314
WHAT’S NEW IN THE SEVENTH EDITION:
A new
In the News
box on “Is a Strong Currency Always in a Nation’s Interest?” has been added.
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 effects of government budget deficits.
➢ how to use the model to analyze the macroeconomic effects of trade policies.
➢ how to use the model to analyze political instability and capital flight.
CONTEXT AND PURPOSE:
The purpose of Chapter 19 is to establish the interdependence of a number of economic variables in an
open economy. In particular, Chapter 19 demonstrates the relationships between the prices and
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 outflow). In the market for foreign-currency
exchange, the real exchange rate adjusts to balance the supply of dollars (from net capital outflow)
and the demand for dollars (for net exports). Because net capital outflow 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.
19
A MACROECONOMIC
THEORY OF THE OPEN
ECONOMY
Chapter 19/A Macroeconomic Theory of the Open Economy ❖ 315
• A policy that reduces national saving, such as a government budget deficit, reduces the supply of
loanable funds and drives up the interest rate. The higher interest rate reduces net capital outflow,
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 tariffs or quotas on imports, are sometimes advocated as a
way to alter the trade balance, they do not necessarily have that effect. A trade restriction increases
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 finance the purchase of
domestic capital or to finance 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 outflow.
a. Because net capital outflow 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 outflow of capital. When
NCO
< 0, the
country is experiencing a net inflow 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.
316 ❖ Chapter 19/A Macroeconomic Theory of the Open Economy
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.
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
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 demand for loanable funds.
You may need to write the equation for net capital outflow 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 outflow is inversely related to the real
interest rate.
Chapter 19/A Macroeconomic Theory of the Open Economy ❖ 317
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 outflow 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. Thus, an increase in
the real exchange rate will reduce the quantity of dollars demanded.
b. The key determinant of net capital outflow is the real interest rate. Thus, as the real
exchange rate changes, there will be no change in net capital outflow.
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.
Go back to the list of factors that influence net capital outflow (from the previous
chapter). Show students that the exchange rate is not there.
318 ❖ Chapter 19/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 fixed 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 differences.
Figure 2
Remind students that net exports determine the demand for dollars by placing “
NX
”
in parentheses next to the demand curve. Show that net capital outflow determines
the supply of dollars by placing “
NCO
” in parentheses next to the supply curve.
Chapter 19/A Macroeconomic Theory of the Open Economy ❖ 319
II. Equilibrium in the Open Economy
A. Net Capital Outflow: The Link between the Two Markets
1. In the market for loanable funds, net capital outflow is one of the sources of demand.
2. In the foreign-currency exchange market, net capital outflow is the source of the supply of
dollars.
3. This means that net capital outflow is the variable that links the two markets.
4. The key determinant of net capital outflow is the real interest rate.
b. This inverse relationship implies that net capital outflow will be downward sloping.
c. Note that net capital outflow can be positive or negative.
Figure 3
Again, you may need to write the equation for net capital outflow on the board to
demonstrate the inverse relationship between the real interest rate and net capital
outflow.
320 ❖ Chapter 19/A Macroeconomic Theory of the Open Economy
B. Simultaneous Equilibrium in Two Markets
1. The real interest rate is determined in the market for loanable funds.
2. This real interest rate determines the level of net capital outflow.
3. Because net capital outflow must be paid for with foreign currency, the quantity of net capital
outflow 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.
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 outflow as part of the demand
for loanable funds.
Figure 4
Students will be frightened by the next diagram showing the market for loanable
funds and the market for foreign-currency exchange, with the diagram of net capital
outflow linking the two. Go through it very slowly. You will likely have to repeat the
equilibrium process several times before students understand it.
Chapter 19/A Macroeconomic Theory of the Open Economy ❖ 321
a. Investment plus net capital outflow must equal saving (
I
+
NCO
=
S
).
3. In the market for foreign-currency exchange, net exports are the source of the demand for
dollars and net capital outflow 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.
III. How Policies and Events Affect an Open Economy
A. Government Budget Deficits
1. A government budget deficit occurs when the government spending exceeds government
revenue.
2. Because a government deficit 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
outflow.
4. Because net capital outflow falls, people need less foreign currency to buy foreign assets,
and therefore supply fewer dollars in the market for foreign-currency exchange.
For the next three applications, use the three-step process developed in Chapter 4.
First, determine which of the curves have been affected. Second, determine in which
direction the curves shift, and finally, use the diagrams to examine how these shifts
alter equilibrium in the two markets.
322 ❖ Chapter 19/A Macroeconomic Theory of the Open Economy
B. Trade Policy
1. Definition of trade policy: a government policy that directly influences the quantity
of goods and services that a country imports or exports.
2. Two common types of trade policies are tariffs (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.
4. Note that the quota will have no effect on the market for loanable funds. Thus, the real
interest rate will be unaffected.
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.
Figure 5
Now would be a good time to discuss the debate in Chapter 23 concerning whether
the federal government should balance the budget.
Chapter 19/A Macroeconomic Theory of the Open Economy ❖ 323
7. In the end, the quota reduces both imports and exports but net exports remain the same.
8. Trade policies do not affect 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 affect national saving or domestic investment, they cannot
affect net exports.
11. Trade policies do have effects on specific firms, industries, and countries. But these effects
are more microeconomic than macroeconomic.
C. Political Instability and Capital Flight
Figure 6
324 ❖ Chapter 19/A Macroeconomic Theory of the Open Economy
2. Capital flight 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.
4. Mexican net capital outflow will rise because investors are selling Mexican assets and
purchasing assets from other countries.
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 flight from Mexico increases Mexican interest rates and decreases the value of
the Mexican peso in the market for foreign-currency exchange.
8. Capital flight in Mexico will also affect other countries. If the capital flows out of Mexico and
into the United States, it has the opposite effect on the U.S. economy.