Open Economies. Chapter 32. A Macroeconomic Theory of the Open Economy. Basic Assumptions of a Macroeconomic Model of an Open Economy

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1 Chapte 32. A Macoeconomic Theoy of the Open Economy Open Economies An open economy is one that inteacts feely with othe economies aound the wold. slide 0 slide 1 Key Macoeconomic Vaiables in an Open Economy The impotant macoeconomic vaiables of an open economy include: net expots net foeign investment nominal exchange ates eal exchange ates Basic Assumptions of a Macoeconomic Model of an Open Economy The model takes the economy s GDP as given. The model takes the economy s pice level as given. slide 2 slide 3

2 SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE The Maket fo Loanable Funds S = I + NCO At the equilibium inteest ate, the amount that people want to save exactly balances the desied quantities of investment and net capital outflows. The Maket fo Loanable Funds The supply of loanable funds comes fom national saving (S). The demand fo loanable funds comes fom domestic investment (I) and net capital outflows (NCO). slide 4 slide 5 The Maket fo Loanable Funds Figue 1 The Maket fo Loanable Funds The supply and demand fo loanable funds depend on the eal inteest ate. A highe eal inteest ate encouages people to save and aises the quantity of loanable funds supplied. The inteest ate adjusts to bing the supply and demand fo loanable funds into balance. Equilibium eal inteest ate Supply of loanable funds (fom national saving) fo loanable funds (fo domestic investment and net capital outflow) slide 6 Equilibium quantity Loanable Funds slide 7

3 The Maket fo Loanable Funds At the equilibium inteest ate, the amount that people want to save exactly balances the desied quantities of domestic investment and net foeign investment. The Maket fo Foeign-Cuency Exchange The two sides of the foeign-cuency exchange maket ae epesented by NCO and NX. NCO epesents the imbalance between the puchases and sales of capital assets. NX epesents the imbalance between expots and impots of goods and sevices. slide 8 slide 9 The Maket fo Foeign-Cuency Exchange In the maket fo foeign-cuency exchange, U.S. dollas ae taded fo foeign cuencies. Fo an economy as a whole, NCO and NX must balance each othe out, o: NCO = NX The Maket fo Foeign-Cuency Exchange The pice that balances the supply and demand fo foeign-cuency is the eal exchange ate. slide 10 slide 11

4 The Maket fo Foeign-Cuency Exchange Figue 2 The Maket fo Foeign-Cuency Exchange The demand cuve fo foeign cuency is downwad sloping because a highe exchange ate makes domestic goods moe expensive. The supply cuve is vetical because the quantity of dollas supplied fo net capital outflow is unelated to the eal exchange ate. Exchange Equilibium eal exchange ate Supply of dollas (fom net capital outflow) fo dollas (fo net expots) slide 12 Equilibium quantity Dollas Exchanged into Foeign Cuency slide 13 The Maket fo Foeign-Cuency Exchange The eal exchange ate adjusts to balance the supply and demand fo dollas. At the equilibium eal exchange ate, the demand fo dollas to buy net expots exactly balances the supply of dollas to be exchanged into foeign cuency to buy assets aboad. EQUILIBRIUM IN THE OPEN ECONOMY In the maket fo loanable funds, supply comes fom national saving and demand comes fom domestic investment and net capital outflow. In the maket fo foeign-cuency exchange, supply comes fom net capital outflow and demand comes fom net expots. slide 14 slide 15

5 EQUILIBRIUM IN THE OPEN ECONOMY Net capital outflow links the loanable funds maket and the foeign-cuency exchange maket. The key deteminant of net capital outflow is the eal inteest ate. Figue 3 How Net Capital Outflow Depends on the slide 16 Net capital outflow is negative. 0 Net capital outflow Net Capital is positive. Outflow slide 17 EQUILIBRIUM IN THE OPEN ECONOMY Pices in the loanable funds maket and the foeign-cuency exchange maket adjust simultaneously to balance supply and demand in these two makets. As they do, they detemine the macoeconomic vaiables of national saving, domestic investment, net foeign investment, and net expots. Figue 4 The Equilibium in an Open Economy (a) The Maket fo Loanable Funds Supply Loanable Funds Exchange E (b) Net Capital Outflow Supply Net capital outflow, NCO Net Capital Outflow Dollas slide 18 (c) The Maket fo Foeign-Cuency Exchange slide 19

6 HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY The magnitude and vaiation in impotant macoeconomic vaiables depend on the following: Govenment budget deficits Tade policies Political and economic stability Govenment Budget Deficits In an open economy, govenment budget deficits... educe the supply of loanable funds, dive up the inteest ate, cowd out domestic investment, cause net foeign investment to fall. slide 20 slide 21 Figue 5 The Effects of Govenment Budget Deficit which inceases the eal inteest ate... (a) The Maket fo Loanable Funds B S A S Loanable Funds 1. A budget deficit educes (b) Net Capital Outflow the supply of loanable funds... 2 Exchange E which E 1 causes the eal exchange ate to appeciate which in tun educes net capital outflow. S S NCO Net Capital Outflow 4. The decease in net capital outflow educes the supply of dollas to be exchanged into foeign cuency... Dollas (c) The Maket fo Foeign-Cuency Exchange slide 22 Govenment Budget Deficits Effect of Budget Deficits on the Loanable Funds Maket A govenment budget deficit educes national saving, which... shifts the supply cuve fo loanable funds to the left, which... aises inteest ates. slide 23

7 Govenment Budget Deficits Effect of Budget Deficits on Net Foeign Investment Highe inteest ates educe net foeign investment. Govenment Budget Deficits Effect on the Foeign-Cuency Exchange Maket A decease in net foeign investment educes the supply of dollas to be exchanged into foeign cuency. This causes the eal exchange ate to appeciate. slide 24 slide 25 Tade Policy A tade policy is a govenment policy that diectly influences the quantity of goods and sevices that a county impots o expots. Taiff: A tax on an impoted good. Impot quota: A limit on the quantity of a good poduced aboad and sold domestically. Tade Policy Because they do not change national saving o domestic investment, tade policies do not affect the tade balance. Fo a given level of national saving and domestic investment, the eal exchange ate adjusts to keep the tade balance the same. Tade policies have a geate effect on micoeconomic than on macoeconomic makets. slide 26 slide 27

8 Figue 6 The Effects of an Impot Quota (a) The Maket fo Loanable Funds Supply Loanable Funds and causes the eal exchange ate to appeciate. Exchange E 2 E 3. Net expots, howeve, emain the same. (b) Net Capital Outflow Supply NCO D Net Capital Outflow 1. An impot quota inceases the demand fo dollas... D Tade Policy Effect of an Impot Quota Because foeignes need dollas to buy U.S. net expots, thee is an inceased demand fo dollas in the maket fo foeign-cuency. This leads to an appeciation of the eal exchange ate. Dollas slide 28 (c) The Maket fo Foeign-Cuency Exchange slide 29 Tade Policy Effect of an Impot Quota Thee is no change in the inteest ate because nothing happens in the loanable funds maket. Thee will be no change in net expots. Thee is no change in net foeign investment even though an impot quota educes impots. Tade Policy Effect of an Impot Quota An appeciation of the dolla in the foeign exchange maket encouages impots and discouages expots. This offsets the initial incease in net expots due to impot quota. slide 30 slide 31

9 Tade Policy Effect of an Impot Quota Tade policies do not affect the tade balance. Political Instability and Capital Flight Capital flight is a lage and sudden eduction in the demand fo assets located in a county. slide 32 slide 33 Figue 7 The Effects of Capital Flight Political Instability and Capital Flight (a) The Maket fo Loanable Funds in Mexico Supply which inceases the inteest ate. Loanable Funds inceases the demand fo loanable funds... D 1 D 2 Exchange which causes the peso to depeciate. E E (b) Mexican Net Capital Outflow S S 2 1. An incease in net capital outflow... NCO 1 NCO 2 Net Capital Outflow 4. At the same time, the incease in net capital outflow inceases the supply of pesos... Capital flight has its lagest impact on the county fom which the capital is fleeing, but it also affects othe counties. If investos become concened about the safety of thei investments, capital can quickly leave an economy. ates incease and the domestic cuency depeciates. Pesos (c) The Maket fo Foeign-Cuency Exchange slide 34 slide 35

10 Political Instability and Capital Flight When investos aound the wold obseved political poblems in Mexico in 1994, they sold some of thei Mexican assets and used the poceeds to buy assets of othe counties. Political Instability and Capital Flight This inceased Mexican net capital outflow. The demand fo loanable funds in the loanable funds maket inceased, which inceased the inteest ate. This inceased the supply of pesos in the foeign-cuency exchange maket. slide 36 slide 37 Summay To analyze the macoeconomics of open economies, two makets ae cental the maket fo loanable funds and the maket fo foeign-cuency exchange. In the maket fo loanable funds, the inteest ate adjusts to balance supply fo loanable funds (fom national saving) and demand fo loanable funds (fom domestic investment and net capital outflow). Summay In the maket fo foeign-cuency exchange, the eal exchange ate adjusts to balance the supply of dollas (fo net capital outflow) and the demand fo dollas (fo net expots). Net capital outflow is the vaiable that connects the two makets. slide 38 slide 39

11 Summay A policy that educes national saving, such as a govenment budget deficit, educes the supply of loanable funds and dives up the inteest ate. The highe inteest ate educes net capital outflow, educing the supply of dollas. The dolla appeciates, and net expots fall. Summay A tade estiction inceases net expots and inceases the demand fo dollas in the maket fo foeign-cuency exchange. As a esult, the dolla appeciates in value, making domestic goods moe expensive elative to foeign goods. This appeciation offsets the initial impact of the tade estictions on net expots. slide 40 slide 41 Summay When investos change thei attitudes about holding assets of a county, the amifications fo the county s economy can be pofound. Political instability in a county can lead to capital flight. Capital flight tends to incease inteest ates and cause the county s cuency to depeciate. slide 42 slide 43

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