2. Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 13: A Macroeconomic Theory of the Open Economy

3. Econ 202 Dr. Ugur Aker 2 What Is To Come? We will concentrate on the long run. –Real GDP is given. Labor, capital, technology. –Price level is determined by supply and demand for money. Savings and investments will be matched in the market for loanable funds. NFI and NX will determine the real exchange rate.

4. Econ 202 Dr. Ugur Aker 3 The Market for Loanable Funds This is the complete financial system. All savers go here to deposit (lend) their savings. All borrowers go there to get loans. When funds lent matches funds borrowed an equilibrium interest rate is reached. Equilibrium interest rate is the return on saving and cost of borrowing.

5. Econ 202 Dr. Ugur Aker 4 Circular Flow Equilibrium Y = C + I + G + NX Y = C + S + T C + S + T = C + I + G + NX S + (T – G) = I + NX Private Saving + Government Saving = Investment + Net Exports S + (T – G) = I + NFI National Saving = Investment + Net Foreign Investment

6. Econ 202 Dr. Ugur Aker 5 The Market for Loanable Funds Each dollar saved can be used to finance to purchase domestic capital or an asset abroad. The supply of loanable funds comes from national savings [S + (T – G)]. The demand for loanable funds comes from domestic investment (I) and net foreign investment (NFI). If NFI is negative (capital inflow), the demand would shift left.

7. Econ 202 Dr. Ugur Aker 6 The Market for Loanable Funds A higher real rate of interest encourages people to save more. –Supply in the loanable funds market is upward sloping. Demand in the loanable funds market is downward sloping. –A higher real interest rate discourages investment because of higher cost of borrowing. –A higher real interest rate at home discourages net foreign investment.

8. Econ 202 Dr. Ugur Aker 7 The Market for Loanable Funds r1 r2 Ld2 Ls1Ld1 Ls2 S+(T-G) I+NFI At r1, the quantity of funds demanded (Ld1) exceeds the quantity of funds supplied (Ls1). Real interest rate will be forced upward. At r2, the quantity of funds demanded (Ld2) falls far short of quantity of funds supplied (Ls2). Real interest rate will be forced downward.

9. Econ 202 Dr. Ugur Aker 8 The Forex Market Participants in this market exchange USD for foreign currency. When net exports is positive (trade surplus), the quantity of USD demanded will be positive. When net exports is negative (trade deficit), the quantity of USD demanded will be negative. When NFI is positive (capital outflow), the quantity supplied of USD is positive. When NFI is negative (capital inflow), the quantity supplied of USD is negative.

10. Econ 202 Dr. Ugur Aker 9 The Forex Market NX NFI Real Exchange Rate 0 As the real exchange rate drops (our currency depreciates), our exports will increase and our imports will decrease. NX will rise. Since NFI has to match NX, given the trade deficit in the graph, NFI is also negative, indicating a capital inflow into US. The real exchange rate is determined through the interaction of NX and NFI.

11. Econ 202 Dr. Ugur Aker 10 The Forex Market NFI depends on the real interest rates in our economy and abroad. –R is not shown on the graph; so NFI is given for the Forex graph. At equilibrium real exchange rate, the demand for dollars by foreigners arising from US net exports exactly balances the supply of dollars from Americans arising from US NFI. At equilibrium real exchange rate, the supply of dollars by Americans arising from negative US NX exactly balances the demand of dollars by foreigners arising from negative US NFI.

12. Econ 202 Dr. Ugur Aker 11 Net Foreign Investment 0+NFI-NFI Real Interest rate The higher the real interest is in our economy, the more foreigners and Americans would keep their savings in the US. The lower is the real interest rate in US economy, the more Americans and foreigners would like to keep their savings abroad.

13. Econ 202 Dr. Ugur Aker 12 Simultaneous Equilibrium Real Interest Rate, R R Real Exchange Rate Loanable Funds I+NFI S+(T-G) NFI NX NFI

14. Econ 202 Dr. Ugur Aker 13 Using the Double Markets What happens when government deficit increases? What happens when government has a surplus? What happens when there is a tariff increase? What happens when there is capital flight?

15. Econ 202 Dr. Ugur Aker 14 Government Deficit Real Interest Rate, R R Real Exchange Rate Loanable Funds I+NFI S+(T-G) NFI NX

16. Econ 202 Dr. Ugur Aker 15 Tariff or Quota Real Interest Rate, R R Real Exchange Rate Loanable Funds NX S+(T-G) I+NFI

17. Econ 202 Dr. Ugur Aker 16 Capital Flight Real Interest Rate, R R Real Exchange Rate Loanable Funds

18. Econ 202 Dr. Ugur Aker 17 Questions 1.Japan usually runs a huge trade surplus. Using the equilibrium condition in the loanable markets, speculate what could be the reason for it. 2.“The president was clearly determined to signal that the United States remains solidly on a course of deficit reduction, which should make the dollar more attractive to investors.” (The New York Times, April 14, 1995). Is this possible? 3.Suppose that Congress passes an investment tax credit, which subsidizes domestic investment. Show effects on S, NFI, I, R, NX, Real exchange rate.

19. Econ 202 Dr. Ugur Aker 18 More Questions 1.In 1998 the Russian government defaulted on its debt payments, leading investors worldwide to raise their preference for US government bonds. What effect do you think this “flight to safety” had on the US economy? 2.Especially in the 80s Japanese savings flowed into US to finance US investments. What would happen to the US economy if the Japanese no longer wanted to buy American assets (or US NFI with Japan changed from negative to positive)? 3.Can we eliminate the trade deficit by subsidizing exports? 4.What happens when real interest rates abroad increase?