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Chapter
A Macroeconomic Theory
of the Open Economy
32
Supply and Demand for Loanable Funds
The market for loanable funds
In an open economy
S =I +NCO
Saving =Domestic investment +Net capital outflow
Supply of loanable funds
From national saving (S)
Demand for loanable funds
From domestic investment (I)
And net capital outflow (NCO)
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Supply and Demand for Loanable Funds
The market for loanable funds
Loanable funds: domestically generated flow of
resources available for capital accumulation
Purchase of a capital asset adds to the demand for
loanable funds
Asset located at home: I
Asset located abroad: NCO
If NCO >0, net outflow of capital - adds to demand
If NCO <0, net inflow of capital - reduce the demand
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Supply and Demand for Loanable Funds
The market for loanable funds
Higher real interest rate
Encourages people to save
Increases quantity of loanable funds supplied
Discourages investment
Decreases quantity of loanable funds demanded
Discourages Americans from buying foreign assets
Reduces U.S. net capital outflow
Encourages foreigners to buy U.S. assets
Reduces U.S. net capital outflow
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Supply and Demand for Loanable Funds
The market for loanable funds
Supply of loanable funds slopes upward
Demand of loanable funds slopes downward
At equilibrium interest rate
Amount that people want to save
Exactly balances the desired quantities of domestic
investment and net capital outflow
5
Figure
Real
Interest
Rate
The market for loanable funds
1
6
Quantity of
Loanable Funds
Equilibrium
real interest
rate
Supply of loanable funds
(from national saving)
Demand for loanable
funds (for domestic
investment and net
capital outflow)
Equilibrium
quantity
The interest rate in an open economy, as in a closed economy, is determined by the supply
and demand for loanable funds. National saving is the source of the supply of loanable
funds. Domestic investment and net capital outflow are the sources of the demand for
loanable funds. At the equilibrium interest rate, the amount that people want to save exactly
balances the amount that people want to borrow for the purpose of buying domestic capital
and foreign assets.
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Market for Foreign-Currency Exchange
The market for foreign-currency exchange
Identity: NCO =NX
Net capital outflow =Net exports
If trade surplus, NX >0
Foreigners - buy more U.S. goods & services
Than Americans - buy foreign goods & services
Americans use foreign currency
Buy foreign assets
Capital is flowing abroad, NCO >0
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Market for Foreign-Currency Exchange
The market for foreign-currency exchange
If trade deficit, NX <0
Americans - buy more foreign goods & services
Than foreigners - buy U.S. goods & services
Some of this spending
Financed by selling American assets abroad
Foreign capital is flowing into U.S.
NCO <0
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Market for Foreign-Currency Exchange
The market for foreign-currency exchange
Supply of foreign-currency exchange
Net capital outflow
Quantity of dollars supplied - buy foreign assets
Supply curve vertical
Quantity of dollars supplied for net capital outflow
Does not depend on the real exchange rate
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Market for Foreign-Currency Exchange
The market for foreign-currency exchange
Demand for foreign-currency exchange
Net exports
Quantity of dollars demanded buy U.S. net exports
of goods and services
Demand curve - downward sloping
A higher real exchange rate
Makes U.S. goods more expensive
Reduces the quantity of dollars demanded to buy those goods
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Market for Foreign-Currency Exchange
The market for foreign-currency exchange
Equilibrium real exchange rate
Demand for dollars
By foreigners
Arising from U.S. net exports of goods & services
Exactly balances supply of dollars
From Americans
Arising from U.S. net capital outflow
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Figure
The market for foreign-currency exchange
2
12
Real
Exchange
Rate
Quantity of Dollars Exchanged
into Foreign Currency
Equilibrium real
exchange rate
Supply of dollars
(from net capital outflow)
Demand for dollars
(for net exports)
Equilibrium
quantity
The real exchange rate is determined by the supply and demand for foreign-currency exchange.
The supply of dollars to be exchanged into foreign currency comes from net capital outflow.
Because net capital outflow does not depend on the real exchange rate, the supply curve is
vertical. The demand for dollars comes from net exports. Because a lower real exchange rate
stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net
exports), the demand curve is downward sloping. At the equilibrium real exchange rate, the
number of dollars people supply to buy foreign assets exactly balances the number of dollars
people demand to buy net exports.
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Equilibrium in the Open Economy
Net capital outflow: link between the two markets
Identities
Market for loanable funds: S =I +NCO
Market for foreign-currency exchange: NCO=NX
Net-capital-outflow curve
Link between
Market for loanable funds
Market for foreign-currency exchange
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Figure
How net capital outflow depends on the interest rate
3
14
Real
Interest
Rate
Net Capital
Outflow
Because a higher domestic real interest rate makes domestic assets more attractive, it
reduces net capital outflow. Note the position of zero on the horizontal axis: Net capital
outflow can be positive or negative. A negative value of net capital outflow means that the
economy is experiencing a net inflow of capital.
0 Net capital outflow
is positive
Net capital outflow
is negative
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Equilibrium in the Open Economy
Simultaneous equilibrium in two markets
Market for loanable funds
Supply: national saving
Demand: domestic investment & net capital
outflow
Equilibrium real interest rate, r
Net capital outflow
Slopes downward
Equilibrium interest rate, r
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Equilibrium in the Open Economy
Simultaneous equilibrium in two markets
Market for foreign-currency exchange
Supply: net capital outflow
Demand: net exports
Equilibrium real exchange rate, E
Equilibrium real interest rate, r
Price of goods and services in the present
Relative to goods and services in the future
Equilibrium real exchange rate, E
Price of domestic goods and services
Relative to foreign goods and services
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Equilibrium in the Open Economy
Simultaneous equilibrium in two markets
E and r - adjust simultaneously
To balance supply and demand
In both markets
Loanable funds
Foreign-currency exchange
Determine
National saving
Domestic investment
Net capital outflow
Net exports
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Figure
The real equilibrium in an open economy
4
18
Real
Interest
Rate
Supply
Demand
Quantity of
Loanable Funds
(a) The Market for Loanable Funds
Real
Interest
Rate
Net capital
outflow, NCO
Net capital outflow
(b) Net Capital Outflow
r
1
r
1
Real
Exchange
Rate
Supply
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
E
1
In panel (a), the supply and demand for
loanable funds determine the real interest rate.
In panel (b), the interest rate determines net
capital outflow, which provides the supply of
dollars in the market for foreign-currency
exchange.
In panel (c), the supply and demand for dollars
in the market for foreign-currency exchange
determine the real exchange rate.
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How Policies & Events Affect an Open Economy
Government budget deficits
Negative public saving
Reduces national saving
Reduces supply of loanable funds
Increase in interest rate
Reduces net capital outflow
Crowd-out domestic investment
Decrease in supply of foreign-currency exchange
Exchange rate appreciates
Net exports fall
Push the trade balance toward deficit
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Figure
The effects of a government budget deficit
5
20
Real
Interest
Rate
S
1
Demand
Quantity of
Loanable Funds
(a) The Market for Loanable Funds
Real
Interest
Rate
NCO
Net capital outflow
(b) Net Capital Outflow
r
1
Real
Exchange
Rate
S
1
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
E
1
When the government runs a budget deficit, it
reduces the supply of loanable funds from S
1
to
S
2
in panel (a). The interest rate rises from r
1
to r
2
to balance the supply and demand for loanable
funds. In panel (b), the higher interest rate
reduces net capital outflow. Reduced net capital
outflow, in turn, reduces the supply of dollars in
the market for foreign-currency exchange from S
1
to S
2
in panel (c). This fall in the supply of dollars
causes the real exchange rate to appreciate from
E
1
to E
2
. The appreciation of the exchange rate
pushes the trade balance toward deficit.
S
2
r
1
A
1. A budget deficit reduces
the supply of loanable funds . . .
r
2
B
2. . . .
which
increases
the real
interest
rate . . .
r
2
3. . . . which in
turn reduces
net capital
outflow.
S
2
4. The decrease
in net capital
outflow reduces
the supply of dollars
to be exchanged
into foreign
currency . . .
E
2
5. . . . Which
causes the real
exchange rate
to appreciate.
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How Policies & Events Affect an Open Economy
Trade policy
Government policy
Directly influences the quantity of goods and
services
That a country imports or exports
Tariff
Tax on imports
Import quota
Limit on quantity of imports
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How Policies & Events Affect an Open Economy
Trade policy
Macroeconomic impact of trade policy
Decrease imports Increase in net exports
Increase in demand for foreign-currency exchange
Real exchange rate appreciates
Discourage exports
No change in real interest rate
No change in net capital outflow
No change in net exports
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Figure
The effects of an import quota
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Real
Interest
Rate
Supply
Demand
Quantity of Loanable Funds
(a) The Market for Loanable Funds
Real
Interest
Rate
NCO
Net capital outflow
(b) Net Capital Outflow
r
1
r
1
Real
Exchange
Rate
Supply
D
1
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
E
1
When the U.S. government imposes a quota on
the import of Japanese cars, nothing happens in
the market for loanable funds in panel (a) or to net
capital outflow in panel (b). The only effect is a rise
in net exports (exports minus imports) for any
given real exchange rate. As a result, the demand
for dollars in the market for foreign-currency
exchange rises, as shown by the shift from D
1
to
D
2
in panel (c). This increase in the demand for
dollars causes the value of the dollar to appreciate
from E
1
to E
2
. This appreciation of the dollar tends
to reduce net exports, offsetting the direct effect of
the import quota on the trade balance.
D
2
1. An import
quota increases
the demand for
dollars . . .
E
2
2. . . . And causes
the real exchange
rate to appreciate.
3. Net exports,
however, remain
the same.
How Policies & Events Affect an Open Economy
Trade policy
Macroeconomic impact of trade policy
Trade policies do not affect the U.S. trade balance
NX =NCO =S I
Trade policies affect specific
Firms
Industries
Countries
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How Policies & Events Affect an Open Economy
Political instability and capital flight
Political instability
Leads to capital flight
Capital flight
Large and sudden reduction in the demand for
assets located in a country
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How Policies & Events Affect an Open Economy
Mexico - capital flight affects both markets
Investors
Sell Mexican assets & Buy U.S. assets
Net-capital-outflow curve increases
Supply of pesos in the market for foreign-currency
exchange increases
Demand curve in the market for loanable funds
increases Interest rate increases, the peso
depreciates
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Figure
The effects of capital flight
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Real
Interest
Rate
Supply D
1
Quantity of Loanable Funds
(a) The Market for Loanable Funds in Mexico
Real
Interest
Rate
NCO
1
Net capital outflow
(b) Mexican Net Capital Outflow
r
1
r
1
Real
Exchange
Rate
S
1
Demand
Quantity of Pesos
(c) The Market for Foreign-Currency Exchange
E
1
If people decide that Mexico is a risky place to keep their
savings, they will move their capital to safer havens such
as the U.S., resulting in an increase in Mexican net
capital outflow. The demand for loanable funds in
Mexico rises from D
1
to D
2
, as shown in panel (a), and
this drives up the Mexican real interest rate from r
1
to r
2
.
Because net capital outflow is higher for any interest
rate, that curve also shifts to the right from NCO
1
to
NCO
2
in panel (b). At the same time, in the market for
foreign-currency exchange, the supply of pesos rises
from S
1
to S
2
, as shown in panel (c). This increase in the
supply of pesos causes the peso to depreciate from E
1
to E
2
, so the peso becomes less valuable compared to
other currencies.
NCO
2
1. An increase
in net capital
outflow . . .
D
2
2. . . . increases the demand
for loanable funds . . .
r
2
3. . . . Which increases
the interest rate.
r
2
S
2
E
2
4. At the same time, the
increase in net capital
outflow increases the
supply of pesos . . .
5. . . . which causes
the peso to depreciate
Nation that experiences capital flight
Outflow of capital
Its currency weaken in foreign exchange markets
Depreciation
Increases the nations net exports
Nation that experiences inflow of capital
Its currency strengthen
Appreciation
Pushes its trade balance toward deficit
Capital flows from China
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A nations government policy:
Encourages capital to flow to another country
By making foreign investments itself
Effect?
Nation encouraging capital outflows
Weaker currency
Trade surplus
For the recipient of capital flows
Stronger currency
Trade deficit
Capital flows from China
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Ongoing policy disputes: U.S. and China
China tried to depress its currency (renminbi) in
foreign exchange markets
Promote its export industries
Accumulate foreign assets
Including U.S. government bonds
In 2007: $1.5 trillion
Chinese goods - less expensive
Contributes to the U.S. trade deficit
Hurts American producers who make products that
compete with imports from China
Capital flows from China
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Ongoing policy disputes: U.S. and China
U.S. government
Encouraged China to stop influencing the exchange value
of its currency
Impact of the Chinese policy on the U.S. economy
American consumers of Chinese imports
Benefit from lower prices
Inflow of capital from China
Lowers U.S. interest rates
Increases investment in the U.S. economy
Chinese government - financing U.S. economic
growth
Capital flows from China
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Chinese policy of investing in U.S. economy
Creates winners and losers among Americans
Net impact on U.S. economy - probably small
Motives behind the policy
China - wants to accumulate a reserve of foreign
assets
National rainy-day fund
Misguided policy
Capital flows from China
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