0. A Macroeconomic Theory Of Open Economies

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

2. 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:

3. 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.

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

5. 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.

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

7. 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.

8. 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.

9. 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.

10. 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”

11. 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.

12. 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

13. 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).

14. 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.

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

16. 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.

17. 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.

18. 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.

19. 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

20. 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

21. 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

22. 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.

23. 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

24. 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
which
increases
the real
interest
rate . . .
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
which
causes the
real exchange
rate to
appreciate.
Demand
Quantity of
liras
(c) The Market for Foreign-Currency Exchange

25. 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

26. 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 Mexico in 1994, Argentina 2002, East Asia in 1997, Russia 1998.

27. 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.

28. 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.

29. 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
which
increases
the interest
rate. r1 r1
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
which
causes the
peso to
depreciate. E
Demand
Quantity of
Pesos
(c) The Market for Foreign-Currency Exchange

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