PowerPoint Presentations for Principles of Macroeconomics Sixth Canadian Edition by Mankiw/Kneebone/McKenzie Adapted for the Sixth Canadian Edition by Marc Prud’homme University of Ottawa

A MACROECONOMIC THEORY OF THE SMALL OPEN ECONOMY Chapter 13 Copyright © 2014 by Nelson Education Ltd.13-2

A MACROECONOMIC THEORY OF THE SMALL OPEN ECONOMY  The goal of the model in this chapter is to highlight the forces that determine the economy’s trade balance and exchange rate.  To understand what factors determine a country’s trade balance and how government policies can affect it, we need a macroeconomic theory of the small open economy. Copyright © 2014 by Nelson Education Ltd.13-3

 Assumptions for our small open economy model: 1.The level of GDP is a given. 2.The price level is fixed. 3.The real interest rate is equal to the world interest rate and is taken as given. Copyright © 2014 by Nelson Education Ltd.13-4 A MACROECONOMIC THEORY OF THE SMALL OPEN ECONOMY

SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE  The focus is on supply and demand on two markets to understand the forces at work in an open economy:  Market for loanable funds  Market for foreign currency exchange Copyright © 2014 by Nelson Education Ltd.13-5

The Market for Loanable Funds  The place to start to understand the market for loanable funds in a small open economy is with this identity: Copyright © 2014 by Nelson Education Ltd.13-6

 Recall that in a small open economy with perfect capital mobility (e.g., Canada), the domestic interest rate will equal the world interest rate.  The market for loanable funds in a small open economy with perfect capital mobility is different from that in a closed economy.  The interest rate is no longer determined by the demand and supply of loanable funds. Copyright © 2014 by Nelson Education Ltd.13-7 The Market for Loanable Funds

FIGURE 13.1: The Market for Loanable Funds Copyright © 2014 by Nelson Education Ltd.13-8

 The quantity of loanable funds made available by the savings of Canadians does not have to equal the quantity of loanable funds demanded for domestic investment.  The difference between these two amounts is net capital outflow. Copyright © 2014 by Nelson Education Ltd.13-9 The Market for Loanable Funds

 The market for foreign exchange exists because people want to trade goods, services, and financial assets with people in other countries, but they want to be paid for these things in their own currency. Copyright © 2014 by Nelson Education Ltd The Market for Foreign-Currency Exchange

 To understand the market for foreign-currency exchange … Copyright © 2014 by Nelson Education Ltd The Market for Foreign-Currency Exchange

 We can view the two sides of this identity as representing the two sides of the market for foreign-currency exchange.  The difference between national saving and domestic investment represents net capital outflow.  This difference, then, represents the quantity of dollars supplied in the market for foreign-currency exchange for the purpose of buying foreign assets. Copyright © 2014 by Nelson Education Ltd.13-12

 What price balances the supply and demand in the market for foreign-currency exchange?  The real exchange rate  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. Copyright © 2014 by Nelson Education Ltd The Market for Foreign-Currency Exchange

FIGURE 13.2: The Market for Foreign-Currency Exchange Copyright © 2014 by Nelson Education Ltd.13-14

 The division of transactions between “supply” and “demand” in this model is somewhat artificial.  In our model, net exports are the source of the demand for dollars, and net capital outflow is the source of the supply. Copyright © 2014 by Nelson Education Ltd The Market for Foreign-Currency Exchange

QuickQuiz Describe the sources of supply and demand in the market for loanable funds and the market for foreign-currency exchange. Copyright © 2014 by Nelson Education Ltd.13-16

EQUILIBRIUM IN THE SMALL OPEN ECONOMY  Let’s now consider how the market for loanable funds and the market for foreign-currency exchange are related to each other. Copyright © 2014 by Nelson Education Ltd.13-17

Net Capital Outflow: The Link Between the Two Markets  So far, we have discussed how the economy coordinates four important macroeconomic variables: 1.National saving (S) 2.Domestic investment (I) 3.Net capital outflow (NCO) 4.Net exports (NX)  NCO is the variable that links these two markets. Copyright © 2014 by Nelson Education Ltd.13-18

FIGURE 13.3: The Real Equilibrium in a Small Open Economy Copyright © 2014 by Nelson Education Ltd.13-19

QuickQuiz In the model of the small open economy just developed, two markets determine one price and the value of three variables. What are the markets? What three variables are determined? What price is determined? Copyright © 2014 by Nelson Education Ltd.13-20

Copyright © 2014 by Nelson Education Ltd.  Initially, the government budget is balanced and trade is balanced (NX = 0).  Suppose the government runs a budget deficit. As we saw earlier, r rises and NCO falls.  How does the budget deficit affect the Canadian real exchange rate? The balance of trade? Active Learning The Budget Deficit, Exchange Rate, and NX

Copyright © 2014 by Nelson Education Ltd. The budget deficit reduces NCO and the supply of dollars. The real exchange rate appreciates, reducing net exports. Since NX = 0 initially, the budget deficit causes a trade deficit ( NX < 0). S 1 = NCO 1 E Dollars D = NX E1E1 S 2 = NCO 2 E2E2 Market for foreign-currency exchange Active Learning Answers

HOW POLICIES AND EVENTS AFFECT A SMALL OPEN ECONOMY  When using the model to analyze any event, we can apply the same three steps outlined in Chapter 4. 1.Determine which of the supply and demand curves the event affects. 2.Determine which way the curves shift. 3.Use the supply-and-demand diagrams to examine how these shifts alter the economy’s equilibrium. Copyright © 2014 by Nelson Education Ltd. Xin Qiu/Shutterstock 13-23

Increase in World Interest Rates  Canadians have good reason to closely watch movements in world interest rates. Why? Copyright © 2014 by Nelson Education Ltd.13-24

FIGURE 13.4: The Effects of an Increase in the World Interest Rate Copyright © 2014 by Nelson Education Ltd.13-25

Government Budget Deficits and Surpluses  In a closed economy, a government budget deficit reduces the supply of loanable funds, drives up the domestic interest rate, and crowds out investment.  What is the effect of a government budget deficit in an open economy? Copyright © 2014 by Nelson Education Ltd.13-26

FIGURE 13.5: The Effects of an Increase in the Government Budget Deficit Copyright © 2014 by Nelson Education Ltd.13-27

 In a small open economy with perfect capital mobility, a decrease in government budget deficits causes the dollar to depreciate and causes net exports to rise. Copyright © 2014 by Nelson Education Ltd Government Budget Deficits and Surpluses

Trade Policy  Trade policy : a government policy that directly influences the quantity of goods and services that a country imports or exports  Tariff : a tax on goods produced abroad and sold domestically  Import quota : a limit on the quantity of a good that is produced abroad and sold domestically Copyright © 2014 by Nelson Education Ltd.13-29

FIGURE 13.6: The Effects of an Import Quota Copyright © 2014 by Nelson Education Ltd.13-30

Trade Policy  Trade policies do not affect the trade balance. Copyright © 2014 by Nelson Education Ltd.13-31

Political Instability and Capital Flight  Capital flight : a large and sudden reduction in the demand for assets located in a country Copyright © 2014 by Nelson Education Ltd. Thinkstock 13-32

FIGURE 13.7: The Effects of Capital Flight Copyright © 2014 by Nelson Education Ltd.13-33

Political Instability and Capital Flight  Capital flight from Mexico increases Mexican interest rates and decreases the value of the Mexican peso in the market for foreign-currency exchange.  These price changes that result from capital flight influence some key macroeconomic quantities.  Exports become cheaper  Imports become more expensive  Net exports increase.  The interest rate increases.  Capital accumulation slows  Economic growth slows. Copyright © 2014 by Nelson Education Ltd.13-34

QuickQuiz Suppose that Canadians decided to spend a smaller fraction of their incomes. What would be the effect on saving, domestic investment, net capital outflow, the real exchange rate, and the trade balance? Copyright © 2014 by Nelson Education Ltd.13-35

Classroom Activity Copyright © 2014 by Nelson Education Ltd. Open Economy Article Find an article in a recent newspaper or magazine illustrating a change that will affect net capital outflow or net exports. Explain how and why net capital outflow or net exports would shift. Use the market open-economy model (the market for loanable funds and the market for foreign-currency exchange) to analyze this change. Graph the world real interest rate showing net capital outflow and real exchange rate before the change. Then show how the change will affect these variables. Turn in a copy of the article along with your explanation

THE END Chapter 13 Copyright © 2014 by Nelson Education Ltd.13-37