Principles of economics 2nd by mankiw chapter 30

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A Macroeconomic Theory of the Open Economy Chapter 30 Copyright © 2001 by Harcourt, Inc All rights reserved.   Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777 Key Macroeconomic Variables in an Open Economy ◆ The important macroeconomic variables of an open economy include: net exports ◆ net foreign investment ◆ nominal exchange rates ◆ real exchange rates ◆ Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Basic Assumptions of a Macroeconomic Model of an Open Economy ◆ The model takes the economy’s GDP as given ◆ The model takes the economy’s price level as given Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Market for Loanable Funds S = I + NFI ◆ At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net foreign investment Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 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 foreign investment (NFI) Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Market for Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Equilibrium real interest rate Demand for loanable funds (for domestic investment and net foreign investment) Equilibrium quantity Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Quantity Loanable Funds of 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Market for ForeignCurrency Exchange ◆ The two sides of the foreign-currency exchange market are represented by NFI and NX ◆ NFI represents the imbalance between the purchases and sales of capital assets ◆ NX represents the imbalance between exports and imports of goods and services Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Market for ForeignCurrency Exchange ◆ In the market for foreign-currency exchange, U.S dollars are traded for foreign currencies ◆ For an economy as a whole, NFI and NX must balance each other out, or: NFI = NX Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Political Instability in Mexico and Capital Flight ◆ This increased Mexican net foreign investment 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 ◆ Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Effects of Capital Flight Real Interest Rate (a) The Market for Loanable Funds r2 Real Interest Rate r2 r1 r1 S1 D2 (b) Mexican Net Foreign Investment NFI1 NFI1 An increase in net foreign investment D1 …which increases the interest rate …increases the demand for loanable funds Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate E1 …which causes the real exchange rate to appreciate Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc E2 S1 S2 At the same time, the increase in net foreign investment increases the supply of pesos Demand Quantity of Pesos (c) The Market for Foreign-Currency Summary ◆ To analyze the macroeconomics of open economies, two markets are central – the market for loanable funds and the market for foreign-currency exchange ◆ In the market for loanable funds, the interest rate adjusts to balance supply for loanable funds (from national saving) and demand for loanable funds (from domestic investment and net foreign investment) Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Summary ◆ 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) ◆ Net foreign investment is the variable that connects the two markets Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Summary ◆ 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, reducing the supply of dollars ◆ The dollar appreciates, and net exports fall Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Summary ◆ A trade restriction increases net exports and 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 restrictions on net exports Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Summary ◆ When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound ◆ Political instability in a country can lead to capital flight ◆ Capital flight tends to increase interest rates and cause the country’s currency to depreciate Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Graphical Review Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Market for Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Equilibrium real interest rate Demand for loanable funds (for domestic investment and net foreign investment) Equilibrium quantity Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Quantity Loanable Funds of The Market for Foreign-Currency Exchange Real Exchange Rate Supply of dollars (from net foreign investment) Equilibrium real exchange rate Demand for dollars (for net exports) Equilibrium quantity Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Quantity of Dollars Exchang into Foreign Currenc How Net Foreign Investment Depends on the Interest rate Real Interes t Rate Net foreign investment is negative Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Net foreign investment is positive Net Foreign Investment The Real Equilibrium in an Open Economy Real Interest Rate (a) The Market for Loanable Funds Real Supply Interest Rate r1 r1 Demand (b) Net Foreign Investment Net foreign investment, NFI Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate Supply E1 Demand Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Quantity of Dollars (c) The Market for Foreign-Currency The Effects of Government Budget Deficit Real Interest Rate (a) The Market for Loanable Funds S2 Real Interest Rate r2 S1 B r2 A r1 (b) Net Foreign Investment .which in turn reduces net foreign investment r1 Demand A budget deficit reduces the supply of loanable funds .which increases the real interest NFI Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate E2 …which causes the real exchange rate to appreciate Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc E1 S2 S1 The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency… Demand Quantity of Dollars (c) The Market for Foreign-Currency The Effects of an Import Quota Real Interest Rate (a) The Market for Loanable Funds Real Interest Rate S1 r1 (b) Net Foreign Investment Net exports, however, remain the same r1 NFI Demand Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate …and causes the real exchange rate to appreciate E2 Supply An import quota increases the demand for dollars… E1 Demand Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Quantity of Dollars (c) The Market for Foreign-Currency The Effects of Capital Flight Real Interest Rate (a) The Market for Loanable Funds r2 Real Interest Rate r2 r1 r1 S1 D2 (b) Mexican Net Foreign Investment NFI1 NFI1 An increase in net foreign investment D1 …which increases the interest rate …increases the demand for loanable funds Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate E1 …which causes the real exchange rate to appreciate Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc E2 S1 S2 At the same time, the increase in net foreign investment increases the supply of pesos Demand Quantity of Pesos (c) The Market for Foreign-Currency ... copyright © 2001 by Harcourt, Inc Effect of an Import Quota ◆ An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports ◆ This offsets the initial... derived items copyright © 2001 by Harcourt, Inc The Market for ForeignCurrency Exchange ◆ The two sides of the foreign-currency exchange market are represented by NFI and NX ◆ NFI represents... purchases and sales of capital assets ◆ NX represents the imbalance between exports and imports of goods and services Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The
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