32,A Macroeconomic Theory of the Open Economy,Open Economies,An open economy is one that interacts freely with other economies around the world.,Key Macroeconomic Variables in an Open Economy,The important macroeconomic variables of an open economy include:net exports net foreign investmentnominal exchange ratesreal exchange rates,Basic Assumptions of a Macroeconomic Model of an Open Economy,The model takes the economys GDP as given.The model takes the economys price level as given.,SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE,The Market for Loanable FundsS = I + NCOAt the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net capital outflows.,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) and net capital outflows (NCO).,The Market for Loanable Funds,The supply and demand for loanable funds depend on the real interest rate. A higher real interest rate encourages people to save and raises the quantity of loanable funds supplied.The interest rate adjusts to bring the supply and demand for loanable funds into balance.,Figure 1 The Market for Loanable Funds,Copyright2003 Southwestern/Thomson Learning,Quantity of,Loanable Funds,Real,Interest,Rate,The Market for Loanable Funds,At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment.,The Market for Foreign-Currency Exchange,The two sides of the foreign-currency exchange market are represented by NCO and NX.NCO represents the imbalance between the purchases and sales of capital assets.NX represents the imbalance between exports and imports of goods and services.,The Market for Foreign-Currency Exchange,In the market for foreign-currency exchange, U.S. dollars are traded for foreign currencies.For an economy as a whole, NCO and NX must balance each other out, or:NCO = NX,The Market for Foreign-Currency Exchange,The price that balances the supply and demand for foreign-currency is the real exchange rate.,The Market for Foreign-Currency Exchange,The demand curve for foreign currency is downward sloping because a higher exchange rate makes domestic goods more expensive.The supply curve is vertical because the quantity of dollars supplied for net capital outflow is unrelated to the real exchange rate.,Figure 2 The Market for Foreign-Currency Exchange,Copyright2003 Southwestern/Thomson Learning,Quantity of Dollars Exchanged,into Foreign Currency,Real,Exchange,Rate,The Market for Foreign-Currency Exchange,The real exchange rate adjusts to balance the supply and demand for dollars.At the equilibrium real exchange rate, the demand for dollars to buy net exports exactly balances the supply of dollars to be exchanged into foreign currency to buy assets abroad.,EQUILIBRIUM IN THE OPEN ECONOMY,In the market for loanable funds, supply comes from national saving and demand comes from domestic investment and net capital outflow.In the market for foreign-currency exchange, supply comes from net capital outflow and demand comes from net exports.,EQUILIBRIUM IN THE OPEN ECONOMY,Net capital outflow links the loanable funds market and the foreign-currency exchange market.The key determinant of net capital outflow is the real interest rate.,Figure 3 How Net Capital Outflow Depends on the Interest Rate,Copyright2003 Southwestern/Thomson Learning,0,Net Capital,Outflow,Real,Interest,Rate,EQUILIBRIUM IN THE OPEN ECONOMY,Prices in the loanable funds market and the foreign-currency exchange market adjust simultaneously to balance supply and demand in these two markets.As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.,Figure 4 The Real Equilibrium in an Open Economy,Copyright2003 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,Dollars,Quantity of,Loanable Funds,Net Capital,Outflow,Real,Exchange,Rate,HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY,The magnitude and variation in important macroeconomic variables depend on the following:Government budget deficitsTrade policiesPolitical and economic stability,Government Budget Deficits,In an open economy, government budget deficits . . . reduce the supply of loanable funds,drive up the interest rate,crowd out domestic investment,cause net foreign investment to fall.,Figure 5 The Effects of Government Budget Deficit,Copyright2003 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,