Macro Unit VII: International Economics Chapters 35 and 36

International Trade and Government Intervention in International Trade Chapter 35

Absolute vs. Comparative Advantage 0 Absolute advantage 0 The ability to produce more of a good or service than another OR the ability to produce a good or service using the least amount of resources 0 Comparative advantage 0 The ability to produce a good or service at a lower opportunity cost than another producer

Production Possibilities in One Day of Work 0 Which country has the comparative advantage in the production of oranges? 0 US 0 Which country has the comparative advantage in the production of avocadoes? 0 Israel 0 What is the range in terms of trade for the United States? 0 Trade one bushel of oranges for 2+ bushels of avocados 0 What is the range in terms of trade for Israel? 0 1 bushel of oranges for <4 bushels of avocados OrangesAvocados United States 75 Bushels150 Bushels Israel100 Bushels400 Bushels

United States and Israel

Terms of Trade 0 The terms of trade are expressed in terms of the commodities to be exchanged. 0 For each country there is a range of acceptable terms of trade. 0 The United States is willing to trade one bushel of oranges for two or more bushels of avocadoes. 0 Israel is willing to trade one bushel of oranges for less than four bushels of avocadoes. 0 Thus, both the United States and Israel would be willing to trade one bushel of oranges for three bushels of avocadoes. 0 Both countries gain from the trade.

Specialization and Trade 0 Before specialization and trade, the United States was producing 50 bushels of oranges and 50 bushels of avocadoes: Point A on the PPC. 0 If, after specialization and trade, the United States wants to continue to have 50 bushels of oranges — and the terms of trade are one bushel of oranges for three bushels of avocadoes — then the United States could trade 25 bushels of oranges for 75 bushels of avocadoes. 0 Note that this combination — 50 bushels of oranges and 75 bushels of avocadoes — puts the United States outside of its production possibilities curve as indicated as point A' on the PPC.

Specialization and Trade 0 Similarly, Israel would have 25 bushels of oranges and 325 bushels of avocadoes: Point B’ after specialization and trade on the PPC 0 Note: 0 Had Israel produced 25 bushels of oranges before specialization and trade, it would have had only 300 bushels of avocadoes (Point B on PPC) 0 The combination of 25 bushels of oranges and 325 bushels of avocadoes (B') puts Israel outside of its production possibilities curve. 0 Thus, the United States has gained 25 bushels of avocadoes, and Israel has gained 25 bushels of avocadoes.

Terms of Trade 0 The terms of trade can be anywhere between one bushel of oranges for two to four bushels of avocadoes. 0 The actual terms of trade are based on market prices that reflect the opportunity costs. 0 There is a wide range of solutions depending on the agreed-to terms of trade and the willingness to trade specific amounts of the commodities.

Tariffs 0 Tax imposed by a nation on an imported good 0 Example: US imposes tariff of more than 10% on imports of textiles and shoes

Quotas 0 Restriction on the quantity or value of a good or service that can be imported or exported 0 Example: The voluntary export restraint (VER) Japan agreed to in the 1980s limiting the number of cars it exported to the United States

Other regulations to limit trade… 0 Example: The Federal Drug Administration’s test requirements of pharmaceuticals imported into the United States.

Unit 6 : Macroeconomics National Council on Economic Education Visual Domestic and Foreign Supply

Argument in Support of Limitations on Trade 0 National defense argument 0 Infant industry argument 0 Preservation of domestic jobs 0 Maintenance of a diverse and stable economy 0 Prevention of exploitation. 0 Most of these arguments do not stand up to scrutiny. 0 Limitations on trade fundamentally allow domestic producers to be inefficient and increase the costs to domestic consumers.

History of Tariffs in US 0 With the Smoot-Hawley Act of 1933, tariffs reached a high average rate of 20 percent. 0 Over time, the United States has attempted to reduce tariffs using trade agreements such as the North American Free Trade Agreement. 0 In the Uruguay Round (1986 to 1994) of World Trade Organization negotiations, the United States negotiated its lowest rate ever.

International Finance and Balance of Payments Accounts

Why does International Finance Matter?

Balance of Payments 0 Balance of payments: annual record of all of a nation’s transactions with other nations 0 Records all payments received from and paid to rest of the world

Balance of Payments 0 Current account: section of a nation’s balance of payments that records its trade in currently produced goods and services 0 Balance on goods = exports of goods minus imports of goods 0 Balance on goods and services = exports of goods & services minus imports of goods & services 0 Balance on the current account = balance on goods and services plus the net investment income (dividends and interest) from other nations and the net private and public transfers to other nations 0 Balance may produce trade deficit or trade surplus

Balance of Payments 0 Capital and financial account of a nation’s balance of payments records consists of two accounts: capital accounts and financial accounts 0 Capital account: measures debt forgiveness, is a “net” account 0 If Americans forgave more debt that was owed to them by foreigners than foreigners forgave debt that was owed to them by Americans, the capital account would be entered as a negative (-)

Balance of Payments 0 Financial account: shows foreign purchases of real and financial assets in the US 0 This earns the US some foreign currencies, so it’s entered as a plus (+) in the capital account 0 US purchases of real and financial assets abroad draw down US holdings, so this is entered as a minus (-) 0 There’s a surplus in the financial account if foreign purchases of US assets > US purchases of assets abroad 0 Balance on the capital and financial account = value of capital account minus value of financial account

Financial Accounts 0 Financial accounts record the flows money from the purchase and sale of assets domestically and abroad. 0 Let’s say U.S. investors buy a hotel building in Tokyo, or, shares of stock in a Swedish company while foreign investors buy a factory in the United States, or, stock in a U.S. company 0 Foreign assets are bought and sold using currencies purchased on foreign exchange markets.

Balance of Payments and the Market for Loanable Funds 0 The balance of payments is related to changes in the market for loanable funds. 0 The financial flows recorded in the financial account are part of the loanable funds market. 0 Foreign investors provide funds that are used to purchase assets, which means they supply loanable funds. 0 Changes in the supply of loanable funds affect the equilibrium real interest rate in the loanable funds market, which then affects a country’s investment, aggregate demand, output, employment, and price level.

Balance of Payments and the Market for Loanable Funds 0 Net capital outflows (NCOs, also called net foreign investment) refer to the difference between the acquisition of foreign assets by domestic residents and the acquisition of domestic assets by non-residents. Net capital outflows

Payments Deficits and Surpluses 0 A drawing down of official reserves measures a nation’s payments deficits; a building up of official reserves measures a nation’s surpluses 0 Adding to foreign reserves would occur if there’s a surplus 0 A balance of payments deficit isn’t necessarily bad, nor is a balance of payments surplus necessarily good. 0 HOWEVER, persistent payment deficits ultimately deplete the foreign exchange reserves 0 To correct its balance of payments deficits, a nation might implement a major depreciation of its currency or other policies to encourage exports 0 The US has persistently large current account deficits that must be offset by capital and financial account surpluses, which of growing concern…

Payments Deficits and Surpluses

Foreign Exchange Markets

Financing International Trade 0 Foreign exchange markets (also known as currency markets) enable international transactions to take place by providing markets for the exchange of national currencies 0 Exchange rate – the price of the domestic currency in terms of another currency 0 Generally expressed in terms of one unit of the domestic currency 0 For example, an exchange rate of 80 means that $1 is exchanged for 80 yen. 0 If the exchange rate increases, the quantity demanded falls and the quantity supplied increases. 0 Two types of foreign exchange rates: 0 Flexible exchange rates 0 Fixed exchange rates

Financing International Trade 0 Let’s look at an American export transaction: 0 US firms sells $300,000 worth of computers to British firm 0 Let’s say the current exchange rate is $2 = £1, so British firm will pay £150,000 0 The British firm will draw a check on its deposits at a London bank for £150,000, then send it to the US exporter 0 Exporter sells the British check to an American bank for $300,000 in exchange for the British check, and the exporter’s account is credited 0 The American bank will deposit the £150,000 in a correspondent London bank for future sales

Financing International Trade 0 Major points to note: 0 Exports create a demand for dollars and a supply of foreign money, in this case British pounds 0 The financing of an American export reduces the supply of money (demand deposits) in the UK and increases it in the US

Flexible Exchange Rates 0 Determined by the forces of supply and demand 0 Demand for any currency is downward sloping because as the currency becomes less expensive, people will be able to buy more of that nation’s goods and, therefore, want larger quantities of the currency 0 Supply of any currency is upward sloping because as its prices rise, holders of that currency can obtain other currencies more cheaply and will want to buy more imported goods and, therefore, will give up more of their currency to obtain other currencies 0 As with other commodities, the intersection of supply and demand determines the equilibrium price (the exchange rate)

Flexible Exchange Rates The supply of British pounds is determined by British demand for foreign goods, services and investments Demand for British pounds is determined by foreign demand for British goods, services and investments

Currency Appreciation 0 An increase in the exchange rate for a currency (which can be caused by an increase in demand or a decrease in supply) is called appreciation of that currency. 0 When a currency appreciates, it is said to have strengthened. 0 For example, if the exchange rate increases in the market for dollars, it means that it takes more of the foreign currency to purchase a dollar. 0 This means that a dollar can buy more of the foreign currency.

Currency Depreciation 0 A decrease in the exchange rate for a currency (which can be caused by a decrease in demand or an increase in supply) is called depreciation of that currency. 0 When a currency depreciates, it is said to have weakened. 0 For example, if the exchange rate decreases in the market for dollars, it means that it takes less of the foreign currency to purchase a dollar. 0 This means it takes more dollars to buy the foreign currency.

Currency Appreciation/Depreciation and Imports and Exports 0 Appreciation or depreciation of a currency changes the price of imports and exports. 0 When a country’s currency appreciates, it is more expensive for foreigners to buy the country’s exports and it is cheaper for the country to buy imports. 0 When a country’s currency depreciates, it is cheaper for foreigners to buy the country’s exports and it is more expensive for the country to buy imports. 0 Appreciation and depreciation of a currency will affect the economy because they affect net exports.

Factors that shift the curves… 0 If the exchange rate increases, the quantity demanded falls and the quantity supplied increases. 0 A change in any factor other than the exchange rate will cause the demand curve or the supply curve to shift. 0 For example, if the UK’s income increases, then the British demand for US dollars will increase because the British will want to buy more American goods. 0 If interest rates in the UK change relative to interest rates in other countries or if the expected future exchange rate changes, then the demand curve will shift.

Fixed Exchange Rates 0 Fixed exchange rates are pegged to some set value, like the US dollar or gold 0 Official reserves are used to correct an imbalance in the balance of payments, since exchange rates cannot fluctuate to bring about automatic balance 0 This is called currency intervention 0 Trade policies directly controlling the amount of trade and finance might be used to avoid imbalance in trade and payments

Fixed Exchange Rates 0 Exchange controls and rationing of currency have been used in the past but are disagreeable for several reasons: 1. Controls distort efficient patterns of trade 2. Rationing involves favoritism among importers 3. Rationing reduces freedom of consumer choice 4. Enforcement problems are likely as “black market” rates develop

Fixed Exchange Rates 0 Domestic macroeconomic adjustments may be more difficult under fixed rates 0 For example, a persistent deficit of trade may call for tight monetary and fiscal policies to reduce prices, which raises exports and reduces imports 0 THESE CONTRACTIONARY POLICIES COULD LEAD TO RECESSIONS AND UNEMPLOYMENT!!!

Monetary and Fiscal Policy in the Global Economy Chapter 36

Domestic Economic Policies and International Trade 0 A country’s domestic monetary and fiscal policy and its balance of trade and exchange rates. 0 Changes in a nation’s monetary and fiscal policies affect its exchange rates and its balance of trade through their effect on the real interest rate, income, and the price level. 0 Domestic policies influence currency values, and currency values influence domestic policies. 0 Policy makers cannot ignore the international effects of changes in monetary and fiscal policies.

Review 0 How would changes in the value of a country’s currency affect that country’s balance of trade? 0 Aggregate demand would be affected. 0 Changes in aggregate demand then affect real output and the price level.

Review 0 What are the short-run effects of expansionary monetary and fiscal policy on domestic interest rates? 0 Expansionary monetary policy decreases interest rates in the short run. 0 Expansionary fiscal policy increases interest rates if deficit financing is required.

Effects of Fiscal Policy 0 If the U.S. government raises spending to stimulate the economy, borrowing increases and U.S. interest rates increase. 0 Higher interest rates attract investment from abroad and the dollar appreciates. 0 As a result of the appreciated dollar, exports decrease and imports increase. 0 The result is a smaller stimulative effect.

Effects of Monetary Policy 0 If the Federal Reserve stimulates the economy by causing interest rates to decline, investment from abroad will decline. 0 The dollar will decrease in value. 0 As a result, exports increase and imports will decrease. 0 The outcome is a larger stimulative effect.

Net Exports and Capital Flows

Capital Flow 0 The term capital flow refers to the movement of financial capital (money) between economies. 0 Capital inflows are foreign funds moving into an economy from another country. 0 Capital outflows are the opposite—they are domestic funds moving out of an economy to another country.

Capital Flow 0 For example: 0 From the perspective of the U.S. economy, the construction of a new plant by a Japanese automobile manufacturer within the United States is an example of capital inflow. 0 When an American manufacturer finances the construction of a plant outside of the United States, it is an example of capital outflow.

A Macroeconomic Theory of the Open Economy

Macroeconomic Variables in an Open Economy 0 An open economy is one that interacts freely with other economies around the world. 0 The important macroeconomic variables of an open economy include: 0 net exports (NX) 0 net capital outflow (NCO) 0 nominal exchange rates (e) 0 real exchange rates (eP/P * ) 0 real interest rates (r) 0 Loanable funds (LF=I=S) 0 Theory helps us to link these variables together; however, to simplify the analysis we will make some assumptions.

Basic Assumptions 0 The model takes the economy’s GDP as given. Y = Y- bar (like the quantity theory) 0 The model takes the economy’s price level as given. P = P-bar (unlike the quantity theory)

The Theory of the Open Economy: A Complete Logical Flow 0 The theory relates and determines r, NCO, eP/P *, and NX 0 It begins with conditions in the loanable funds market and then the foreign exchange market. 0 In each market, the demand and supply are used, put together to determine equilibrium, and then the effects of shifts in demand and supply are analyzed. 0 The two markets are linked together and r, NCO, eP/P *, and NX are jointly determined. 0 Different policies and situations are then analyzed and their affect on r, NCO, eP/P *, and NX identified.

The Loanable Funds Market 0 The supply and demand in the loanable funds market determines the real interest rate {r} 0 Closed Economy: S=I only domestic borrowing and lending are allowed. 0 Open Economy: S=I+NCO this allows trade and borrowing and lending from the ROW (rest of the world)

SUPPLY AND DEMAND FOR LOANABLE FUNDS: OPEN ECONOMY 0 The Market for Loanable Funds S = I + NCO 0 At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net capital outflows. 0 The supply of loanable funds comes from national saving (S). 0 The demand for loanable funds comes from domestic investment (I) and net capital outflows (NCO).

0 The supply and demand for loanable funds depend on the real interest rate. 0 A higher real interest rate encourages people to save and raises the quantity of loanable funds supplied. 0 The interest rate adjusts to bring the supply and demand for loanable funds into balance 0 At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment.

0 National Saving: S → S LF is positively related to r↓(↑) → S LF ↓(↑) 0 Investment and Net Capital Flow: I+NCO → D LF is negatively related to r ↓(↑) → D LF ↑(↓) 0 r ↓(↑) I ↑(↓) 0 r↓(↑) PV ↑(↓) of future returns 0 r ↓(↑) NCO ↑(↓) 0 r US ↓(↑) US increases (decreases) demand for ROW assets and ROW decreases (increases) demand for US assets

Figure 3 How Net Capital Outflow Depends on the Interest Rate Copyright©2003 Southwestern/Thomson Learning 0 Net Capital Outflow Net capital outflow is negative. Net capital outflow is positive. Real Interest Rate

0 The equilibrium r in the LF market brings national saving = investment +net capital outflow or S=I+NCO. 0 Supply-side shocks to LF 0 S↓ (income taxes↑ or budget →deficit), then r↑→LF↓ 0 S↑ (income taxes↓ or budget →surplus), then r↓→LF↑ 0 Demand-side shocks to LF 0 I↑ (tax credits↑ or expected Y↑), then r↑→LF↑ 0 I↓ (tax credits↓ or expected Y↓), then r↓→LF↓ 0 NCO↓ (political instability abroad↑), then r↓→LF↓ [US holds fewer ROW assets and ROW holds more US assets] 0 NCO↑ (political stability abroad ↓), then r↑→LF↑ [US holds more ROW assets and ROW holds less US assets] 0 We have now fully described the LF market and the determination of r

Figure 1 The Market for Loanable Fund 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 Foreign-Currency Exchange 0 The two sides of the foreign-currency exchange market are represented by NCO and NX. 0 NCO represents the imbalance between the purchases and sales of capital assets. 0 NX represents the imbalance between exports and imports of goods and services. 0 In the market for foreign-currency exchange, U.S. dollars are traded for foreign currencies. 0 For an economy as a whole, NCO and NX must balance each other out, or: NCO = NX

The Market for Foreign-Currency Exchange 0 The price that balances the supply and demand for foreign-currency is the real exchange rate. 0 The demand curve for dollars is downward sloping because a higher exchange rate makes domestic goods more expensive. 0 The supply curve is vertical because the quantity of dollars supplied for net capital outflow is unrelated to the real exchange rate. It is related to the real interest rate and comes from the loanable funds market.

0 The real exchange rate adjusts to balance the supply and demand for dollars. 0 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. 0 For example, if the US has a trade surplus, foreigners are demanding US dollars to buy the net exports. At the same time, US dollars are being supplied to buy the foreign assets from the resulting net capital outflow (US receipt of foreign assets).

The Foreign Exchange Market 0 The supply and demand in the foreign exchange market determines the real exchange rate eP/P * 0 Closed Economy: no trading, NX, or eP/P *. 0 Open Economy: NX=NCO this allows trade and borrowing and lending from the ROW (rest of the world)

0 Net Capital Outflow - NCO → S $ 0 If NCO↑, US is supplying more dollars, on net, to purchase foreign assets 0 If NCO↓, US is supplying fewer dollars, on net, to purchase fewer foreign assets 0 NCO is determined by r in the loanable funds markets and is not related to eP/P*. 0 As eP/P*↓(↑), NCO remains the same

0 Net Exports - NX → D $ is negatively related to eP/P* 0 If eP/P*↓, NX↑, D $ ↑ - US goods become cheaper, net exports increase, and ROW needs more US dollars to purchase more goods and services 0 If eP/P*↑, NX↓, D $ ↓ - US goods become more expensive, net exports decrease, and ROW needs fewer US dollars to purchase fewer goods and services 0 Equilibrium in the foreign exchange market occurs when the eP/P* equates the D $ with the S $ or NX=NCO. 0 Foreign Exchange Shocks 0 D $ ↑, S $ is constant from NCO, eP/P*↑, until quantity of D $ ↓ and equals the quantity of S $ 0 D $ ↓, S $ is constant from NCO, eP/P*↓, until quantity of D $ ↑ and equals the quantity of S $

Figure 2 The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning Quantity of Dollars Exchanged into Foreign Currency Real Exchange Rate Supply of dollars (from net capital outflow) Demand for dollars (for net exports) Equilibrium quantity Equilibrium real exchange rate

EQUILIBRIUM IN THE OPEN ECONOMY 0 In the market for loanable funds, supply comes from national saving and demand comes from domestic investment and net capital outflow. 0 In the market for foreign-currency exchange, supply comes from net capital outflow and demand comes from net exports. 0 Net capital outflow links the loanable funds market and the foreign-currency exchange market. 0 The key determinant of net capital outflow is the real interest rate.

0 Prices in the loanable funds market and the foreign- currency exchange market adjust simultaneously to balance supply and demand in these two markets. 0 As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports. WOW!

Linking the Loanable Funds and Foreign Exchange Market 0 NCO link the two markets together 0 Step 1: S=I+NCO or S LF =D LF →r 0 Step 2: r →NCO 0 Step 3: NCO →S $ 0 Step 4: NX →D $ 0 Step 5: D $ =S $ →eP/P * and NX=NCO

Examples of Transmission of LF and FEM Shocks 0 Loanable Funds Shocks: 0 S↓, S LF ↓, r↑,NCO↓,S $ ↓, eP/P*↑,NX↓ 0 S↑, S LF ↑, r↓,NCO↑,S $ ↑, eP/P*↓,NX↑ 0 I↑, D LF ↑, r↑,NCO↓,S $ ↓, eP/P*↑,NX↓ 0 I↓, D LF ↓, r↓,NCO↑,S $ ↑, eP/P*↓,NX↑ 0 Foreign Exchange Shocks 0 D $ ↑, S $ is constant from NCO, eP/P*↑, until quantity of D $ ↓, but NX are constant, r is constant 0 D $ ↓, S $ is constant from NCO, eP/P*↓, until quantity of D $ ↑, but NX are constant, r is constant

Figure 4 The Real Equilibrium in an Open Economy Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds(b) Net Capital Outflow Net capital outflow,NCO Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate Supply Demand rr E

HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY 0 The magnitude and variation in important macroeconomic variables depend on the following: 0 Government budget deficits 0 Trade policies 0 Political and economic stability

Government Budget Deficits 0 In an open economy, government budget deficits... 0 reduce the supply of loanable funds, 0 drive up the interest rate, 0 crowd out domestic investment, 0 cause net foreign investment to fall.

Figure 5 The Effects of Government Budget Deficit Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds(b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate Demand r2r2 NCO SS S S r2r2 B E1E1 rr A 1. A budget deficit reduces the supply of loanable funds which increases the real interest rate The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency which causes the real exchange rate to appreciate which in turn reduces net capital outflow. E2E2

0 Effect of Budget Deficits on the Loanable Funds Market 0 A government budget deficit reduces national saving, which... 0 shifts the supply curve for loanable funds to the left, which... 0 raises interest rates 0 Effect of Budget Deficits on Net Foreign Investment 0 Higher interest rates reduce net foreign investment. 0 Effect on the Foreign-Currency Exchange Market 0 A decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency. 0 This causes the real exchange rate to appreciate.

Trade Policy 0 A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports. 0 Tariff: A tax on an imported good. 0 Import quota: A limit on the quantity of a good produced abroad and sold domestically. 0 Because they do not change national saving or domestic investment, trade policies do not affect the trade balance. 0 For a given level of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same. 0 Trade policies have a greater effect on microeconomic than on macroeconomic markets.

Trade Policy 0 Effect of an Import Quota 0 Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency. 0 This leads to an appreciation of the real exchange rate. 0 There is no change in the interest rate because nothing happens in the loanable funds market. 0 There will be no change in net exports. 0 There is no change in net foreign investment even though an import quota reduces imports.

0 Effect of an Import Quota 0 An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports. 0 This offsets the initial increase in net exports due to import quota. 0 Trade policies do not affect the trade balance.

Figure 6 The Effects of an Import Quota Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds(b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate rr Supply Demand NCO D D 3. Net exports, however, remain the same and causes the real exchange rate to appreciate. E E2E2 1. An import quota increases the demand for dollars...

Political Instability and Capital Flight 0 Capital flight is a large and sudden reduction in the demand for assets located in a country. 0 Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries. 0 If investors become concerned about the safety of their investments, capital can quickly leave an economy. 0 Interest rates increase and the domestic currency depreciates.

0 When investors around the world observed political problems in Mexico in 1994, they sold some of their Mexican assets and used the proceeds to buy assets of other countries. 0 This increased Mexican net capital outflow. 0 The demand for loanable funds in the loanable funds market increased, which increased the interest rate. 0 This increased the supply of pesos in the foreign- currency exchange market.

Figure 7 The Effects of Capital Flight Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds in Mexico(b) Mexican Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Pesos Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate r1r1 r1r1 D1D1 D2D2 E Demand SS2S2 Supply NCO 2 NCO 1 1. An increase in net capital outflow which increases the interest rate increases the demand for loanable funds At the same time, the increase in net capital outflow increases the supply of pesos which causes the peso to depreciate. r2r2 r2r2 E

Summary 0 To analyze the macroeconomics of open economies, two markets are central—the market for loanable funds and the market for foreign-currency exchange. 0 In the market for loanable funds, the interest rate adjusts to balance supply for loanable funds (from national saving) and demand for loanable funds (from domestic investment and net capital outflow).

Summary 0 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). 0 Net capital outflow is the variable that connects the two markets.

Summary 0 A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate. 0 The higher interest rate reduces net capital outflow, reducing the supply of dollars. 0 The dollar appreciates, and net exports fall.

Summary 0 A trade restriction increases net exports and increases the demand for dollars in the market for foreign-currency exchange. 0 As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods. 0 This appreciation offsets the initial impact of the trade restrictions on net exports.

Summary 0 When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound. 0 Political instability in a country can lead to capital flight. 0 Capital flight tends to increase interest rates and cause the country’s currency to depreciate.