978-1305971509 Chapter 32_19 Lecture Notes

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 eects of government budget de cits.

 how to use the model to analyze the macroeconomic eects of trade policies.

 how to use the model to analyze political instability and capital ight.

518

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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 outow). In the market for foreign-currency exchange, the real exchange rate

adjusts to balance the supply of dollars (from net capital outow) and the demand for

dollars (for net exports). Because net capital outow 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 outow, 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 taris or quotas on imports, are sometimes

advocated as a way to alter the trade balance, they do not necessarily have that eect.

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 osets the initial impact of the trade restriction on net

exports.

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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

outow.

a. Because net capital outow 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 outow of capital. When

NCO < 0, the country is experiencing a net inow 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.

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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 outow. 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.

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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.

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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 outow 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 outow 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 outow.

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 outow 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.

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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 outow is the real interest rate. Thus, as

the real exchange rate changes, there will be no change in net capital outow.

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 inuence on the quantity of dollars supplied.

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Go back to the list of factors that inuence net capital outow (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 dierences.

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 dierential disappears.

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Remind students that net exports determine the demand for dollars by

placing “NX ” in parentheses next to the demand curve. Show that net

capital outow 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 Outow: The Link between the Two Markets

1. In the market for loanable funds, net capital outow is one of the sources of

demand.

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527 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy

2. In the foreign-currency exchange market, net capital outow is the source of the

supply of dollars.

3. This means that net capital outow is the variable that links the two markets.

4. The key determinant of net capital outow is the real interest rate.

5. We can show the relationship between net capital outow and the real interest

rate graphically.

a. When the real interest rate is high, owning domestic assets is more attractive

and thus, net capital outow is low.

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Again, you may need to write the equation for net capital outow on the

board to demonstrate the inverse relationship between the real interest

rate and net capital outow.

Figure 3

Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 528

b. This inverse relationship implies that net capital outow will be downward

sloping.

c. Note that net capital outow can be positive or negative.

B. Simultaneous Equilibrium in Two Markets

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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 outow 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 outow.

3. Because net capital outow must be paid for with foreign currency, the quantity

of net capital outow 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 outow, and net

exports.

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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 outow as part of

the demand for loanable funds.

a. Investment plus net capital outow must equal saving (I + NCO = S).

b. Thus, we could say instead that investment is equal to saving minus net

capital outow (I = S – NCO).

3. In the market for foreign-currency exchange, net exports are the source of the

demand for dollars and net capital outow 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 Aect an Open Economy

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For the next three applications, use the three-step process developed in

Chapter 4. First, determine which of the curves have been aected.

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 outow.

4. Because net capital outow 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 aect the

trade de cit, these “twins” are not identical.

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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 taris (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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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 eect on the market for loanable funds. Thus,

the real interest rate will be unaected.

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.

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Figure 6

Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 534

8. Trade policies do not aect 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 aect national saving or domestic investment, they

cannot aect net exports.

11. Trade policies do have eects on speci c rms, industries, and countries. But

these eects 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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535 ❖ Chapter 32/A Macroeconomic Theory of the Open Economy

4. Mexican net capital outow will rise because investors are selling Mexican assets

and purchasing assets from other countries.

a. Because net capital outow determines the supply of pesos, the supply of

pesos increases.

b. Because net capital outow 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 aect other countries. If the capital ows out of

Mexico and into the United States, it has the opposite eect 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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Chapter 32/A Macroeconomic Theory of the Open Economy ❖ 536

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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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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 outow, 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.

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