Lu9: A Macroeconomic theory of the open economy (Supply and Demand for…
Lu9: A Macroeconomic theory of the open economy
Supply and Demand for loanable funds
The Market for Loanable Funds
S = I + NCO
At the equilibrium interest rate
, the amount that people want to save exactly balances the desired quantities of investment and net capital outflows.
The supply of loanable funds comes from
national saving (S).
The demand for loanable funds comes from domestic i
nvestment (I) and net capital outflows (NCO).
The price that balances the supply and demand for foreign-currency is
the real exchange rate
represents the imbalance between the purchases and sales of capital assets.
represents the imbalance between exports and imports of goods and services.
For an economy as a whole, NCO and NX must balance, or:
NCO = NX
Equilibrium in the open economy
Net capital outflow links the loanable funds market and the foreign-currency exchange market.
Simultaneous Equilibrium in Two Markets
Prices in the loanable funds market and the foreign-currency exchange market adjust simultaneously to balance supply and demand in these two markets.
As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.
In the market for loanable funds, supply comes from national saving and demand comes from domestic investment and net capital outflow.
How policies and events affects sn open economy
The magnitude and variation in important macroeconomic variables depend on the following:
Government budget deficits
drive up the interest rate,
crowd out domestic investment,
reduce the supply of loanable funds,
cause net foreign investment to fall.
a government policy that directly influences the quantity of goods and services that a country imports or exports.
Tariff: A tax on an imported good.
Import quota: A limit on the quantity of a good produced abroad and sold domestically.
do not change
national saving or domestic investment, trade policies do not affect the trade balance.
no change in the interest rate
Political and economic stability
is a large and sudden reduction in the demand for assets located in a country.
Interest rates increase and the domestic currency depreciates.
This increased the supply of pesos in the foreign-currency exchange market.
An open economy is one that interacts freely with other economies around the world.
The important macroeconomic variables of an open economy include:
net foreign investment
nominal exchange rates
real exchange rates
Basic Assumptions of a Macroeconomic Model of an Open Economy:
The model takes the economy’s GDP as given.
The model takes the economy’s price level as given.