Chapter 19

WHAT’S NEW IN THE THIRD EDITION:

The term "net foreign investment" has been replaced with "net capital outflow." There is a new In the News box on "The U.S. Trade Deficit."

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

Ø how to build a model to explain an open economy’s trade balance and exchange rate.

Ø how to use the model to analyze the effects of government budget deficits.

Ø how to use the model to analyze the macroeconomic effects of trade policies.

Ø how to use the model to analyze political instability and capital flight.

CONTEXT AND PURPOSE:

Chapter 19 is the second chapter in a two-chapter sequence on open-economy macroeconomics. Chapter 18 explained the basic concepts and vocabulary associated with an open economy. Chapter 19 ties these concepts together into a theory of the open economy.

The purpose of Chapter 19 is to establish the interdependence of a number of economic variables in an open economy. In particular, Chapter 19 demonstrates the relationships between the prices and quantities in the market for loanable funds and the prices and quantities in the market for foreign-currency exchange. Using these markets, we can analyze the impact of a variety of government policies on an economy’s exchange rate and trade balance.

KEY POINTS:

1. To analyze the macroeconomics of open economies, two markets are central—the market for loanable funds and the market for foreign-currency exchange. In the market for loanable funds, the interest rate adjusts to balance the supply of loanable funds (from national saving) and the demand for loanable funds (from domestic investment and net capital outflow). In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (for net capital outflow) and the demand for dollars (for net exports). Because net capital outflow is part of the demand for loanable funds and provides the supply of dollars for foreign-currency exchange, it is the variable that connects these two markets.

2. A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate. The higher interest rate reduces net capital outflow, which reduces the supply of dollars in the market for foreign-currency exchange. The dollar appreciates, and net exports fall.

3. Although restrictive trade policies, such as tariffs or quotas on imports, are sometimes advocated as a way to alter the trade balance, they do not necessarily have that effect. A trade restriction increases net exports for a given exchange rate and, therefore, increases the demand for dollars in the market for foreign-currency exchange. As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods. This appreciation offsets the initial impact of the trade restriction on net exports.

4. When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound. In particular, political instability can lead to capital flight, which tends to increase interest rates and cause the currency to depreciate.

CHAPTER OUTLINE:

I. Supply and Demand for Loanable Funds and for Foreign-Currency Exchange

A. The Market for Loanable Funds

1. Whenever a nation saves a dollar of income, it can use that dollar to finance the purchase of domestic capital or to finance the purchase of an asset abroad.

2. The supply of loanable funds comes from national saving.

3. The demand for loanable funds comes from domestic investment and net capital outflow.

4. The quantity of loanable funds demanded and the quantity of loanable funds supplied depend on the real interest rate.

a. A higher real interest rate encourages people to save and thus raises the quantity of loanable funds supplied.

b. A higher interest rate makes borrowing to finance capital projects more costly, discouraging investment and reducing the quantity of loanable funds demanded.

c. A higher real interest rate in a country will also lower net capital outflow. All else equal, a higher domestic interest rate implies that purchases of foreign assets by domestic residents will fall and purchases of domestic assets by foreigners will rise.

5. The supply and demand for loanable funds can be shown graphically.

a. The real interest rate is the price of borrowing funds and is therefore on the vertical axis; the quantity of loanable funds is on the horizontal axis.

b. The supply of loanable funds is upward sloping because of the positive relationship between the real interest rate and the quantity of loanable funds supplied.

c. The demand for loanable funds is downward sloping because of the inverse relationship between the real interest rate and the quantity of loanable funds demanded.

Figure 1

6. The interest rate adjusts to bring the supply and demand for loanable funds into balance.

a. If the interest rate was below r*, the quantity of loanable funds demanded would be greater than the quantity of loanable funds supplied. This would lead to upward pressure on the interest rate.

b. If the interest rate was above r*, the quantity of loanable funds demanded would be less than the quantity of loanable funds supplied. This would lead to downward pressure on the interest rate.

7. 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.

B. The Market for Foreign-Currency Exchange

1. The imbalance between the purchase and sale of capital assets abroad must be equal to the imbalance between exports and imports of goods and services.

2. Net capital outflow represents the quantity of dollars supplied for the purpose of buying assets abroad.

3. Net exports represent the quantity of dollars demanded for the purpose of buying U.S. net exports of goods and services.

4. The real exchange rate is the price that balances the supply and demand in the market for foreign-currency exchange.

a. When the U.S. real exchange rate appreciates, U.S. goods become more expensive relative to foreign goods, lowering U.S. exports and raising imports. Thus, an increase in the real exchange rate will reduce the quantity of dollars demanded.

b. The key determinant of net capital outflow is the real interest rate. Thus, as the real exchange rate changes, there will be no change in net capital outflow.

5. We can show the market for foreign-currency exchange graphically.

a. The real exchange rate is on the vertical axis; the quantity of dollars exchanged is on the horizontal axis.

b. The demand for dollars will be downward sloping because of the inverse relationship between the real exchange rate and the quantity of dollars demanded.

c. 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.

Figure 2

6. The real exchange rate adjusts to balance the supply and demand for dollars.

a. If the real exchange rate was 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.

b. If the real exchange rate was 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.

7. 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.

C. FYI: Purchasing-Power Parity as a Special Case

1. Purchasing-power parity suggests that a dollar must buy the same quantity of goods and services in every country. As a result, the real exchange rate is fixed and the nominal exchange rate is determined by the price levels in the two countries.

2. Purchasing-power parity assumes that international trade responds quickly to international price differences.

a. If goods were cheaper in one country than another, they would be exported from the country where they are cheaper and imported into the second country where the prices are higher until the price differential disappears.

b. Because net exports are so responsive to small changes in the real exchange rate, purchasing-power parity implies that the demand for dollars would be horizontal. Thus, purchasing-power parity is simply a special case of the model of the foreign-currency exchange market.

c. However, it is more realistic to draw the demand curve downward sloping.

II. Equilibrium in the Open Economy

A. Net Capital Outflow: The Link between the Two Markets

1. In the market for loanable funds, net capital outflow is one of the sources of demand.

Figure 3

2. In the foreign-currency exchange market, net capital outflow is the source of the supply of dollars.

3. This means that net capital outflow is the variable that links the two markets.

4. The key determinant of net capital outflow is the real interest rate.

5. We can show the relationship between net capital outflow and the real interest rate graphically.

a. When the real interest rate is high, owning domestic assets is more attractive and thus, net capital outflow is low.

b. This inverse relationship implies that net capital outflow will be downward sloping.

c. Note that net capital outflow can be positive or negative.

B. Simultaneous Equilibrium in Two Markets

Figure 4

1. The real interest rate is determined in the market for loanable funds.

2. This real interest rate determines the level of net capital outflow.

3. Because net capital outflow must be paid for with foreign currency, the quantity of net capital outflow determines the supply of dollars.

4. The equilibrium real exchange rate brings into balance the quantity of dollars supplied and the quantity of dollars demanded.

5. Thus, the real interest rate and the real exchange rate adjust simultaneously to balance supply and demand in the two markets. As they do so, they determine the levels of national saving, domestic investment, net capital outflow, and net exports.

III. How Policies and Events Affect an Open Economy

A. Government Budget Deficits

Figure 5

1. A government budget deficit occurs when the government spending exceeds government revenue.

2. Because a government deficit represents negative public saving, it lowers national saving. This leads to a decline in the supply of loanable funds.

3. The real interest rate rises, leading to a decline in both domestic investment and net capital outflow.

4. Because net capital outflow falls, people need less foreign currency to buy foreign assets so the supply of dollars declines.

5. The real exchange rate rises, making U.S. goods more expensive relative to foreign goods. Exports will fall, imports will rise, and net exports will fall.

6. In an open economy, government budget deficits raise real interest rates, crowd out domestic investment, cause the dollar to appreciate, and push the trade balance toward deficit.

7. 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.

B. Trade Policy

Figure 6

1. Definition of trade policy: a government policy that directly influences the quantity of goods and services that a country imports or exports.

2. Two common types of trade policies are tariffs (taxes on imported goods) and quotas (limits on the quantity of imported goods).

3. Example: the U.S. government imposes a quota on the number of cars imported from Japan.

4. Note that the quota will have no effect on the market for loanable funds. Thus, the real interest rate will be unaffected.

5. The quota will lower imports and thus increase net exports. Since net exports are the source of demand for dollars in the market for foreign-currency exchange, the demand for dollars will increase.

6. 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.

7. In the end, the quota reduces both imports and exports but net exports remain the same.

8. Thus, trade policies do not affect the trade balance.

9. Recall that NX = NCO. Also remember that S = I + NCO.

Rewriting, we get:

NCO = S – I.

Substituting for NCO, we get:

NX = S – I.

10. Since trade policies do not affect national saving or domestic investment, they cannot affect net exports.

11. Trade policies do have effects on firms, industries, and countries. But these effects are more microeconomic than macroeconomic.

C. Political Instability and Capital Flight

1. Definition of capital flight: a large and sudden reduction in the demand for assets located in a country.

2. Capital flight often occurs because investors feel that the country is unstable, due to either economic or political problems.

3. Example: Investors around the world observe political problems in Mexico and begin selling Mexican assets and buying U.S. assets.

Figure 7

4. Mexican net capital outflow will rise because investors are selling Mexican assets and purchasing assets from another country.

a. Since net capital outflow determines the supply of pesos, the supply of pesos increases.

b. Since net capital outflow is also a part of the demand for loanable funds, the demand for loanable funds rises.

5. The increased demand for loanable funds causes the equilibrium real interest rate to rise.

6. The increased supply of pesos lowers the equilibrium real exchange rate.

7. Thus, capital flight from Mexico increases Mexican interest rates and lowers the value of the Mexican peso in the market for foreign-currency exchange.

8. Capital flight in Mexico will also affect other countries. If the capital flows out of Mexico and into the United States, it has the opposite effect on the U.S. economy.

9. In 1997, several Asian countries experienced capital flight. The same thing occurred in Russia in 1998.

Activity 1 — Open Economy Article

Type: Take-home assignment

Topics: Open-economy macroeconomics

Class limitations: Works in any class

Purpose

This assignment helps students apply the open-economy macro model to world events.

Instructions

This model is often confusing to students. This assignment has them work through an example of real world events that relate to international macroeconomics. Students may need more direction in finding appropriate topics—interest rate changes, changes in net capital outflow, changes in net exports

Assignment

1. Find an article in a recent newspaper or magazine illustrating a change that will affect Net Capital Outflow or Net Exports.

2. Explain how and why Net Capital Outflow or Net Exports would shift.

3. Use the three market open-economy model (the market for loanable funds, net foreign investment, and the market for foreign-currency exchange) to analyze this change.

4. Graph the equilibrium real interest rate, level of net capital outflow, and real exchange rate before the change. Then show how the change will affect these variables.

5. Turn in a copy of the article along with your explanation.

D. In the News: The U.S. Trade Deficit

1. A large amount of borrowing from abroad makes Americans vulnerable if foreigners decide to reduce the flow of loans and investments to the United States.

2. This is an article written by two economists suggesting that U.S. policymakers would be wise to develop policies that promote saving to lower our dependence on foreign investment.

Figure 10

12. a. When U.S. mutual funds become more interested in investing in Canada, Canadian net capital outflow declines as the U.S. mutual funds make portfolio investments in Canadian stocks and bonds. The demand for loanable funds shifts to the left and the net capital outflow curve shifts to the left, as shown in Figure 11. As the figure shows, the real interest rate declines, thus reducing Canada’s private saving, but increasing Canada’s domestic investment. In equilibrium, Canadian net capital outflow declines.

b. Since Canada's domestic investment increases, in the long run, Canada's capital stock will increase.

c. With a higher capital stock, Canadian workers will be more productive (the value of their marginal product will increase) so wages will rise. Thus Canadian workers will be better off.

d. The shift of investment into Canada means increased U.S. net capital outflow. As a result, the U.S. real interest rises, leading to less domestic investment, which in the long run reduces the U.S. capital stock, lowers the value of marginal product of U.S. workers, and therefore decreases the wages of U.S. workers. The impact on U.S. citizens would be different from the impact on U.S. workers because some U.S. citizens own capital that now earns a higher real interest rate.

Figure 11