1. Copyright © 2006 Thomson Learning 32 A Macroeconomic Theory of the Open Economy

2. Figure 1 The Market for Loanable Funds Copyright©2003 Southwestern/Thomson Learning Quantity of Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity Equilibrium real interest rate

3. Figure 2 The Market for Foreign Currency Exchange Copyright©2003 Southwestern/Thomson Learning Quantity of Pounds Exchanged into Foreign Currency Real Exchange Rate Supply of pounds (from net capital outflow) Demand for pounds (for net exports) Equilibrium quantity Equilibrium real exchange rate

4. Figure 3 How Net Capital Outflow Depends on the Interest Rate Copyright©2003 Southwestern/Thomson Learning 0 Net Capital Outflow Net capital outflow is negative. Net capital outflow is positive. Real Interest Rate

5. Figure 4 The Real Equilibrium in an Open Economy Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds(b) Net Capital Outflow Net capital outflow,NCO Real Interest Rate Real Interest Rate (c) The Market for Foreign Currency Exchange Quantity of Pounds Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate Supply Demand rr E

6. Figure 5 The Effects of Government Budget Deficit Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds(b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign Currency Exchange Quantity of Pounds Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate Demand r2r2 NCO SS S S r2r2 B E1E1 rr A 1. A budget deficit reduces the supply of loanable funds... 2.... which increases the real interest rate... 4. The decrease in net capital outflow reduces the supply of pounds to be exchanged into foreign currency... 5.... which causes the real exchange rate to appreciate. 3.... which in turn reduces net capital outflow. E2E2

7. Figure 6 The Effects of an Import Quota Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds(b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Pounds Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate rr Supply Demand NCO D D 3. Net exports, however, remain the same. 2.... and causes the real exchange rate to appreciate. E E2E2 1. An import quota increases the demand for pounds...

8. Figure 7 The Effects of Capital Flight Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds in Mexico(b) Mexican Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Pesos Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate r1r1 r1r1 D1D1 D2D2 E Demand SS2S2 Supply NCO 2 NCO 1 1. An increase in net capital outflow... 3.... which increases the interest rate. 2.... increases the demand for loanable funds... 4. At the same time, the increase in net capital outflow increases the supply of pesos... 5.... which causes the peso to depreciate. r2r2 r2r2 E