Chapter 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY23A MACROECONOMIC THEORY OF THE OPEN ECONOMY30WHATS NEW:The section on capital flight has been updated to include Asia and Russia. The topic of “The Twin Deficits in the United States” is now briefly discussed in the main text. There is a new In the News box on “How the Chinese Help American Home Buyers.”LEARNING OBJECTIVES:By the end of this chapter, students should understand: how to build a model to explain an open economys trade balance and exchange rate. how to use the model to analyze the effects of government budget deficits. how to use the model to analyze the macroeconomic effects of trade policies. how to use the model to analyze political instability and capital flight.KEY POINTS:1. To analyze the macroeconomics of open economies, two markets are centralthe market for loanable funds and the market for foreign-currency exchange. In the market for loanable funds, the interest rate adjusts to balance the supply of loanable funds (from national saving) and the demand for loanable funds (from domestic investment and net foreign investment). In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (for net foreign investment) and the demand for dollars (for net exports). Because net foreign investment is part of the demand for loanable funds and provides the supply of dollars for foreign-currency exchange, it is the variable that connects these two markets.2. A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate. The higher interest rate reduces net foreign investment, which reduces the supply of dollars in the market for foreign-currency exchange. The dollar appreciates, and net exports fall.3. Although restrictive trade policies, such as a tariff or quota on imports, are sometimes advocated as a way to alter the trade balance, they do not necessarily have that effect. A trade restriction increases net exports for a given exchange rate and, therefore, increases the demand for dollars in the market for foreign-currency exchange. As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods. This appreciation offsets the initial impact of the trade restriction on net exports.4. When investors change their attitudes about holding assets of a country, the ramifications for the countrys economy can be profound. In particular, political instability can lead to capital flight, which tends to increase interest rates and cause the currency to depreciate.CHAPTER OUTLINE:I.Supply and Demand for Loanable Funds and for Foreign-Currency ExchangeA.The Market for Loanable Funds1.Whenever a nation saves a dollar of income, it can use that dollar to finance the purchase of domestic capital or to finance the purchase of an asset abroad.2.The supply of loanable funds comes from national saving.3.The demand for loanable funds comes from domestic investment and net foreign investment.4.The quantity of loanable funds demanded and the quantity of loanable funds supplied depend on the real interest rate.a.A higher real interest rate encourages people to save and thus raises the quantity of loanable funds supplied.b.A higher interest rate makes borrowing to finance capital projects more costly, discouraging investment and lowering the quantity of loanable funds demanded.c.A higher real interest rate in a country will also lower net foreign investment. All else equal, a higher domestic interest rate implies that purchases of foreign assets by domestic residents will fall and purchases of domestic assets by foreigners will rise.You may need to write the equation for net foreign investment on the board to explain its relationship with the real interest rate. Point out that, when the real interest rate in the United States rises, purchases of foreign assets by domestic residents fall and purchases of U.S. assets by foreigners rise. Thus, net foreign investment is inversely related to the real interest rate.5.The supply and demand for loanable funds can be shown graphically.a.The real interest rate is the price of borrowing funds and is therefore on the vertical axis; the quantity of loanable funds is on the horizontal axis.b.The supply of loanable funds is upward-sloping because of the positive relationship between the real interest rate and the quantity of loanable funds supplied.c.The demand for loanable funds is downward-sloping because of the inverse relationship between the real interest rate and the quantity of loanable funds demanded.Figure 30-1Supply (saving)Real Interest Rater*Demand (I + NFI)Quantity of Loanable FundsPut “saving” in