensive to Canadians. Therefore, Canadian
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consumers are hurt by increases in world interest rates.
Case 2 Government Budget Deficits and Surpluses
• See Figure 18-5.
• Because a government budget deficit represents negative
public saving, it reduces national saving ( the sum of public
and private saving). Therefore, the supply of loanable funds
from national saving shifts to the left.
• Thus, a government budget deficit reduces the supply of
loanable funds, drives up the real interest rate, and crowds ou
investment.
• Because net foreign investment is reduced, the supply of
Canadian dollars offered for sale in the market for foreign
investment exchange is reduced. Shifting to the left.
• The reduced supply of dollars causes the real exchange rate to
appreciate from E1 to E2.
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• Hence, in a small open economy with perfect capital
mobility,an increase in government budget deficits causes
the dollar to appreciate and causes net exports to fall.
• Hence, in a small open economy with perfect capital
mobility,a decrease in government budget deficits causes
the dollar to depreciate and causes net exports to rise.
Case 3 Trade Policy
• A trade policy is a government policy that directly
influences the quantity of goods and services that a country
imports or exports. One common trade policy is a tariff, a
tax on imported goods. Another is an import quota, a limit
on the quantity of a good that can be produced abroad and
sold domestically.
• See Figure 18-6, the effects of an import quota.
• When the Canadian government imposes a quota on the
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import of Japanese car, nothing happens in the market for
• loanable funds in panel (a) or to the supply of dollars in the
market for foreign-currency exchange in panel (b).
• Because the quota restricts the number of Japanese cars sold
in Canada, it reduces imports at any given real exchange
rate. Net exports, will therefore rise for any given real
exchange rate. As a result, the demand for dollars in the
market for foreign-currency exchange rises, as shown by the
shift of the demand curve in panel (b).
• This increase in the demand for dollars to appreciate from
E1 to E2. This appreciation encourages imports and
discourages exports. Therefore, this appreciation in the
value of the dollar tends to reduce net exports, offsetting the
direct of the import quota on the trade balance.
• In the end, an import quota reduces both imports and
exports, but net exports are unchanged.
• Implication: Trade policies do not affect the trade balance.
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• Although trade policies do not affect a country’s overall
trade balance, these policies do affect specific firms,
industries and countries.
• For example, when Canadian government imposes an
import quota on Japanese cars, GM has less competition
from abroad and will sell more cars. At the same time,
because the dollar has appreciated in value, Bombardier, the
Canadian aircraft maker, will find it harder to compete with
aircraft makers in other countries.
• The effect of trade policies are therefore, more
microeconomic than macroeconomic.
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Case 4 Political instability and capital flight
• Capital Flight is a situation in which a large and sudden
movement of funds out of a country occurs due to political
instability (e.g. 1994 Mexican government instability.)
• See Figure 18-7.
• In panel (a), at the world interest rate, rw, the supply of
loanable funds is greater than the demand of loanable funds.
The distance between points A and B is Mexican saving that
is available to purchase foreign assets - in other words,
Mexico’s net foreign investment. This is shown in panel (b)
by the curve (S-I)1. The point at which the demand and
supply of pesos are in equilibrium determines the real
exchange rate, E1.
• If the world financial community begins to question the
ability of Mexico to repay its debts, lenders will only hold
Mexican debt if they receive a higher interest rate than14they
receive in other countries.
• Let’s define r as the risk premium that risky borrowers must
pay.
• The curve shifts up by the amount of risk premium to
indicate that Mexicans will choose to contribute the same
quantity of their savings to the Mexican market for loanable
funds only if they are compensated for the greater risk they
incur by doing so.
• With the quantity of loanable funds supplied unchanged and
the quantity demanded reduced, Mexico’s net foreign
investment rises.
• The increase in Mexico’s net foreign investment increases
the supply of pesos from (S-I)1 to (S-I)2. This increase in
supply causes the peso to depreciate from E1 to E2.
• Thus, capital flight from Mexico increases Mexican interests
rates and decreases the value of the Mexican peso in the
market for foreign-currency exchange.
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