Chapter13AMacroeconomicsTheoryoftheOpenEconomy,OpenEconomiesAnopeneconomyisonethatinteractsfreelywithothereconomiesaroundtheworld.,AMacroeconomicsTheoryoftheOpenEconomy,KeyMacroeconomicVariablesinanOpenEconomyTheimportantmacroeconomicvariablesofanopeneconomyinclude:netexportsnetforeigninvestmentnominalexchangeratesrealexchangerates,AMacroeconomicsTheoryoftheOpenEconomy,BasicAssumptionsofaMacroeconomicModelofanOpenEconomyThemodeltakestheeconomysGDPasgiven.Themodeltakestheeconomyspricelevelasgiven.,SUPPLYANDDEMANDFORLOANABLEFUNDSANDFORFOREIGN-CURRENCYEXCHANGE,TheMarketforLoanableFundsS=I+NCOAttheequilibriuminterestrate,theamountthatpeoplewanttosaveexactlybalancesthedesiredquantitiesofinvestmentandnetcapitaloutflows.,TheMarketforLoanableFunds,Thesupplyofloanablefundscomesfromnationalsaving(S).Thedemandforloanablefundscomesfromdomesticinvestment(I)andnetcapitaloutflows(NCO).,TheMarketforLoanableFunds,Thesupplyanddemandforloanablefundsdependontherealinterestrate.Ahigherrealinterestrateencouragespeopletosaveandraisesthequantityofloanablefundssupplied.Theinterestrateadjuststobringthesupplyanddemandforloanablefundsintobalance.,Figure1TheMarketforLoanableFunds,Quantityof,LoanableFunds,Real,Interest,Rate,TheMarketforLoanableFunds,Attheequilibriuminterestrate,theamountthatpeoplewanttosaveexactlybalancesthedesiredquantitiesofdomesticinvestmentandnetforeigninvestment.,TheMarketforForeign-CurrencyExchange,Thetwosidesoftheforeign-currencyexchangemarketarerepresentedbyNCOandNX.NCOrepresentstheimbalancebetweenthepurchasesandsalesofcapitalassets.NXrepresentstheimbalancebetweenexportsandimportsofgoodsandservices.,TheMarketforForeign-CurrencyExchange,Inthemarketforforeign-currencyexchange,U.S.dollarsaretradedforforeigncurrencies.Foraneconomyasawhole,NCOandNXmustbalance,or:NCO=NX,TheMarketforForeign-CurrencyExchange,Thepricethatbalancesthesupplyanddemandforforeign-currencyistherealexchangerate.,TheMarketforForeign-CurrencyExchange,Thedemandcurveforforeigncurrencyisdownwardslopingbecauseahigherexchangeratemakesdomesticgoodsmoreexpensive.Thesupplycurveisverticalbecausethequantityofdollarssuppliedfornetcapitaloutflowisunrelatedtotherealexchangerate.,Figure2TheMarketforForeign-CurrencyExchange,QuantityofDollarsExchanged,intoForeignCurrency,Real,Exchange,Rate,TheMarketforForeign-CurrencyExchange,Therealexchangerateadjuststobalancethesupplyanddemandfordollars.Attheequilibriumrealexchangerate,thedemandfordollarstobuynetexportsexactlybalancesthesupplyofdollarstobeexchangedintoforeigncurrencytobuyassetsabroad.,EQUILIBRIUMINTHEOPENECONOMY,Inthemarketforloanablefunds,supplycomesfromnationalsavinganddemandcomesfromdomesticinvestmentandnetcapitaloutflow.Inthemarketforforeign-currencyexchange,supplycomesfromnetcapitaloutflowanddemandcomesfromnetexports.,EQUILIBRIUMINTHEOPENECONOMY,Netcapitaloutflowlinkstheloanablefundsmarketandtheforeign-currencyexchangemarket.Thekeydeterminantofnetcapitaloutflowistherealinterestrate.,Figure3HowNetCapitalOutflowDependsontheInterestRate,0,NetCapital,Outflow,Real,Interest,Rate,SimultaneousEquilibriuminTwoMarkets,Pricesintheloanablefundsmarketandtheforeign-currencyexchangemarketadjustsimultaneouslytobalancesupplyanddemandinthesetwomarkets.Astheydo,theydeterminethemacroeconomicvariablesofnationalsaving,domesticinvestment,netforeigninvestment,andnetexports.,Figure4TheRealEquilibriuminanOpenEconomy,(a)TheMarketforLoanableFunds,(b)NetCapitalOutflow,Real,Interest,Rate,Real,Interest,Rate,(c)TheMarketforForeign-CurrencyExchange,Quantityof,Dollars,Quantityof,LoanableFunds,NetCapital,Outflow,Real,Exchange,Rate,HOWPOLICIESANDEVENTSAFFECTANOPENECONOMY,Themagnitudeandvariationinimportantmacroeconomicvariablesdependonthefollowing:GovernmentbudgetdeficitsTradepoliciesPoliticalandeconomicstability,GovernmentBudgetDeficits,Inanopeneconomy,governmentbudgetdeficits.reducethesupplyofloanablefunds,driveuptheinterestrate,crowdoutdomesticinvestment,causenetforeigninvestmenttofall.,Figure5TheEffectsofGovernmentBudgetDeficit,(a)TheMarketforLoanableFunds,(b)NetCapitalOutflow,Real,Interest,Rate,Real,Interest,Rate,(c)TheMarketforForeign-CurrencyExchange,Quantityof,Dollars,Quantityof,LoanableFunds,NetCapital,Outflow,Real,Exchange,Rate,Demand,Demand,NCO,S,S,GovernmentBudgetDeficits,EffectofBudgetDeficitsontheLoanableFundsMarketAgovernmentbudgetdeficitreducesnationalsaving,which.shiftsthesupplycurveforloanablefundstotheleft,which.raisesinterestrates.,GovernmentBudgetDeficits,EffectofBudgetDeficitsonNetForeignInvestmentHigherinterestratesreducenetforeigninvestment.EffectontheForeign-CurrencyExchangeMarketAdecreaseinnetforeigninvestmentreducesthesupplyofdollarstobeexchangedintoforeigncurrency.Thiscausestherealexchangeratetoappreciate.,TradePolicy,Atradepolicyisagovernmentpolicythatdirectlyinfluencesthequantityofgoodsandservicesthatacountryimportsorexports.Tariff:Ataxonanimportedgood.Importquota:Alimitonthequantityofagoodproducedabroadandsolddomestically.,TradePolicy,Becausetheydonotchangenationalsavingordomesticinvestment,tradepoliciesdonotaffectthetradebalance.Foragivenlevelofnationalsavinganddomesticinvestment,therealexchangerateadjuststokeepthetradebalancethesame.Tradepolicieshaveagreatereffectonmicroeconomicthanonmacroeconomicmarkets.,TradePolicy,EffectofanImportQuotaBecauseforeignersneeddollarstobuyU.S.netexports,thereisanincreaseddemandfordollarsinthemarketforforeign-currency.Thisleadstoanappreciationoftherealexchangerate.,TradePolicy,EffectofanImportQuotaThereisnochangeintheinterestratebecausenothinghappensintheloanablefundsmarket.Therewillbenochangeinnetexports.Thereisnochangeinnetforeigninvestmenteventhoughanimportquotareducesimports.,TradePolicy,EffectofanImportQuotaAnappreciationofthedollarintheforeignexchangemarketencouragesimportsanddiscouragesexports.Thisoffsetstheinitialincreaseinnetexportsduetotheimportquota.,Figure6TheEffectsofanImportQuota,(a)TheMarketforLoanableFunds,(b)NetCapitalOutflow,Real,Interest,Rate,Real,Interest,Rate,(c)TheMarketforForeign-CurrencyExchange,Quantityof,Dollars,Quantityof,LoanableFunds,NetCapital,Outflow,Real,Exchange,Rate,r,r,Supply,Supply,Demand,NCO,D,E,TradePolicy,EffectofanImportQuotaTradepoliciesdonotaffectthetradebalance.,PoliticalInstabilityandCapitalFlight,Capitalflightisalargeandsuddenreductioninthedemandforassetslocatedinacountry.,PoliticalInstabilityandCapitalFlight,Capitalflighthasitslargestimpactonthecountryfromwhichthecapitalisfleeing,butitalsoaffectsothercountries.Ifinvestorsbecomeconcernedaboutthesafetyoftheirinvestments,capitalcanquicklyleaveaneconomy.Interestratesincreaseandthedomesticcurrencydepreciates.,PoliticalInstabilityandCapitalFlight,WheninvestorsaroundtheworldobservedpoliticalproblemsinMexicoin1994,theysoldsomeoftheirMexicanassetsandusedtheproceedstobuyassetsofothercountries.ThisincreasedMexicannetcapitaloutflow.Thedemandforloanablefundsintheloanablefundsmarketincreased,whichincreasedtheinterestrate.Thisincreasedthesupplyofpesosintheforeign-currencyexchangemarket.,Figure7TheEffectsofCapitalFlight,(a)TheMarketforLoanableFundsinMexico,(b)MexicanNetCapitalOutflow,Real,Interest,Rate,Real,Interest,Rate,(c)TheMarketforForeign-CurrencyExchange,Quantityof,Pesos,Quantityof,LoanableFunds,NetCapital,Outflow,Real,Exchange,Rate,r1,r1,D1,E,Demand,S,Supply,NCO1,Toanalyzethemacroeconomicsofopeneconomies,twomarketsarecentralthemarketforloanablefundsandthemarketforforeign-currencyexchange.Inthemarketforloanablefunds,theinterestrateadjuststobalancesupplyforloanablefunds(fromnationalsaving)anddemandforloanablefunds(fromdomesticinvestmentandnetcapitaloutflow).,Inthemarketforforeign-currencyexchange,therealexchangerateadjuststobalancethesupplyofdollars(fornetcapitaloutflow)andt