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Chapter 32: A Macroeconomic Theory of the Open Economy - Coggle Diagram
Chapter 32: A Macroeconomic Theory of the Open Economy
Supply and Demand for Loanable Funds and for Foreign - Currency Exchange
Supply and Demand for Loanable Funds
Demand: Domestic Investment & Net Capital Outflow
Supply and Demand fepend on Real Interest Rate
Real Interest rates is high will lead national saving increase, but domestic investment and NCO decrease.
If the interest rate were below r*, the quantity of loanable funds demanded would be greater than the quantity of loanable funds supplied. The shortage of loanable funds would lead to upward pressure on the interest rate.
If the interest rate were above r*, the quantity of loanable funds demanded would be less than the quantity of loanable funds supplied. The surplus of loanable funds would lead to downward pressure on the interest rate.
At the equilibrium interest rate, the amount that people want to save is exactly equal to the desired quantities of domestic investment and net capital outflow.
Supply: National Saving
Supply and Demand for Foreign - Curnency Exchange
NCO=NX
NCO represents the quantity of dollars supplied for the purpose of buying assets abroad.
NX represent the quantity of dollars demanded for the purpose of buying U.S. net exports of goods and services.
Real Exchange Rates
Price of the U.S goods > Price of the relative to foreign goods
Lowering the U.S. exports and raising imports
Reduce the quantity of dollars demanded
The real exchange rate is on the vertical axis; the quantity of dollars exchanged is on the horizontal axis.
The demand for dollars will be downward sloping because of the inverse relationship between the
real exchange rate and the quantity of dollars demanded.
The supply of dollars will be a vertical line because of the fact that changes in the real exchange rate have no influence on the quantity of dollars supplied.
If the real exchange rate were lower than real e*, the quantity of dollars demanded would be greater than the quantity of dollars supplied and there would be upward pressure on the real exchange rate.
At the equilibrium real 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.
If the real exchange rate were higher than real e*, the quantity of dollars demanded would be less than the quantity of dollars supplied and there would be downward pressure on the real exchange rate.
Equilibrium in the Open Economy
Net Capital Outflow: The Link between the Two Markets
The key determinant of net capital outflow is the real interest rate.
When the real interest rate is high, owning domestic assets is more attractive and thus, net capital outflow is low.
This inverse relationship implies that net capital outflow will be downward sloping.
NCO can be positive or negative
Simultaneous Equilibrium in Two Markets
The real interest rate is determined in the market for loanable funds.
This real interest rate determines the level of net capital outflow.
NCO must be paid for with foreign currency, the quantity of NCO determines the supply of dollars.
The equilibrium real exchange rate brings into balance the quantity of dollars supplied and the quantity of dollars demanded.
Real Interest Rates and Real Exchange Rates determine: national saving, domestic investment, NCO and NX
How Policies and Events affect an open economy
Government Budget Deficits
A government budget deficit occurs when the government spending exceeds government revenue.
T - G <0, Because a government deficit represents negative public saving, it reduces national saving. This leads to a decline in the supply of loanable funds.
Supply of Loanable Funds decrease => Interest Rates increase => NCO decrease => Crowd out investment => Curency to appreciate => Push the trade balance toward deficit
Because they are so closely related, the budget deficit and the trade deficit are often called the twin deficits. Note that because many other factors affect the trade deficit, these “twins” are not identical.
Trade Policy
Government policy that directly influences the quntity of goods and services that a country imports or exports
Two common types of trade policies are tariffs (taxes on imported goods) and import quotas (limits on the quantity of goods produced abroad that can be sold domestically)
Note that the quota will have no effect on the market for loanable funds. Thus, the real interest rate will be unaffected.
The quota will lower imports and thus increase net exports. Because net exports are the source of demand for dollars in the market for foreign-currency exchange, the demand for dollars will increase
The real exchange rate will rise, making U.S. goods relatively more expensive than foreign goods. Exports will fall, imports will rise, and net exports will fall.
In the end, the quota reduces both imports and exports but net exports remain the same.
