Chapter 18 A Macroeconomic Theory Of the Open Economy Supply and Demand for loanable funds and for foreign-currency exchange Equilibrium in the Open Economy How Policies and events affect an open economy

Supply and Demand for loanable funds and for foreign-currency exchange 1, The market for loanable funds, which coordinates the economy’s saving and investment Recall the identity : S = I + NFI Saving = Domestic investment + Net foreign investment In a small open economy with perfect capital mobility, like Canada, the domestic real interest rate is equal to the world real interest rate. The Supply of Loanable Funds comes from national saving (S) and from net foreign investment (NFI). The Demand for Loanable Funds comes from domestic investment (I). At the equilibrium interest rate, the amount that people want to save, exactly balances the desired quantities of investment and net foreign investment.

See Figure 18-1 In panel (a), at the world interest rate, the difference between domestic investment and national saving, is net foreign assets purchased by Canadian. It is a positive NFI. In panel (b), net foreign investment is negative, indicating that foreigners are purchasing more Canadian assets than Canadian are purchasing foreign assets. Recall another identity from the preceding chapter: NFI = NX (Net foreign investment = Net exports) Therefore, we get S = I + NX. Net exports are determined by the difference between the supply of loanable funds due to national saving (S) and the demand for loanable funds (I) at the world interest rate.

2, The market for foreign-currency exchange Recall the identity: S = I + NX, we can rearrange it to be: S - I = NX ( Saving – Domestic investment = Net exports) This new identity states that the imbalance between the domestic supply of loanable funds that is due to national saving (S) and the demand for loanable funds for domestic investment (I) must equal the imbalance between exports and imports (NX). We can view the two sides of this identity as representing the two sides of the market for foreign-currency exchange. Left hand side, S – I, represents the quantity of dollars supplied in the market for foreign-currency exchange for the purpose of buying foreign assets. Net exports represent the quantity of dollars demanded in that market for the purpose of buying Canadian net exports

of goods and services. The price that balances the supply and demand is the “real exchange rate”, i.e. the relative price of domestic and foreign goods. See Figure 18-2. The supply curve is vertical because neither savings nor investment depends on the real exchange rate. A higher exchange rate makes domestic goods more expensive. The demand curve is downward sloping because a lower real exchange rate stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net exports). The real exchange rate adjusts to balance the supply and demand for dollars. At the equilibrium 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.

Equilibrium in the Open Economy Net foreign investment (NFI) links the loanable funds market with the foreign-currency exchange market.The key determinant of net foreign investment is the world interest rate. In the market for loanable funds, NFI is a portion of demand. In the market for foreign-currency exchange, NFI is the source of supply. See Figure 18-3. This figure shows how the market for loanable funds and the market for foreign-currency exchange jointly determine the important variables of an open economy. In panel (a), the real interest rate is determined by the world real interest rate. At the world interest rate, national saving (S) exceeds the demand for loanable funds for domestic investment (I). Because national saving is more than sufficient to provide loanable funds for domestic

investment, the excess is used to buy foreign assets investment, the excess is used to buy foreign assets. This is net foreign investment. When Canadian purchase foreign currency, they must sell Canadian dollars in the market for foreign exchange. For this reason, the quantity of net foreign investment from panel (a) determines the supply of dollars to be exchanged into foreign currencies. The equilibrium real exchange rate (E1) brings into balance the quantity of dollars supplied and the quantity of dollars demanded in the market for foreign-currency exchange.

How Policy and Events Affect an Open Economy The magnitude and variation in important macroeconomic variables may be illustrated by these specific events: Increase in world interest rates Government Budget Deficits and surpluses Trade Policy Political instability and capital flight Case 1 Increase in world interest rates See Figure 18-4 In panel (a), when the world interest rate increases, it increases the supply of loanable funds made available by the savings of Canadians and reduces the quantity of loanable funds demanded for domestic investment. For both of these reasons, net foreign investment increases.

In panel (b), the increase in net foreign investment shifts the curve that measure the supply of dollars to be exchanged in the market for foreign currency exchange to the right. The increased supply of dollars causes the real exchange rate to depreciate form E1 to E2. That is, the dollar becomes less valuable relative to other currencies. Hence, in a small open economy with perfect capital mobility, an increase in world interest rates crowds out domestic investment, causes the dollar to depreciate, and increases net exports. An increase in world interest rates, by causing the Canadian dollar to depreciate, benefits exporters by making goods priced in Canadian dollars cheaper to foreigners. At the same time, the depreciation of the dollar hurts Canadian importers by making goods priced in foreign currencies more expensive to Canadians. Therefore, Canadian consumers are hurt by increases in world interest rates.

Case 2 Government Budget Deficits and Surpluses See Figure 18-5. Because a government budget deficit represents negative public saving, it reduces national saving ( the sum of public and private saving). Therefore, the supply of loanable funds from national saving shifts to the left. Thus, a government budget deficit reduces the supply of loanable funds, drives up the real interest rate, and crowds out investment. Because net foreign investment is reduced, the supply of Canadian dollars offered for sale in the market for foreign investment exchange is reduced. Shifting to the left. The reduced supply of dollars causes the real exchange rate to appreciate from E1 to E2.

Hence, in a small open economy with perfect capital mobility,an increase in government budget deficits causes the dollar to appreciate and causes net exports to fall. Hence, 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. Case 3 Trade Policy A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports. One common trade policy is a tariff, a tax on imported goods. Another is an import quota, a limit on the quantity of a good that can be produced abroad and sold domestically. See Figure 18-6, the effects of an import quota. When the Canadian government imposes a quota on the import of Japanese car, nothing happens in the market for

loanable funds in panel (a) or to the supply of dollars in the market for foreign-currency exchange in panel (b). Because the quota restricts the number of Japanese cars sold in Canada, it reduces imports at any given real exchange rate. Net exports, will therefore rise for any given real exchange rate. As a result, the demand for dollars in the market for foreign-currency exchange rises, as shown by the shift of the demand curve in panel (b). This increase in the demand for dollars to appreciate from E1 to E2. This appreciation encourages imports and discourages exports. Therefore, this appreciation in the value of the dollar tends to reduce net exports, offsetting the direct of the import quota on the trade balance. In the end, an import quota reduces both imports and exports, but net exports are unchanged. Implication: Trade policies do not affect the trade balance.

Although trade policies do not affect a country’s overall trade balance, these policies do affect specific firms, industries and countries. For example, when Canadian government imposes an import quota on Japanese cars, GM has less competition from abroad and will sell more cars. At the same time, because the dollar has appreciated in value, Bombardier, the Canadian aircraft maker, will find it harder to compete with aircraft makers in other countries. The effect of trade policies are therefore, more microeconomic than macroeconomic.

Case 4 Political instability and capital flight Capital Flight is a situation in which a large and sudden movement of funds out of a country occurs due to political instability (e.g. 1994 Mexican government instability.) See Figure 18-7. In panel (a), at the world interest rate, rw, the supply of loanable funds is greater than the demand of loanable funds. The distance between points A and B is Mexican saving that is available to purchase foreign assets - in other words, Mexico’s net foreign investment. This is shown in panel (b) by the curve (S-I)1. The point at which the demand and supply of pesos are in equilibrium determines the real exchange rate, E1. If the world financial community begins to question the ability of Mexico to repay its debts, lenders will only hold Mexican debt if they receive a higher interest rate than they receive in other countries.

Let’s define r as the risk premium that risky borrowers must pay. The curve shifts up by the amount of risk premium to indicate that Mexicans will choose to contribute the same quantity of their savings to the Mexican market for loanable funds only if they are compensated for the greater risk they incur by doing so. With the quantity of loanable funds supplied unchanged and the quantity demanded reduced, Mexico’s net foreign investment rises. The increase in Mexico’s net foreign investment increases the supply of pesos from (S-I)1 to (S-I)2. This increase in supply causes the peso to depreciate from E1 to E2. Thus, capital flight from Mexico increases Mexican interests rates and decreases the value of the Mexican peso in the market for foreign-currency exchange.