In this chapter you will build a model to explain an open economy’s trade balance and exchange rate, use the model to analyze the effects of government budget deficits, use the model to analyze the macroeconomic effects of trade policies, use the model to analyze political instability and capital flight. | 32 A Macroeconomic Theory of the Open Economy Open Economies An open economy is one that interacts freely with other economies around the world. Key Macroeconomic Variables in an Open Economy The important macroeconomic variables of an open economy include: net exports 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. SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE 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 Market for Loanable Funds The supply of loanable funds comes from national saving (S). The demand for loanable funds comes from domestic investment (I) and net capital outflows (NCO). The Market for Loanable Funds The supply and demand . | 32 A Macroeconomic Theory of the Open Economy Open Economies An open economy is one that interacts freely with other economies around the world. Key Macroeconomic Variables in an Open Economy The important macroeconomic variables of an open economy include: net exports 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. SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE 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 Market for Loanable Funds The supply of loanable funds comes from national saving (S). The demand for loanable funds comes from domestic investment (I) and net capital outflows (NCO). The Market for Loanable Funds The supply and demand for loanable funds depend on the real interest rate. A higher real interest rate encourages people to save and raises the quantity of loanable funds supplied. The interest rate adjusts to bring the supply and demand for loanable funds into balance. Figure 1 The Market for Loanable Funds Copyright©2003 Southwestern/Thomson Learning Quantity of Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity Equilibrium real interest rate The Market for Loanable Funds At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment. Last line: “net capital outflow” The Market for Foreign-Currency Exchange The two sides of the foreign-currency exchange market are represented by NCO and NX. NCO represents the imbalance between the purchases and sales of capital assets. NX represents the
