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WHAT’S NEW IN THE EIGHTH EDITION:
There is an updated discussion of capital ows from China.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
how to build a model to explain an open economy’s trade balance and exchange rate.
how to use the model to analyze the eects of government budget de cits.
how to use the model to analyze the macroeconomic eects of trade policies.
how to use the model to analyze political instability and capital ight.
518
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
32 A MACROECONOMIC
THEORY OF THE OPEN
ECONOMY
519 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy
CONTEXT AND PURPOSE:
The purpose of Chapter 32 is to establish the interdependence of a number of economic
variables in an open economy. In particular, Chapter 32 demonstrates the relationships
between the prices and quantities in the market for loanable funds and the prices and
quantities in the market for foreign-currency exchange. Using these markets, we can analyze
the impact of a variety of government policies on an economy’s exchange rate and trade
balance.
KEY POINTS:
Two markets are central to the macroeconomics of open economies: the market for
loanable funds and the market for foreign-currency exchange. In the market for loanable
funds, the real interest rate adjusts to balance the supply of loanable funds (from
national saving) and the demand for loanable funds (for domestic investment and net
capital outow). In the market for foreign-currency exchange, the real exchange rate
adjusts to balance the supply of dollars (from net capital outow) and the demand for
dollars (for net exports). Because net capital outow is part of the demand for loanable
funds and because it provides the supply of dollars for foreign-currency exchange, it is
the variable that connects these two markets.
A policy that reduces national saving, such as a government budget de cit, reduces the
supply of loanable funds and drives up the interest rate. The higher interest rate reduces
net capital outow, which reduces the supply of dollars in the market for foreign-currency
exchange. The dollar appreciates, and net exports fall.
Although restrictive trade policies, such as taris or quotas on imports, are sometimes
advocated as a way to alter the trade balance, they do not necessarily have that eect.
A trade restriction increases net exports for a given exchange rate and, therefore,
increases the demand for dollars in the market for foreign-currency exchange. As a
result, the dollar appreciates in value, making domestic goods more expensive relative to
foreign goods. This appreciation osets the initial impact of the trade restriction on net
exports.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 520
When investors change their attitudes about holding assets of a country, the
rami cations for the country’s economy can be profound. In particular, political
instability can lead to capital ight, which tends to increase interest rates and cause the
currency to depreciate.
CHAPTER OUTLINE:
I. Supply and Demand for Loanable Funds and for Foreign-Currency Exchange
A. The Market for Loanable Funds
1. Whenever a nation saves a dollar of income, it can use that dollar to nance the
purchase of domestic capital or to nance the purchase of an asset abroad.
2. The supply of loanable funds comes from national saving.
3. The demand for loanable funds comes from domestic investment and net capital
outow.
a. Because net capital outow can be positive or negative, it can either add to or
subtract from the demand for loanable funds that arises from domestic
investment.
b. When NCO > 0, the country is experiencing a net outow of capital. When
NCO < 0, the country is experiencing a net inow of capital.
4. The quantity of loanable funds demanded and the quantity of loanable funds
supplied depend on the real interest rate.
a. A higher real interest rate encourages people to save and thus raises the
quantity of loanable funds supplied.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
521 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy
b. A higher interest rate makes borrowing to nance capital projects more costly,
discouraging investment and reducing the quantity of loanable funds
demanded.
c. A higher real interest rate in a country will also lower net capital outow. All
else being equal, a higher domestic interest rate implies that purchases of
foreign assets by domestic residents will fall and purchases of domestic assets
by foreigners will rise.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 522
5. The supply and demand for loanable funds can be shown graphically.
a. The real interest rate is the price of borrowing funds and is therefore on the
vertical axis; the quantity of loanable funds is on the horizontal axis.
b. The supply of loanable funds is upward sloping because of the positive
relationship between the real interest rate and the quantity of loanable funds
supplied.
c. The demand for loanable funds is downward sloping because of the inverse
relationship between the real interest rate and the quantity of loanable funds
demanded.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Figure 1
Put “saving” in parentheses next to the supply of loanable funds and “I
+
NCO ” next to the demand for loanable funds. Encourage students to do
the same. These will serve as reminders of the sources of the supply and
You may need to write the equation for net capital outow on the board to
explain its relationship with the real interest rate. Point out that when the
U.S. real interest rate rises, purchases of foreign assets by domestic
residents fall and purchases of U.S. assets by foreigners rise. Thus, net
capital outow is inversely related to the real interest rate.
523 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy
6. The interest rate adjusts to bring the supply and demand for loanable funds into
balance.
a. If the interest rate were below r*, the quantity of loanable funds demanded
would be greater than the quantity of loanable funds supplied. The shortage
of loanable funds would lead to upward pressure on the interest rate.
b. If the interest rate were above r*, the quantity of loanable funds demanded
would be less than the quantity of loanable funds supplied. The surplus of
loanable funds would lead to downward pressure on the interest rate.
7. At the equilibrium interest rate, the amount that people want to save is exactly
equal to the desired quantities of domestic investment and net capital outow.
B. The Market for Foreign-Currency Exchange
1. The imbalance between the purchase and sale of capital assets abroad must be
equal to the imbalance between exports and imports of goods and services.
2. Net capital outow represents the quantity of dollars supplied for the purpose of
buying assets abroad.
3. Net exports represent the quantity of dollars demanded for the purpose of buying
U.S. net exports of goods and services.
4. The real exchange rate is the price that balances the supply and demand in the
market for foreign-currency exchange.
a. When the U.S. real exchange rate appreciates, U.S. goods become more
expensive relative to foreign goods, lowering U.S. exports and raising imports.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 524
Thus, an increase in the real exchange rate will reduce the quantity of dollars
demanded.
b. The key determinant of net capital outow is the real interest rate. Thus, as
the real exchange rate changes, there will be no change in net capital outow.
5. We can show the market for foreign-currency exchange graphically.
a. The real exchange rate is on the vertical axis; the quantity of dollars
exchanged is on the horizontal axis.
b. The demand for dollars will be downward sloping because of the inverse
relationship between the real exchange rate and the quantity of dollars
demanded.
c. The supply of dollars will be a vertical line because of the fact that changes in
the real exchange rate have no inuence on the quantity of dollars supplied.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Go back to the list of factors that inuence net capital outow (from the
previous chapter). Show students that the exchange rate is not there.
Figure 2
525 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy
6. The real exchange rate adjusts to balance the supply and demand for dollars.
a. If the real exchange rate were lower than real e*, the quantity of dollars
demanded would be greater than the quantity of dollars supplied and there
would be upward pressure on the real exchange rate.
b. If the real exchange rate were higher than real e*, the quantity of dollars
demanded would be less than the quantity of dollars supplied and there would
be downward pressure on the real exchange rate.
7. 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.
C. FYI: Purchasing-Power Parity as a Special Case
1. Purchasing-power parity suggests that a dollar must buy the same quantity of
goods and services in every country. As a result, the real exchange rate is xed
and the nominal exchange rate is determined by the price levels in the two
countries.
2. Purchasing-power parity assumes that international trade responds quickly to
international price dierences.
a. If goods were cheaper in one country than another, they would be exported
from the country where they are cheaper and imported into the second
country where the prices are higher until the price dierential disappears.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Remind students that net exports determine the demand for dollars by
placing “NX ” in parentheses next to the demand curve. Show that net
capital outow determines the supply of dollars by placing “NCO ” in
Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 526
b. Because net exports are so responsive to small changes in the real exchange
rate, purchasing-power parity implies that the demand for dollars would be
horizontal. Thus, purchasing-power parity is simply a special case of the
model of the foreign-currency exchange market.
c. However, in practice, foreign and domestic goods are not always perfect
substitutes and there are costs that impede trade. Therefore, it is more
realistic to draw the demand curve downward sloping.
II. Equilibrium in the Open Economy
A. Net Capital Outow: The Link between the Two Markets
1. In the market for loanable funds, net capital outow is one of the sources of
demand.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
527 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy
2. In the foreign-currency exchange market, net capital outow is the source of the
supply of dollars.
3. This means that net capital outow is the variable that links the two markets.
4. The key determinant of net capital outow is the real interest rate.
5. We can show the relationship between net capital outow and the real interest
rate graphically.
a. When the real interest rate is high, owning domestic assets is more attractive
and thus, net capital outow is low.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Again, you may need to write the equation for net capital outow on the
board to demonstrate the inverse relationship between the real interest
rate and net capital outow.
Figure 3
Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 528
b. This inverse relationship implies that net capital outow will be downward
sloping.
c. Note that net capital outow can be positive or negative.
B. Simultaneous Equilibrium in Two Markets
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Students may be intimidated by the next diagram showing the market for
loanable funds and the market for foreign-currency exchange, with the
diagram of net capital outow linking the two. Go through it very slowly.
You will likely have to repeat the equilibrium process several times before
529 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy
Figure 4
1. The real interest rate is determined in the market for loanable funds.
2. This real interest rate determines the level of net capital outow.
3. Because net capital outow must be paid for with foreign currency, the quantity
of net capital outow determines the supply of dollars.
4. The equilibrium real exchange rate brings into balance the quantity of dollars
supplied and the quantity of dollars demanded.
5. Thus, the real interest rate and the real exchange rate adjust simultaneously to
balance supply and demand in the two markets. As they do so, they determine
the levels of national saving, domestic investment, net capital outow, and net
exports.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 530
C. FYI: Disentangling Supply and Demand
1. Sometimes it is a bit arbitrary how we divide things between supply and demand.
2. In the market for loanable funds, our model treats net capital outow as part of
the demand for loanable funds.
a. Investment plus net capital outow must equal saving (I + NCO = S).
b. Thus, we could say instead that investment is equal to saving minus net
capital outow (I = S – NCO).
3. In the market for foreign-currency exchange, net exports are the source of the
demand for dollars and net capital outow is the source of the supply of dollars.
a. When a U.S. citizen buys an imported good, we treat it as a decrease in the
quantity of dollars demanded rather than an increase in the quantity of dollars
supplied.
b. When a Japanese citizen buys a U.S. government bond, we treat the
transaction as a decline in the quantity of dollars supplied rather than an
increase in the quantity of dollars demanded.
III. How Policies and Events Aect an Open Economy
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
For the next three applications, use the three-step process developed in
Chapter 4. First, determine which of the curves have been aected.
Second, determine in which direction the curves shift, and nally, use the
diagrams to examine how these shifts alter equilibrium in the two
531 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy
A. Government Budget De cits
1. A government budget de cit occurs when the government spending exceeds
government revenue.
2. Because a government de cit represents negative public saving, it reduces
national saving. This leads to a decline in the supply of loanable funds.
3. The real interest rate rises, leading to a decline in both domestic investment and
net capital outow.
4. Because net capital outow falls, people need less foreign currency to buy foreign
assets, and therefore supply fewer dollars in the market for foreign-currency
exchange.
5. The real exchange rate rises, making U.S. goods more expensive relative to
foreign goods. Exports will fall, imports will rise, and net exports will fall.
6. In an open economy, government budget de cits raise real interest rates, crowd
out domestic investment, cause the currency to appreciate, and push the trade
balance toward de cit.
7. Because they are so closely related, the budget de cit and the trade de cit are
often called the twin de!cits. Note that because many other factors aect the
trade de cit, these “twins” are not identical.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 532
B. Trade Policy
1. De nition of trade policy: a government policy that directly in.uences the
quantity of goods and services that a country imports or exports.
2. Two common types of trade policies are taris (taxes on imported goods) and
import quotas (limits on the quantity of goods produced abroad that can be sold
domestically).
3. Example: The U.S. government imposes a quota on the number of cars imported
from Japan.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Now would be a good time to discuss the debate in Chapter 23
concerning
whether the federal government should balance the budget.
Figure 5
533 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy
4. Note that the quota will have no eect on the market for loanable funds. Thus,
the real interest rate will be unaected.
5. The quota will lower imports and thus increase net exports. Because net exports
are the source of demand for dollars in the market for foreign-currency exchange,
the demand for dollars will increase.
6. The real exchange rate will rise, making U.S. goods relatively more expensive
than foreign goods. Exports will fall, imports will rise, and net exports will fall.
7. In the end, the quota reduces both imports and exports but net exports remain
the same.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Figure 6
Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 534
8. Trade policies do not aect the trade balance.
9. Recall that NX = NCO. Also remember that S = I + NCO.
Rewriting, we get:
NCO = S – I.
Substituting for NCO, we get:
NX = S – I.
10. Because trade policies do not aect national saving or domestic investment, they
cannot aect net exports.
11. Trade policies do have eects on speci c rms, industries, and countries. But
these eects are more microeconomic than macroeconomic.
C. Political Instability and Capital Flight
1. De nition of capital .ight: a large and sudden reduction in the demand
for assets located in a country.
2. Capital ight often occurs because investors feel that the country is unstable, due
to either economic or political problems.
3. Example: Investors around the world observe political problems in Mexico and
begin selling Mexican assets and buying assets from other countries that are
viewed as safe.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
535 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy
4. Mexican net capital outow will rise because investors are selling Mexican assets
and purchasing assets from other countries.
a. Because net capital outow determines the supply of pesos, the supply of
pesos increases.
b. Because net capital outow is also a part of the demand for loanable funds,
the demand for loanable funds rises.
5. The increased demand for loanable funds causes the equilibrium real interest rate
to rise.
6. The increased supply of pesos lowers the equilibrium real exchange rate.
7. Thus, capital ight from Mexico increases Mexican interest rates and decreases
the value of the Mexican peso in the market for foreign-currency exchange.
8. Capital ight in Mexico will also aect other countries. If the capital ows out of
Mexico and into the United States, it has the opposite eect on the U.S. economy.
9. In 1997, several Asian countries experienced capital ight. A similar experience
occurred in Russia in 1998 and Argentina in 2002.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 536
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
ALTERNATIVE CLASSROOM EXAMPLE:
Suppose that investors feel very con dent about the prospects for investment in
Brazilian assets.
In this case (from the perspective of Brazil):
1. The demand for loanable funds will shift left because NCO decreases.
Figure 7
537 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy
10. Case Study: Capital Flows from China
a. What happens if a country’s government encourages capital to ow to other
countries?
b. It leads to a weaker currency and a trade surplus.
c. In recent years, this has been the case with China as its government has tried
to depress its currency.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 538
Activity 1—Open Economy Article
Type: Take-home assignment
Topics: Open-economy macroeconomics
Class limitations: Works in any class
Purpose
This assignment helps students apply the open-economy macro model to world
events.
Instructions
This model is often confusing to students. This assignment has them work through
an example of real-world events that relate to international macroeconomics.
Students may need some direction in nding appropriate topics such as interest
rate changes, changes in net capital outow, or changes in net exports.
11. In the News: Is a Strong Currency Always in a Nation's Interest
a. Politicians assert that the U.S. favors a strong dollar.
b. This article from The New York Times discusses when a strong or weak
currency can be bene cial.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
