Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001)

1
Mankiw Brief Principles of Macroeconomics,
Second Edition (Harcourt, 2001)

• Ch. 13 A Macroeconomic Theory of the Open Economy

2
What Is To Come?

• We will concentrate on the long run.
• Real GDP is given.
• Labor, capital, technology.
• Price level is determined by supply and demand
  for money.
• Savings and investments will be matched in the
  market for loanable funds.
• NFI and NX will determine the real exchange rate.

3
The Market for Loanable Funds

• This is the complete financial system.
• All savers go here to deposit (lend) their
  savings.
• All borrowers go there to get loans.
• When funds lent matches funds borrowed an
  equilibrium interest rate is reached.
• Equilibrium interest rate is the return on saving
  and cost of borrowing.

4
Circular Flow Equilibrium

• Y C I G NX
• Y C S T
• C S T C I G NX
• S (T G) I NX
• Private Saving Government Saving Investment
  Net Exports
• S (T G) I NFI
• National Saving Investment Net Foreign
  Investment

5
The Market for Loanable Funds

• Each dollar saved can be used to finance to
  purchase domestic capital or an asset abroad.
• The supply of loanable funds comes from national
  savings S (T G).
• The demand for loanable funds comes from domestic
  investment (I) and net foreign investment (NFI).
• If NFI is negative (capital inflow), the demand
  would shift left.

6
The Market for Loanable Funds

• A higher real rate of interest encourages people
  to save more.
• Supply in the loanable funds market is upward
  sloping.
• Demand in the loanable funds market is downward
  sloping.
• A higher real interest rate discourages
  investment because of higher cost of borrowing.
• A higher real interest rate at home discourages
  net foreign investment.

7
The Market for Loanable Funds
S(T-G)
At r1, the quantity of funds demanded (Ld1)
exceeds the quantity of funds supplied
(Ls1). Real interest rate will be forced upward.
At r2, the quantity of funds demanded (Ld2)
falls far short of quantity of funds
supplied (Ls2). Real interest rate will
be forced downward.
r2
r1
INFI
Ls1
Ld1
Ld2
Ls2
8
The Forex Market

• Participants in this market exchange USD for
  foreign currency.
• When net exports is positive (trade surplus), the
  quantity of USD demanded will be positive.
• When net exports is negative (trade deficit), the
  quantity of USD demanded will be negative.
• When NFI is positive (capital outflow), the
  quantity supplied of USD is positive.
• When NFI is negative (capital inflow), the
  quantity supplied of USD is negative.

9
The Forex Market
As the real exchange rate drops (our currency
depreciates), our exports will increase and our
imports will decrease. NX will rise. Since NFI
has to match NX, given the trade deficit in the
graph, NFI is also negative, indicating a capital
inflow into US. The real exchange rate is
determined through the interaction of NX and NFI.
NFI
Real Exchange Rate
NX
0
10
The Forex Market

• NFI depends on the real interest rates in our
  economy and abroad.
• R is not shown on the graph so NFI is given for
  the Forex graph.
• At equilibrium real exchange rate, the demand for
  dollars by foreigners arising from US net exports
  exactly balances the supply of dollars from
  Americans arising from US NFI.
• At equilibrium real exchange rate, the supply of
  dollars by Americans arising from negative US NX
  exactly balances the demand of dollars by
  foreigners arising from negative US NFI.

11
Net Foreign Investment
Real Interest rate
The higher the real interest is in our economy,
the more foreigners and Americans would keep
their savings in the US. The lower is the real
interest rate in US economy, the more Americans
and foreigners would like to keep their savings
abroad.
0
NFI
-NFI
12
Simultaneous Equilibrium
Real Interest Rate, R

R
S(T-G)
NFI
INFI
Loanable Funds
Real Exchange Rate
NFI
NX
13
Using the Double Markets

• What happens when government deficit increases?
• What happens when government has a surplus?
• What happens when there is a tariff increase?
• What happens when there is capital flight?

14
Government Deficit
R
Real Interest Rate, R

S(T-G)
NFI
INFI
Loanable Funds
NFI
Real Exchange Rate
NX
15
Tariff or Quota
R
Real Interest Rate, R

S(T-G)
INFI
Loanable Funds
Real Exchange Rate
NX
16
Capital Flight
R
Real Interest Rate, R

Loanable Funds
Real Exchange Rate
17
Questions

1. Japan usually runs a huge trade surplus. Using
   the equilibrium condition in the loanable
   markets, speculate what could be the reason for
   it.
2. The president was clearly determined to signal
   that the United States remains solidly on a
   course of deficit reduction, which should make
   the dollar more attractive to investors. (The
   New York Times, April 14, 1995). Is this
   possible?
3. Suppose that Congress passes an investment tax
   credit, which subsidizes domestic investment.
   Show effects on S, NFI, I, R, NX, Real exchange
   rate.

18
More Questions

1. In 1998 the Russian government defaulted on its
   debt payments, leading investors worldwide to
   raise their preference for US government bonds.
   What effect do you think this flight to safety
   had on the US economy?
2. Especially in the 80s Japanese savings flowed
   into US to finance US investments. What would
   happen to the US economy if the Japanese no
   longer wanted to buy American assets (or US NFI
   with Japan changed from negative to positive)?
3. Can we eliminate the trade deficit by subsidizing
   exports?
4. What happens when real interest rates abroad
   increase?