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:
� how
to build a model to explain an open economy�s trade balance and exchange rate.
� how
to use the model to analyze the effects of government budget deficits.
� how
to use the model to analyze the macroeconomic effects of trade policies.
� 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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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
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A.�������� Government Budget Deficits
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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.
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B.�������� Trade Policy
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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.
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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.
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����������� 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.
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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.
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Figure 11
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