A Macroeconomic Theory of the Open-Economy

1. A Macroeconomic Theory of the Open-Economy

2. Outline: • Develop a model to study forces that determine the open economy variables (NX, NFI, RER) • How are these variables related to one another?

3. Assumptions • Real GDP is determined by factor supplies and level of technology • Economy’s price level is given • Real interest rate equals world interest rate due to perfect capital mobility.

4. Supply and demand in the open economy • Market for loanable funds • Market for foreign currency exchange

5. Market for loanable funds • S=I+NFI • Supply of loanable funds comes from comes from national savings • Demand for loanable funds comes from domestic investment • The difference between S and I at world interest rate is the NFI (savings by foreigners).

6. Open economy Interest rate = world interest rate NFI exists because S is not equal to I NX is also determined by the difference in S and I Closed economy Interest rate is determined by demand and supply of loanable funds S=I, NFI=0 NX=0 Market for loanable funds: Conclusions

7. The Market for Foreign-Currency Exchange • NFI=NX • S-I=NX • Imbalances on both sides of the equation are equal • Positive NFI is the source for supply of domestic currency (Canadian$) in the foreign currency exchange market • Positive NX is the source of demand for domestic currency (Canadian$) in the foreign currency exchange market

8. The Market for Foreign-Currency Exchange • Real Exchange Rate (RER) adjusts to balance the demand and supply of domestic currency (Can$). • At the equilibrium RER, the demand for $ to buy net exports exactly balances the supply of $ to be exchanged into foreign currency to buy assets abroad. • What if the NFI is negative?

9. Simultaneous equilibrium in the two markets • We have studied coordination between 4 macro variables: S, I, NFI, and NX • NFI is the variable that links the two markets together • In the loanable funds market it is the difference in the supply of loanable funds (S) and demand for loanable funds (I) at the world interest rate • In the foreign currency exchange market positive NFI determines the supply of domestic currency.

10. Simultaneous equilibrium in the two markets • In the loanable funds market we determine S and I, which are determined by world interest rate and we determine NFI. • In the foreign currency market we determine the real exchange rate (= price) which balances supply and demand for domestic currency. • Together we have determined S, I, NFI, and RER.

11. Policies affecting an open economy • Increase in world interest rates: • Crowds out domestic investment and increases NFI • Increases supply of domestic currency in the foreign currency exchange market • RER depreciates, increasing NX.

12. Policies affecting an open economy • Increase in government budget deficit: • Reduces supply of loanable funds and crowds out domestic investment • Decrease in NFI reduces the supply of domestic currency in foreign-currency exchange market • RER appreciates and NX fall. • What happens if there is a reduction in budget deficit?

13. Policies affecting an open economy • Increase in government budget deficit: Impact • Depreciation in domestic currency benefits exporters and hurts importers

14. Policies affecting an open economy • Trade policy: • Trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports. • Restrictive trade policy: Imposition of an import quota • Objective: to improve trade balance

15. Policies affecting an open economy • Restrictive trade policy: Imposition of an import quota • No impact on loanable fund market. No change in NFI. • Import quota restricts imports and increases NX for any given RER. • Increase in demand for domestic currency causes RER to appreciate. • NX decline, canceling out the earlier increase. Therefore, no change in NX. • Trade policies do not affect trade balance.

16. Policies affecting an open economy • Restrictive trade policy: Imposition of an import quota • Trade policies do not affect trade balance. • Trade policies have microeconomic rather than macroeconomic effects. • Trade restrictions reduce gains from trade and economic well-being.

17. Policies affecting an open economy • Political instability and capital flight: • Capital flight is a large and sudden reduction in the demand for assets located in a country. • Implications for the economy experiencing capital flight: • Savers to save the same amount of funds as before (to capital flight) must receive a risk premium in order to hold the domestic debt • Borrowers must pay the risk premium in addition to the world interest rate to halt capital flight • Supply of loanable funds remains same and demand decreases, increasing NFI before sale of domestic assets has been halted.

18. Policies affecting an open economy • Political instability and capital flight (continued): • Implications for the economy experiencing capital flight: • Increase in NFI, increases supply of domestic currency (though in this case, a large portion of the supply of domestic currency comes from sale of domestic assets). • RER depreciates. • Capital flight from a country increases the domestic interest rates and depreciates the value of the domestic currency.