Macroeconomics

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Macroeconomics

• Open Economy Macroeconomics

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Principles of Macroeconomicsby N. Gregory
MankiwLarge Open Economy

• Instructor Prof. John M. Veitch

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Large Open Economy Solution

• Large open economy sets own interest rate.
• Market for Loanable Funds
• Market for loanable funds with S and I(r)
  NFI(r)
• Solve for equlibrium domestic real interest rate
  .
• Net Foreign Investment
• Solve for NFI(r) at Domestic real interest rate.
• Market for Foreign Exchange
• Take NFI(r) as Supply of domestic currency.
• Draw NX(e) as Demand for domestic currency.
• Find real exchange rate, e, where NFI(r)
  NX(e).

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Large Open Economy
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Net Foreign Investment
Real
Interest
Rate
NFI
NFI
0
NFI negative
NFI positive
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Market for Foreign Exchange
Real
Supply of
Exchange
(from NFI)
Rate
e1
Demand for
(from NX)
of Exchanged
1
7
Real
Net Foreign Investment
Real
S1
Interest
Interest
Rate
Rate
NFI1
D1
Loanable Funds
NFI
Market for Loanable Funds
Real
S1
D1
Exchange
Rate
Large Economy
Equilibrium
of
Market for Foreign Exchange
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Government Deficits

• An Increase in Government Budget Deficit.
• Govt Budget Deficit is negative public saving.
• Reduces Supply of Loanable Funds.
• Results
• Real Interest Rate Increases which Lowers
  Domestic Investment and NFI.
• Fall in NFI reduces Supply of Foreign Exchange.
• Real Exchange Rate Appreciates.
• Changes in gov't deficit thus affects interest
  rate, investment and exchange rate.

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Trade Policy

• Trade policy directly influences net exports.
• Consider a tariff or import quota.
• Demand for Foreign Exchange increases.
• Real exchange rate increases but surprisingly no
  change in NX or NFI.
• No effect of Market for Loanable Funds.
• No change in real interest rate.
• Trade policy affects only Real exchange rate but
  not the trade balance, domestic interest rate,
  saving, or investment!

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Political Instability

• Political Instability and Capital Flight.
• Investors withdraw capital from unstable country
  and move it to safe havens such as U.S.
• Look at the effects on the unstable country.
• Net Foreign Investment increases as savings move
  out of unstable country to safe havens.
• Increases Demand for Loanable Funds.
• Raises Real Interest Rate in unstable country.
• Increase in NFI also increases Supply of Foreign
  Exchange.
• Result is depreciation in Real Exchange Rate.

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