A Macroeconomic Theory Of Open Economies

A Macroeconomic Theory of an Open Economy Open Economies An open economy is one that interacts freely with other economies around the world.

A Macroeconomic Theory of an Open Economy Key Macroeconomic Variables in an Open Economy net exports net capital outflow (NCO) (opposite of net capital inflows) nominal exchange rates: EYTL/USD real exchange rates:

A Macroeconomic Model of an Open Economy Basic Assumptions of the Model The model takes the economy’s output (GDP) as given. Studied factors of output in Chapter 3. The model takes the economy’s price level as given.

TWO MARKETS INTERACTING WITH EACH OTHER: The Market for Loanable Funds The Market for Foreign Exchange

The Market for Loanable Funds The Market for Loanable Funds is the market where funds are traded. S = I + NCO Holds at the equilibrium real interest rate. Notice the equilibrium can change when the conditions of the economy change.

Figure 1 The Market for Loanable Funds Real Interest Rate Supply = S Demand = I + NCO Equilibrium quantity real interest rate Quantity of Loanable Funds

The Market for Loanable Funds The supply of loanable funds comes from national saving (S). The demand for loanable funds comes from domestic investment (I) plus net capital outflows (NCO). For some countries such as Turkey, NCO is negative. The model can still work with a negative NCO.

The Market for Loanable Funds The real interest rate brings the supply and demand for loanable funds into a balance. A higher real interest rate increases saving and the quantity of loanable funds supplied. So supply curve is positively related with the real interest rate.

The Market for Loanable Funds A higher real interest rate discourages domestic investments and borrowing because it is more costly to borrow funds. encourages foreigners to buy assets from domestic economy, and discourages domestic residents from buying foreign assets. So, NCO decreases. Then I + NCO decreases as int. rates increases. So demand curve is negatively related with the real interest rate.

The Market for Loanable Funds At the equilibrium interest rate, the amount that people want to save (supply of funds) exactly balances the desired quantities of domestic investment plus NCO (demand for funds). Last line: “net capital outflow”

The Market for Foreign Exchange The Market for Foreign Exchange is the market where domestic currency (liras) are exchanged for foreign currency. NX = NCO Holds at the equilibrium real exchange rate. Notice the equilibrium can change when the conditions of the economy change.

Figure 2 The Market for Foreign Exchange Real Exchange Rate Supply of liras = NCO Demand for liras = NX Equilibrium quantity real exchange rate Quantity of Liras Exchanged into Foreign Currency

The Market for Foreign Exchange Demand for domestic currency (liras) comes from NX because this is the amount of extra domestic currency (liras) that foreigners need to buy the extra exports from domestic country (Turkey). Foreigners want to sell dollars and buy NX liras. They will use these liras to buy extra exports of the domestic country (Turkey).

The Market for Foreign Exchange Supply of domestic currency (liras) come from NCO because this is the extra amount of liras that domestic agents need to sell domestic currency (liras) and buy foreign currency (dollars). Domestic agents will use these (dollars) to buy foreign assets.

The Market for Foreign Exchange The price that balances the supply and demand for foreign currency is the real exchange rate.

The Market for Foreign Exchange A higher Real Exchange Rate RERUS/TUR makes domestic goods more expensive, foreign goods cheaper. So NX decreases. Then quantity of domestic currency (liras) demanded decreases. Demand curve is downward sloping. Does not change net capital outflows (supply of liras). NCO changes only with real interest rates. Therefore supply curve is vertical.

The Market for Foreign Exchange The real exchange rate adjusts to balance the supply and demand for liras. At the equilibrium real exchange rate, the demand for liras to buy net exports exactly balances the supply of liras to be exchanged into foreign currency to buy assets abroad.

EQUILIBRIUM IN THE OPEN ECONOMY Combine the Funds Market and Foreign Exchange Market. Net capital outflow links the two markets. NCO is the supply of liras in Forex Market. NCO is part of the demand for funds in Funds Market. Real interest rate is the key determinant of net capital outflows.

Figure 3 How Net Capital Outflow Depends on the Interest Rate Real Interest Rate Net capital outflow is negative. Net capital outflow is positive. Net Capital Outflow

Simultaneous Equilibrium in Two Markets Prices in the Funds Market (real interest rate) and the Foreign Exchange Market (real exchange rate) adjust simultaneously to balance supply and demand in these two markets. When prices come to equilibrium, they determine the macroeconomic variables of national saving, domestic investment, NCO , and net exports. Second bullet: next to last line: net capital outflow

Figure 4 The Real Equilibrium in an Open Economy (a) The Market for Loanable Funds (b) Net Capital Outflow Real Real Interest Supply Interest Net capital outflow, NCO Rate Rate Demand r Quantity of Net Capital Loanable Funds Outflow Real Exchange Supply Rate Demand E Quantity of liras (c) The Market for Foreign-Currency Exchange

HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY Let us analyze the following : Government budget deficits increase. Trade policies: New tariffs on imports imposed. Political and economic stability decreases. Saving Rate increases.

Government Budget Deficits In an open economy, government budget deficits . . . reduce national saving and hence the supply of loanable funds, drive up the interest rate, decreases domestic investment, decreases NCO. Last bullet: net capital outflow

Figure 5 The Effects of Government Budget Deficit 1. A budget deficit reduces the supply of loanable funds . . . (a) The Market for Loanable Funds (b) Net Capital Outflow Real Real Interest S S Interest Rate Rate r2 B r2 E1 r A 2. . . . which increases the real interest rate . . . 3. . . . which in turn reduces net capital outflow. Demand NCO Quantity of Net Capital Loanable Funds Outflow Real Exchange S S Rate 4. The decrease in net capital outflow reduces the supply of liras to be exchanged into foreign currency . . . E2 5. . . . which causes the real exchange rate to appreciate. Demand Quantity of liras (c) The Market for Foreign-Currency Exchange

Government Budget Deficits Effect of Budget Deficits on NCO Higher interest rates reduce NCO. Effect on the Foreign Exchange Market A decrease in NCO reduces the supply of liras. Lira will appreciate. This causes the real exchange rate to appreciate. Reduces NX. Bullet two: net capital outflow

Political Instability and Capital Flight Capital flight is a large and sudden reduction in the demand for TL denominated assets Happens together with a financial crisis when a lot of banks go bankrupt. Happened in Turkey in 1994 and 2001. Mexico in 1994, Argentina 2002, East Asia in 1997, Russia 1998.

Political Instability and Capital Flight If investors become concerned about the safety of their investments, capital can quickly leave a country. Interest rates increase and the domestic currency depreciates sharply.

Political Instability and Capital Flight When investors around the world observed political problems in Turkey in 2001, they sold their TL denominated assets and used the proceeds to buy assets of other countries. This increased Mexican net capital outflow. The demand for loanable funds in the loanable funds market increased, which increased the interest rate. This increased the supply of pesos in the foreign-currency exchange market.

Figure 7 The Effects of Capital Flight (a) The Market for Loanable Funds in Turkey (b) TR’s Net Capital Outflow Real Real 1. An increase in net capital outflow. . . Interest Supply Interest NCO2 Rate D2 Rate r2 3. . . . which increases the interest rate. r1 r1 2. . . . increases the demand for loanable funds . . . D1 NCO1 Quantity of Net Capital Loanable Funds Outflow Real Exchange S S2 Rate 4. At the same time, the increase in net capital outflow increases the supply of pesos . . . E 5. . . . which causes the peso to depreciate. E Demand Quantity of Pesos (c) The Market for Foreign-Currency Exchange

EFFECT OF AN İNCREASE IN THE SAVING RATE What happens to investment, interest rates, real exchange rate, and NX?