February exam  Answers and grades are on WebCT  Problems: me.  ECON me.

US budget

Macroeconomics in an Open Economy CH 13  The important macroeconomic variables of an open economy include: National Saving, Domestic Investment, Net Capital Outflow and Net Exports.  The values of these variables are determined through the interaction of: the Loanable Funds Market and the Market for Foreign-Currency Exchange. –FX--The market where people exchange the domestic currency for the currency of other countries. 2 markets.

Objectives-ch. 13  Develop SOE model to explain: Trade balance and exchange rates  Use the model to analyze a series of related variables.  The model takes as given-real GDP and the price level.

The Market For Loanable Funds  Financial markets co-ordinate the economy’s saving and investment in The Loanable Funds Market  The Supply of Loanable Funds comes from national saving (S) and from net capital outflow (NCO)  The Demand for Loanable Funds comes from domestic investment (I).  In an open economy the amount that a nation saves does not have to equal the amount it spends to purchase domestic capital.

Market for Loanable Funds  If the amount of national saving exceeds the amount needed to finance the purchase of domestic capital, net capital outflow (NCO) is positive.  If the national saving is insufficient to finance the purchase of domestic capital, the NCO is negative.

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

Loanable Funds –closed economy-domestic interest rate is 5%

Loanable Funds-SOE  In a small open economy with perfect capital mobility, like Canada, the domestic interest rate will equal the world interest rate.  As a result, 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 (NCO)

Supply Demand--I Real Interest Rate Loanable Funds Positive Net Capital Outflow World Interest Rate Net Capital Outflow

Supply Demand Real Interest Rate Loanable Funds Negative Net Capital Outflow: Inflow World Interest Rate 90 Net Capital Outflow 130

The Market For Loanable Funds  In a small, open economy with perfect capital mobility, the Canadian interest rate is equal to the world interest rate.  National Saving represents the supply of loanable funds, while domestic investment represents demand.

The Market For Loanable Funds  At the equilibrium interest rate, the amount that people want to save, exactly balances the desired quantities of investment and net capital outflow.  NCO can be positive or negative. Saving = Domestic Investment + Net Capital Outflow u Recall the identity:

The Market for Foreign-Currency Exchange  The market for foreign-currency exchange exists because people want to trade with people in other countries, but they want to be paid in their own currency. –The two sides of the foreign-currency exchange market are represented by NCO and NX. –NCO represents the imbalance between the purchases and sales of capital assets. –NX represents the imbalance between exports and imports of goods and services.

The Equality of Net Exports and Net Capital Outflow  Net exports (NX) and net capital outflow (NCO) are closely linked. For an economy as a whole, NX and NCO balance each other out so that: NX = NCO  NCO represents the quantity of dollars supplied for the purpose of buying assets abroad. NX determines the quantity of dollars demanded for the purpose of buying foreign goods.

The Market for Foreign-Currency Exchange  The identity, NX = NCO represents the two sides of the foreign-exchange market in which Canadian dollars are traded for foreign currencies.  The price that balances the supply and demand is the “real exchange rate”, i.e. the relative price of domestic and foreign goods.

Market for Foreign-Currency Exchange Market for Foreign-Currency Exchange Supply of Dollars (NCO) Demand for Dollars (NX) Quantity of Dollars Exchanged into Foreign Currency Real Exchange Rate

The Market for Foreign-Currency Exchange  The demand curve is negatively related to the real exchange rate. A higher exchange rate makes domestic goods more expensive.  The supply curve is vertical because the quantity of dollars supplied for net capital outflow is unrelated to the real exchange rate.

The Market for Foreign-Currency Exchange 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. 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.

Market for Foreign-Currency Exchange Supply of Dollars (NCO) Demand for Dollars (NX) Quantity Equilibrium Quantity Real Exchange Rate Equilibrium Real Exchange Rate

Equilibrium in the Open Economy  Net capital outflow (NCO) links the loanable funds market with the foreign-currency exchange market. The key determinant of NCO is the world interest rate.  In the market for loanable funds, NCO is a portion of demand. In the market for foreign- currency exchange, NCO is the source of supply.

TUTORIAL GROUP B09  Tutorial was cancelled today due to TA illness. Apologies.  Hand in Assignments to me today.  Next meeting is March 17

Equilibrium in the Open Economy The market for loanable funds and the foreign- currency exchange market determine the real exchange rate, national saving, domestic investment, net exports and the size of net capital outflow. LF: S, I, NCO FX: RER and NX Using NCO

2 Markets—LF and FX

FX market-NCO from LF

LF AND FX MARKETS  1The real interest rate (r) is determined in the market for loanable funds by rw.  2This real interest rate determines the level of NCO. 3NCO must be paid for with foreign currency so the quantity of NCO determines the supply of dollars. 4The equilibrium real exchange rate brings into balance the quantity of dollars supplied and the quantity of dollars demanded. 5The 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 S, domestic I, NCO and NX.

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 – Government Trade Policies – Political and Economic Stability-Greece, Egypt--

Assessing Policies and Events  Three steps in using the model to analyze these events –Determine which of the supply and demand curves each event affects –Determine which way the curves shift –Examine how these shifts alter the economy’s equilibrium. –Like Micro

Increase in World Interest Rates  In an 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.

World Interest Rates Go Up13.4

G Budget deficits  Because a government budget deficit represents negative public saving, it reduces national saving, and therefore reduces... –the supply of loanable funds, –net capital outflow –the supply of Canadian dollars in the market for foreign-currency exchange

Principles of Macroeconomics: Ch. 18 First Canadian Edition Government Budget Deficits  In a small open economy, - an increase in government budget deficits causes the dollar to appreciate and causes net exports to fall. - a decrease in government budget deficits causes the dollar to depreciate and causes net exports to rise.

Government Budget Deficits: Specific Market Effects  Loanable Funds Market Effect: – Reduces national saving which... shifts the supply curve for loanable funds to the left, which reduces NCO. shifts the supply curve for loanable funds to the left, which reduces NCO.

Government Budget Deficits: Specific Market Effects  Foreign-Currency Exchange Market: – The decrease in NCO reduces the supply of dollars to be exchanged into foreign currency, which causes the real exchange rate to appreciate.

G deficits

Government Trade Policy  Government Trade Policy Effect: – Does not alter the trade balance because it does not alter national saving or domestic investment.  For given levels of national saving and domestic investment, the real exchange rate adjusts to keep the balance the same, regardless of the trade policies the government puts in place.  Trade policies are more microeconomic than macroeconomic.

Government Trade Policies: Specific Market Effects  Foreign-Currency Exchange Market: – Nothing happens in the loanable funds market or to the supply of dollars in the market for foreign-currency exchange. – The only effect is a rise in net exports for any given exchange rate. This increases the demand for dollars, which causes the value of the dollar to appreciate.

Government Trade Policies: Specific Market Effects  NCO Market: – Because there is no change in NCO, there will be no change in net exports. – An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports which offsets the direct increase in net exports due to import quota.... offsets the direct increase in net exports due to import quota.

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 Mexico, 2011 Egypt: government instability.)  When investors around the world observe political problems in one country (e.g. Mexico) they decide to sell some of their Mexican assets and use the proceeds to buy other countries’ assets.  Interest rates increase in Mexico and the domestic currency depreciates.

Principles of Macroeconomics: Political Instability and Capital Flight Specific Market Effects  NCO Market: – Observed political problems in Mexico in 1994 increased Mexican interest rates (r+risk). – To save the same amount Mexican savers must get r+risk so Slf shifts upwards. NCO gets bigger. – This increase in NCO increases the supply of pesos in the foreign-currency exchange market. – The peso depreciates. Due to instability.

Capital flight

Summary  To analyze the macroeconomics of open economies, two markets are central—the market for loanable funds and the market for foreign-currency exchange. SOE  LF market: 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).  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).  NCO is the variable that connects the two markets.