A Macroeconomic Theory

1
Chapter 18

• A Macroeconomic Theory
• of the Open Economy

2
Chapter 18 Outline

• Develop an Open Macro Model
• Two key markets
• Loanable Funds
• Currency Exchange
• Applications

3
Applications of Trade Model

• 1 Impact of Budget Deficits on Trade Balance
• 2 Impact of Asian Financial Crisis on Exchange
  Rates Trade Balance

4
The Market For Loanable Funds

• From Chapter 17 recall the identity

Domestic Investment
Net Foreign Investment
Saving


5
Arranging Your Notes
Diagram 1
Diagram 2
Diagram 3
Who Said That?
Oh
OK
6
The Market For Loanable Funds
Interest Rate
Supply Saving
S I NFI
RE
Demand I NFI
QE
Loanable Funds
7
The Market for Foreign-Currency Exchange

• NX NFI reflects the two sides of
  foreign-exchange market
• The real exchange rate ( the relative price of
  domestic foreign goods) ensures this equality

Currency Markets
8
Foreign Currency Market

• NFI is quantity of dollars supplied to buy
  foreign assets .
• NX determines quantity of dollars demanded to buy
  our goods.
• For economy NFI NX

9
The Market for Foreign-Currency Exchange

• Demand curve negatively related to real exchange
  rate (E). A higher E makes domestic goods more
  expensive.
• Supply curve vertical --- quantity of dollars
  supplied for NFI is unrelated to E.

10
The Market for Foreign-Currency Exchange
Supply of Dollars (NFI)
Real Exchange Rate
Equilibrium Real Exchange Rate
Demand for Dollars (NX)
Quantity
Equilibrium Quantity
11
Equilibrium in the Open Economy

• NFI links the loanable funds market with the
  currency exchange market.
• NFI depends on interest rate.
• In loanable funds market, NFI is part of demand.
  
• In market for currency exchange, NFI is source of
  supply.

12
1 Market For Loanable Funds
Interest Rate
Supply Saving
S I NFI
RE
Demand I NFI
QE
Loanable Funds
13
2 Key Link NFI Interest Rate
Interest Rate
RE
NFI
NFI
Net Foreign Investment
14
3 Market for Foreign-Currency Exchange
Supply of Dollars (NFI)
Real Exchange Rate
NX NFI
E
Demand for Dollars (NX)
Quantity

15
Basic Open Macro Model
16
How Policy Events Affect an Open Economy

• Government Budget Deficits
• Political and Economic Stability
• Asian Financial Crisis

17
Application 1 Budget Deficits

• What impact on
• real interest rate
• NFI
• NX
• real exchange rate

18
1 Market For Loanable Funds
Interest Rate
Supply Saving
S I NFI
RE
Demand I NFI
QE
Loanable Funds
19
Government Budget Deficits Specific Market
Effects

• Loanable Funds Market Effect
• Reduces national saving
• supply shifts left
• interest rate rises
• quantity of loanable funds falls

20
Graph 1 The Market For Loanable Funds (Figure
18-1)
Interest Rate
Supply Saving
S I NFI
RE
RE
Demand I NFI
QE
Loanable Funds
21
Government Budget Deficits Specific Market
Effect

• Net Foreign Investment Market
• The higher interest rate reduces net foreign
  investment.

22
Graph 2 The Key Link NFI Interest Rate
Interest Rate
RE
NFI
NFI
Net Foreign Investment
23
Graph 2 The Key Link NFI Interest Rate
Interest Rate
RE
RE
NFI
NFI
Net Foreign Investment
NFI
24
Government Budget Deficits Specific Market
Effects

• . Currency Exchange MarkeT
• Decrease in NFI reduces supply of to be
  exchanged into foreign currency
• Causes real exchange rate (E) to appreciate.

25
3 Market for Foreign-Currency Exchange
Supply of Dollars (NFI)
Real Exchange Rate
NX NFI
E
Demand for Dollars (NX)
Quantity

26
3 Market for Foreign-Currency Exchange
Supply of Dollars (NFI)
Real Exchange Rate
NX NFI
E
E
Demand for Dollars (NX)
Quantity

27
Basic Open Macro Model
28
Government Budget Deficits

• Government Budget Effect
• raises interest rates
• crowds out domestic investment
• .causes dollar to appreciate
• pushes trade balance toward a deficit.

29
Analyzing the Asian Financial Crisis

• How did the Asian Crisis Affect the US?
• Americans fled to safety -- US Government
  securities, US investments generally
• How did this impact our model?
• Lets see...

30
Application 3 Asian Crisis (AC)

• What impact on
• real interest rate
• NFI
• NX
• real exchange rate

31
AC Political Instability Capital Flight

• Capital Flight a situation when large sudden
  movement of funds out of country occurs due to
  political instability
• When world investors sense political problems in
  a country (e.g. Indonesia) they sell some
  Indonesian assets
• Use proceeds to buy other countries assets (US
  assets).

32
ACPolitical Instability and Capital
FlightSpecific Market Effects

• Net Foreign Investment Market
• Problems in Asia in 1997 increased causes drop in
  NFI in US
• Demand for loanable funds fall
• Interest rate falls.

33
1 AC Market For Loanable Funds
Interest Rate
Supply Saving
S I NFI
RE
Demand I NFI
QE
Loanable Funds
34
1 AC Market For Loanable Funds
Interest Rate
Supply Saving
S I NFI
RE
RE
Demand I NFI
QE
Loanable Funds
QE
35
AC NFI

• Political instability makes US citizens reduce
  NFI
• Hence the NFI curve shifts left

36
2 AC Key Link NFI Interest Rate
Interest Rate
RE
NFI
NFI
Net Foreign Investment
37
2 AC Key Link NFI Interest Rate
Interest Rate
RE
RE
NFI
NFI
Net Foreign Investment
NFI
38
AC Political Instability

• Lower NFI means a reduction in the supply of
  dollars to be converted into foreign currency
• This raises the real exchange rate
• This results in a lower level of NX

39
3 Market for Foreign-Currency Exchange
Supply of Dollars (NFI)
Real Exchange Rate
NX NFI
E
Demand for Dollars (NX)
Quantity

40
Graph 3 Market for Foreign-Currency Exchange
Supply of Dollars (NFI)
Real Exchange Rate
NX NFI
E
E
Demand for Dollars (NX)
Quantity
Dol
Dol
41
Open Macro Model
42
Conclusion Model Predicts Financial Crisis
Should Cause

• US Interest rates should fall
• Dollar to Appreciate
• Net Exports to Fall

Chapter Closed!
43
The Market for Foreign-Currency Exchange

• NX NFI reflects two sides of currency market in
  which U.S. dollars are traded for foreign
  currencies
• Price that balances supply demand is E

44
Applications of Trade Model

• 1 Impact of Budget Deficits on Trade Balance
• 2 How Effective are Import Quotas to Reducing
  The US Trade Deficit
• 3 Impact of Asian Financial Crisis on Exchange
  Rates Trade Balance

45
The Market For Loanable Funds (Chapter 13
revisited)

• Financial markets coordinate the economys saving
  and investment in
• The Loanable Funds Market
• The Supply of Loanable Funds comes from people
  who have extra income that they want to loan out.
• The Demand for Loanable Funds comes from those
  who wish to borrow to make investments.

46
The Market For Loanable Funds

• The supply and demand for loanable funds depends
  on the real interest rate. Movement to
  equilibrium is the process of determining the
  real interest rate in the economy.
• Saving represents the supply of loanable funds,
  while investment represents demand.

47
Macroeconomic Variable Determination in an Open
Economy

• The important macroeconomic variables of an open
  economy include National Saving, Domestic
  Investment, Net Foreign Investment and Net
  Exports.
• The values of these variables are determined
  through the interaction of the Loanable Funds
  Market, the Net Foreign Investment Market, and
  the Market for Foreign-Currency Exchange.

48
The Market For Loanable Funds

• From Chapter 17 recall the identity

49
The Market For Loanable Funds

• From Chapter 17 recall the identity

Domestic Investment
Net Foreign Investment
Saving

• At the equilibrium interest rate, the amount that
  people want to save, exactly balances the desired
  quantities of investment and net foreign
  investment.

50
The Market for Foreign-Currency Exchange

• 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.

51
Quick Quiz!

• Describe the sources of supply and demand in the
  market for loanable funds and the market for
  foreign-currency exchange.

52
Equilibrium in the Open Economy (Figure 18-4)

• The market prices of the loanable funds market
  and the foreign-currency exchange market adjust
  simultaneously to balance supply and demand in
  these markets. As they do, they determine the
  macroeconomic variables of national saving,
  domestic investment, net foreign investment and
  net exports.

53
Quick Quiz!

• In the model of the open economy, two markets
  determine two relative prices. What are the
  markets? What are the two relative prices?

54
Government Budget Deficits Specific Market
Effects

• Net Foreign Investment Market
• The higher interest rate reduces net foreign
  investment.
• Foreign-Currency Exchange Market
• The decrease in net foreign investment reduces
  the supply of dollars to be exchanged into
  foreign currency, which causes the real exchange
  rate to appreciate.

55
Application 2 Import Quotas

• What impact on
• real interest rate
• NFI
• NX
• real exchange rate

56
Government Trade Policy

• 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 policies are more microeconomic than
  macroeconomic

57
Government Trade PoliciesSpecific Market
Effects (Figure 18-6)

• Foreign-Currency Exchange Market
• Because foreigners need dollars to buy U.S. net
  exports, there is an increased demand for dollars
  in the market for foreign-currency, which leads
  to an appreciation of the real exchange rate.
• Nothing happens in the loanable funds market
  because there is no change in the interest rate.

58
Government Trade PoliciesSpecific Market
Effects (Figure 18-6)

• Net Foreign Investment Market
• Because there is no change in net foreign
  investment, there will be no change in net
  exports.
• An appreciation of the dollar in the foreign
  exchange market encourages imports and
  discourages exports which...
• ... offsets the direct increase in net exports
  due to import quota.

59
Graph 1 The Market For Loanable Funds (Figure
18-1)
Interest Rate
Supply Saving
S I NFI
RE
Demand I NFI
QE
Loanable Funds
60
Government Trade PoliciesSpecific Market
Effects (Figure 18-6)

• Nothing happens in the loanable funds market
  because there is no change in the interest rate.

61
Graph 2 The Key Link NFI Interest Rate
Interest Rate
RE
NFI
NFI
Net Foreign Investment
62
Graph 3 Market for Foreign-Currency Exchange
Supply of Dollars (NFI)
Real Exchange Rate
NX NFI
E
Demand for Dollars (NX)
Quantity
Dol
63
Graph 3 Market for Foreign-Currency Exchange
Supply of Dollars (NFI)
Real Exchange Rate
NX NFI
E
E
Demand for Dollars (NX)
Quantity
Dol
64
Government Trade PoliciesSpecific Market
Effects (Figure 18-6)

• Foreign-Currency Exchange Market
• Because foreigners need dollars to buy U.S. net
  exports, there is an increased demand for dollars
  in the market for foreign-currency, which leads
  to an appreciation of the real exchange rate.

65
Quick Quiz!

• Suppose that Americans decided to spend a smaller
  fraction of their incomes. What would be the
  effect on saving, investment, interest rates, the
  real exchange rate and the trade balance?

66
Political Instability and Capital FlightSpecific
Market Effects

• Net Foreign Investment Market
• Observed political problems in Mexico in 1994
  increased Mexican net foreign investment which,
• Increased the demand for loanable funds in the
  Loanable Funds Market and increased the interest
  rate, which ...
• ... increased the supply of pesos in the
  Foreign-Currency Exchange Market.

67
Political Instability and Capital FlightSpecific
Market Effects

• Capital Flight has its largest impact on the
  country from which the capital is fleeing but it
  also affects other countries.
• If investors become concerned about the safety of
  their investments, capital can quickly leave an
  economy, thereby increasing interest rates and
  causing the domestic currency to depreciate.

68
Political Instability and Capital FlightSpecific
Market Effects

• Net Foreign Investment Market
• Observed political problems in Asia in 1997
  reduced US net foreign investment which,
• Decreased the demand for loanable funds in the
  Loanable Funds Market and decreased the interest
  rate, which ...
• ... decreased the supply of Dollars in the
  Foreign-Currency Exchange Market.

69
Government Trade PoliciesSpecific Market
Effects (Figure 18-6)

• Foreign-Currency Exchange Market
• Because foreigners need dollars to buy U.S. net
  exports, there is an increased demand for dollars
  in the market for foreign-currency, which leads
  to an appreciation of the real exchange rate.
• Nothing happens in the loanable funds market
  because there is no change in the interest rate.