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32 A Macroeconomic Theory of the Open Economy

Open Economies ,[object Object]

Key Macroeconomic Variables in an Open Economy ,[object Object],[object Object],[object Object],[object Object],[object Object]

Basic Assumptions of a Macroeconomic Model of an Open Economy ,[object Object],[object Object]

SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE ,[object Object],[object Object],[object Object]

The Market for Loanable Funds ,[object Object],[object Object]

The Market for Loanable Funds ,[object Object],[object Object],[object Object]

Figure 1 The Market for Loanable Funds Copyright©2003 Southwestern/Thomson Learning Quantity of Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity Equilibrium real interest rate

The Market for Loanable Funds ,[object Object]

The Market for Foreign-Currency Exchange ,[object Object],[object Object],[object Object]

The Market for Foreign-Currency Exchange ,[object Object]

The Market for Foreign-Currency Exchange ,[object Object],[object Object]

Figure 2 The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning Quantity of Dollars Exchanged into Foreign Currency Real Exchange Rate Supply of dollars (from net capital outflow) Demand for dollars (for net exports) Equilibrium quantity Equilibrium real exchange rate

EQUILIBRIUM IN THE OPEN ECONOMY ,[object Object],[object Object]

Figure 3 How Net Capital Outflow Depends on the Interest Rate Copyright©2003 Southwestern/Thomson Learning 0 Net Capital Outflow Real Interest Rate Net capital outflow is negative. Net capital outflow is positive.

Figure 4 The Real Equilibrium in an Open Economy Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds (b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate Net capital outflow, NCO Supply Supply Demand Demand r r E

HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY ,[object Object],[object Object],[object Object],[object Object]

Government Budget Deficits ,[object Object],[object Object],[object Object],[object Object],[object Object]

Figure 5 The Effects of Government Budget Deficit Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds (b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate Demand Demand NCO S S r 2 S S r 2 B E 1 r r A 1. A budget deficit reduces the supply of loanable funds . . . 2. . . . which increases the real interest rate . . . 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency . . . 5. . . . which causes the real exchange rate to appreciate. 3. . . . which in turn reduces net capital outflow. E 2

Government Budget Deficits ,[object Object],[object Object],[object Object],[object Object]

Government Budget Deficits ,[object Object],[object Object]

Government Budget Deficits ,[object Object],[object Object],[object Object]

Trade Policy ,[object Object],[object Object],[object Object]

Trade Policy ,[object Object],[object Object],[object Object],[object Object]

Figure 6 The Effects of an Import Quota Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds (b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate Supply Supply Demand NCO D E r r D 3. Net exports, however, remain the same. 2. . . . and causes the real exchange rate to appreciate. E 2 1. An import quota increases the demand for dollars . . .

Trade Policy ,[object Object],[object Object]

Political Instability and Capital Flight ,[object Object]

Political Instability and Capital Flight ,[object Object],[object Object],[object Object]

Figure 7 The Effects of Capital Flight Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Pesos Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate r 1 r 1 D 1 Demand S Supply NCO 1 D 2 E S 2 NCO 2 1. An increase in net capital outflow. . . 3. . . . which increases the interest rate. 2. . . . increases the demand for loanable funds . . . 4. At the same time, the increase in net capital outflow increases the supply of pesos . . . 5. . . . which causes the peso to depreciate. r 2 r 2 E

Summary ,[object Object],[object Object]

Summary ,[object Object],[object Object],[object Object]

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