1. A Macroeconomic Theory of the Open-Economy

2. Outline:  Develop a model to study forces that determine the open economy variables (NX, NFI, RER)  How are these variables related to one another?

3. Assumptions  Real GDP is determined by factor supplies and level of technology  Economy’s price level is given  Real interest rate equals world interest rate due to perfect capital mobility.

4. Supply and demand in the open economy  Market for loanable funds  Market for foreign currency exchange

5. Market for loanable funds  S=I+NFI  Supply of loanable funds comes from comes from national savings  Demand for loanable funds comes from domestic investment  The difference between S and I at world interest rate is the NFI (savings by foreigners).

6. Market for loanable funds: Conclusions  Open economy  Interest rate = world interest rate  NFI exists because S is not equal to I  NX is also determined by the difference in S and I Closed economy Interest rate is determined by demand and supply of loanable funds S=I, NFI=0 NX=0

7. The Market for Foreign-Currency Exchange  NFI=NX  S-I=NX  Imbalances on both sides of the equation are equal  Positive NFI is the source for supply of domestic currency (Canadian$) in the foreign currency exchange market  Positive NX is the source of demand for domestic currency (Canadian$) in the foreign currency exchange market

8. The Market for Foreign-Currency Exchange  Real Exchange Rate (RER) adjusts to balance the demand and supply of domestic currency (Can$).  At the equilibrium RER, the demand for $ to buy net exports exactly balances the supply of $ to be exchanged into foreign currency to buy assets abroad.  What if the NFI is negative?

9. Simultaneous equilibrium in the two markets  We have studied coordination between 4 macro variables: S, I, NFI, and NX  NFI is the variable that links the two markets together  In the loanable funds market it is the difference in the supply of loanable funds (S) and demand for loanable funds (I) at the world interest rate  In the foreign currency exchange market positive NFI determines the supply of domestic currency.

10. Simultaneous equilibrium in the two markets  In the loanable funds market we determine S and I, which are determined by world interest rate and we determine NFI.  In the foreign currency market we determine the real exchange rate (= price) which balances supply and demand for domestic currency.  Together we have determined S, I, NFI, and RER.

11. Policies affecting an open economy  Increase in world interest rates:  Crowds out domestic investment and increases NFI  Increases supply of domestic currency in the foreign currency exchange market  RER depreciates, increasing NX.

12. Policies affecting an open economy  Increase in government budget deficit:  Reduces supply of loanable funds and crowds out domestic investment  Decrease in NFI reduces the supply of domestic currency in foreign-currency exchange market  RER appreciates and NX fall.  What happens if there is a reduction in budget deficit?

13. Policies affecting an open economy  Increase in government budget deficit: Impact  Depreciation in domestic currency benefits exporters and hurts importers

14. Policies affecting an open economy  Trade policy:  Trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports.  Restrictive trade policy: Imposition of an import quota  Objective: to improve trade balance

15. Policies affecting an open economy  Restrictive trade policy: Imposition of an import quota  No impact on loanable fund market. No change in NFI.  Import quota restricts imports and increases NX for any given RER.  Increase in demand for domestic currency causes RER to appreciate.  NX decline, canceling out the earlier increase. Therefore, no change in NX.  Trade policies do not affect trade balance.

16. Policies affecting an open economy  Restrictive trade policy: Imposition of an import quota  Trade policies do not affect trade balance.  Trade policies have microeconomic rather than macroeconomic effects.  Trade restrictions reduce gains from trade and economic well-being.

17. Policies affecting an open economy  Political instability and capital flight:  Capital flight is a large and sudden reduction in the demand for assets located in a country.  Implications for the economy experiencing capital flight:  Savers to save the same amount of funds as before (to capital flight) must receive a risk premium in order to hold the domestic debt  Borrowers must pay the risk premium in addition to the world interest rate to halt capital flight  Supply of loanable funds remains same and demand decreases, increasing NFI before sale of domestic assets has been halted.

18. Policies affecting an open economy  Political instability and capital flight (continued):  Implications for the economy experiencing capital flight:  Increase in NFI, increases supply of domestic currency (though in this case, a large portion of the supply of domestic currency comes from sale of domestic assets).  RER depreciates.  Capital flight from a country increases the domestic interest rates and depreciates the value of the domestic currency.