Ten Principles of Economics - Part 68. Economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. | CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 693 Now consider which way these curves shift. When net foreign investment increases there is greater demand for loanable funds to finance these purchases. Thus as panel a of Figure 30-7 shows the demand curve for loanable funds shifts to the right from D1 to D2. In addition because net foreign investment is higher for r2 3. . . . which increases the interest rate. a The Market for Loanable Funds in Mexico b Mexican Net Foreign Investment Real Interest Rate Quantity of Pesos c The Market for Foreign-Currency Exchange The Effects of Capital Flight. If people decide that Mexico is a risky place to keep their savings they will move their capital to safer havens such as the United States resulting in an increase in Mexican net foreign investment. Consequently the demand for loanable funds in Mexico rises from D1 to D2 as shown in panel a and this drives up the Mexican real interest rate from r1 to r2. Because net foreign investment is higher for any interest rate that curve also shifts to the right from NFI1 to NFI2 in panel b . At the same time in the market for foreign-currency exchange the supply of pesos rises from S1 to S2 as shown in panel c . This increase in the supply of pesos causes the peso to depreciate from E1 to E2 so the peso becomes less valuable compared to other currencies. Figure 30-7 694 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES any interest rate the net-foreign-investment curve also shifts to the right from NFI1 to NFI2 as in panel b . To see the effects of capital flight on the economy we compare the old and new equilibria. Panel a of Figure 30-7 shows that the increased demand for loanable funds causes the interest rate in Mexico to rise from r1 to r2. Panel b shows that Mexican net foreign investment increases. Although the rise in the interest rate does make Mexican assets more attractive this development only partly offsets the impact of capital flight on net foreign investment. .
