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February Answers and grades are on WebCT Problems: e-mail me. ECON 1002- e-mail me. US budget
US Macroeconomics in an Open
Economy CH 13
Economy The important macroeconomic variables
of an open economy include: National
Saving, Domestic Investment, Net Capital
Outflow and Net Exports. The values of these variables are determined
through the interaction of: the Loanable Funds
Market and the Market for Foreign-Currency
Exchange. –FX--The market where people
exchange the domestic currency for the currency
of other countries. 2 markets.
of Objectives-ch. 13
Objectives-ch. Develop SOE model to explain: Trade
balance and exchange rates
exchange Use the model to analyze a series of
related The model takes as given-real GDP and
the price level.
the The Market For Loanable Funds
The Financial markets co-ordinate the economy’s
saving and investment in
saving The Loanable Funds Market The Supply of Loanable Funds comes from
national saving (S) and from net capital outflow
(NCO) The Demand for Loanable Funds comes from
domestic investment (I).
domestic In an open economy the amount that a nation saves
does not have to equal the amount it spends to
purchase domestic capital.
purchase Market for Loanable Funds
Market If the amount of national saving exceeds the
amount needed to finance the purchase of
domestic capital, net capital outflow (NCO)
is If the national saving is insufficient to
finance the purchase of domestic capital,
the NCO is negative.
the The Market for Loanable Funds
The The supply and demand for loanable funds
depend on the real interest rate. A higher real interest rate encourages people to
save and raises the quantity of loanable funds
supplied. The interest rate adjusts to bring the supply and
demand for loanable funds into balance.
demand At the equilibrium interest rate, the amount that
people want to save exactly balances the desired
quantities of domestic investment and net foreign
investment. Loanable Funds –closed
economy-domestic interest rate is 5% Loanable Funds-SOE
Loanable In a small open economy with perfect capital
mobility, like Canada, the domestic interest rate
will equal the world interest rate.
will As a result, the quantity of loanable funds made
available by the savings of Canadians does not
have to equal the quantity of loanable funds
demanded for domestic investment.
demanded The difference between these two amounts is net
capital outflow (NCO)
Rate Net Capital Outflow
Outflow Supply World
100 150 Loanable Funds Negative Net Capital
Rate Outflow: Inflow
Rate Net Capital
90 Demand 130 Loanable Funds The Market For Loanable Funds
The In a small, open economy with perfect
capital mobility, the Canadian interest rate is
equal to the world interest rate.
equal National Saving represents the supply of
loanable funds, while domestic investment
demand The Market For Loanable Funds
x Recall the identity: Domestic
Investment + Net Capital
Outflow At the equilibrium interest rate, the amount
that people want to save, exactly balances
the desired quantities of investment and net
capital NCO can be positive or negative. The Market for Foreign-Currency
Exchange The market for foreign-currency exchange exists
because people want to trade with people in other
countries, but they want to be paid in their own
– The two sides of the foreign-currency exchange
market are represented by NCO and NX.
– NCO represents the imbalance between the
purchases and sales of capital assets.
– NX represents the imbalance between exports
and imports of goods and services.
and The Equality of Net Exports and
Net Capital Outflow
Net Net exports (NX) and net capital outflow (NCO) are
closely linked. For an economy as a whole, NX and
NCO balance each other out so that: NX = NCO
NX NCO represents the quantity of dollars supplied for
the purpose of buying assets abroad. NX determines
the quantity of dollars demanded for the purpose of
buying foreign goods.
buying The Market for Foreign-Currency
Exchange The identity, NX = NCO represents the
two sides of the foreign-exchange market in
which Canadian dollars are traded for
foreign currencies. The price that balances the supply and
demand is the “real exchange rate”, i.e. the
relative price of domestic and foreign goods.
relative Market for Foreign-Currency Exchange
Rate Supply of Dollars
(NCO) Demand for Dollars
Quantity of Dollars Exchanged into
Foreign Currency The Market for Foreign-Currency
Exchange The demand curve is negatively related to
the real exchange rate. A higher exchange
rate makes domestic goods more
expensive. The supply curve is vertical because the
quantity of dollars supplied for net capital
outflow is unrelated to the real exchange
rate. The Market for Foreign-Currency
The real exchange rate adjusts to balance
the supply and demand for dollars. At the
equilibrium 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.
foreign Market for Foreign-Currency Exchange
Rate Supply of Dollars
(NCO) Demand for Dollars
Equilibrium Quantity Quantity Equilibrium in the Open Economy
Equilibrium Net capital outflow (NCO) links the loanable
funds market with the foreign-currency
exchange market. The key determinant of
NCO is the world interest rate.
NCO In the market for loanable funds, NCO is a
portion of demand. In the market for foreignportion
currency exchange, NCO is the source of
supply. TUTORIAL GROUP B09
TUTORIAL Tutorial was cancelled today due to TA
illness. Hand in Assignments to me today. Next meeting is March 17 Equilibrium in the Open Economy
The market for loanable funds and the
foreign-currency exchange market
determine the real exchange rate, national
saving, domestic investment, net exports
and the size of net capital outflow.
LF: S, I, NCO
FX: RER and NX--------Using NCO 2 Markets—LF and FX
Markets—LF FX market-NCO from LF
FX Figure 1 3 .2 LF AND FX MARKETS
LF 1The real interest rate (r) is determined in the market for
loanable funds by rw.
loanable 2This real interest rate determines the level of NCO.
3NCO must be paid for with foreign currency so the
quantity of NCO determines the supply of dollars.
4The equilibrium real exchange rate brings into balance the
quantity of dollars supplied and the quantity of dollars
5The 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 S, domestic I, NCO and NX.
national How Policy and Events Affect an
Open The magnitude and variation in important
macroeconomic variables may be illustrated
by these specific events:
– Increase in world interest rates
Government Budget Deficits
Government Trade Policies
Political and Economic Stability-Greece, Egypt-- Assessing Policies and Events
Assessing Three steps in using the model to analyze
– Determine which of the supply and
demand curves each event affects
– Determine which way the curves shift
– Examine how these shifts alter the
– Like Micro Increase in World Interest Rates In an open economy with perfect capital
mobility, an increase in world interest rates
crowds out domestic investment, causes the
dollar to depreciate, and increases net
exports. World Interest Rates Go Up13.4
World G Budget deficits
Budget Because a government budget deficit
represents negative public saving, it
reduces national saving, and therefore
reduces. . .
– the supply of loanable funds,
– net capital outflow
– the supply of Canadian dollars in the
market for foreign-currency exchange
market Government Budget Deficits
Government In a small open economy,
- an increase in government budget deficits
causes the dollar to appreciate and causes
net exports to fall.
- a decrease in government budget deficits
causes the dollar to depreciate and causes
net exports to rise.
Principles of Macroeconomics: Ch. 18 First Canadian Edition Government Budget Deficits:
Specific Market Effects
Specific Loanable Funds Market Effect:
– Reduces national saving which... shifts the supply curve for loanable
funds to the left, which reduces NCO.
funds Government Budget Deficits:
Specific Market Effects
Specific Foreign-Currency Exchange Market:
– The decrease in NCO reduces the supply of
dollars to be exchanged into foreign currency,
which causes the real exchange rate to
appreciate. G deficits
deficits Government Trade Policy
Government Government Trade Policy Effect:
– Does not alter the trade balance because it does
not alter national saving or domestic investment. For given levels of national saving and domestic
investment, the real exchange rate adjusts to
keep the balance the same, regardless of the
trade policies the government puts in place.
trade Trade policies are more microeconomic than
macroeconomic. Government Trade Policies:
Specific Market Effects Foreign-Currency Exchange Market:
– – Nothing happens in the loanable funds market
or to the supply of dollars in the market for
The only effect is a rise in net exports for any
given exchange rate. This increases the
demand for dollars, which causes the value of
the dollar to appreciate. Government Trade Policies:
Specific Market Effects NCO Market:
– Because there is no change in NCO, there will
be no change in net exports.
An appreciation of the dollar in the foreign
exchange market encourages imports and
discourages exports which...
discourages ... offsets the direct increase in net
exports due to import quota.
exports Political Instability and Capital Flight
Political Capital Flight is a situation in which a large and
sudden movement of funds out of a country occurs
due to political instability (e.g. 1994 Mexico, 2011
Egypt: government instability.)
Egypt: When investors around the world observe political
problems in one country (e.g. Mexico) they decide to
sell some of their Mexican assets and use the
proceeds to buy other countries’ assets.
proceeds Interest rates increase in Mexico and the domestic
currency Political Instability and Capital Flight
Specific Market Effects NCO Market:
– Observed political problems in Mexico in 1994
increased Mexican interest rates (r+risk).
To save the same amount Mexican savers must
get r+risk so Slf shifts upwards. NCO gets bigger. This increase in NCO increases the supply of
pesos in the foreign-currency exchange market.
The peso depreciates. Due to instability. Principles of Macroeconomics: Capital flight
Summary To analyze the macroeconomics of open economies, two
markets are central—the market for loanable funds and the
market for foreign-currency exchange. SOE
market LF market: the interest rate adjusts to balance supply for
loanable funds (from national saving) and demand for
loanable funds (from domestic investment and net capital
outflow). In the market for foreign-currency exchange,
– the real exchange rate adjusts to balance the supply of
dollars (for net capital outflow) and the demand for
dollars (for net exports).
dollars NCO is the variable that connects the two markets. ...
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This note was uploaded on 06/14/2011 for the course ECON 1000 taught by Professor Unknown during the Spring '10 term at Carleton CA.
- Spring '10