The Theory of the Open Economy: A Complete Logical Flow

1. The Theory of the Open Economy: A Complete Logical Flow • The theory relates and determines r, NCO, eP/P*, and NX • It begins with conditions in the loanable funds market and then the foreign exchange market. • In each market, the demand and supply are analyzed, put together to determine equilibrium, and then the effects of shifts in demand and supply are analyzed. • The two markets are linked together and r, NCO, eP/P*, and NX are jointly determined. • Different policies and situations are then analyzed and their effect on r, NCO, eP/P*, and NX identified.

2. The Loanable Funds Market • The supply and demand in the loanable funds market determines the real interest rate {r} • Closed Economy: S=I only domestic borrowing and lending are allowed. • Open Economy: S=I+NCO this allows trade and borrowing and lending from the ROW (rest of the world)

3. National Saving: S → SLF is positively related to r↓(↑) → SLF ↓(↑) • Investment and Net Capital Flow: I+NCO → DLF is negatively related to r ↓(↑) → DLF ↑(↓) • r ↓(↑) I ↑(↓) • r↓(↑) PV ↑(↓) of future returns • r ↓(↑) NCO ↑(↓) • rUS ↓(↑) US increases (decreases) demand for ROW assets and ROW decreases (increases) demand for US assets

4. The equilibrium r in the LF market brings national saving = investment + net capital outflow or S=I+NCO. • Supply-side shocks to LF • S↓ (income taxes↑ or budget →deficit), then r↑→LF↓ • S↑ (income taxes↓ or budget →surplus), then r↓→LF↑ • Demand-side shocks to LF • I ↑ (tax credits↑ or expected Y↑), then r↑→LF↑ • I ↓ (tax credits↓ or expected Y↓), then r↓→LF↓ • NCO↓ (political instability abroad↑), then r↓→LF↓ [US holds fewer ROW assets and ROW holds more US assets] • NCO↑ (political stability abroad↑), then r↑→LF↑ [US holds more ROW assets and ROW holds less US assets] • We have now fully described the LF market and the determination of r

5. The Foreign Exchange Market • The supply and demand in the foreign exchange market determines the real interest exchange rate eP/P* • Closed Economy: no trading, NX, or eP/P*. • Open Economy: NX=NCO this allows trade and borrowing and lending from the ROW (rest of the world)

6. Net Capital Outflow - NCO: S → S$ • If NCO↑, US is supplying more dollars, on net, to purchase foreign assets • If NCO↓, US is supplying fewer dollars, on net, to purchase foreign assets • NCO is determined by r in the loanable funds markets and is not related to eP/P*. • As eP/P*↓(↑), NCO remains the same

7. Net Exports - NX: → D$ is negatively related to eP/P*↓(↑) • If eP/P*↓, NX↑, D$↑ - US goods become cheaper, net exports increase, and ROW needs more US dollars to purchase more goods and services • If eP/P*↑, NX↓, D$↓ - US goods become more expensive, net exports decrease, and ROW needs fewer US dollars to purchase fewer goods and services • Equilibrium in the foreign exchange market occurs when the eP/P* equates the D$ with the S$ or NX=NCO .

8. Linking the Loanable Funds and Foreign Exchange Market • NCO links the two markets together • Step 1: S=I+NCO or SLF=DLF →r • Step 2: r →NCO • Step 3: NCO →S$ • Step 4: NX →D$ • Step 5: D$=S$ →eP/P* and NX=NCO

9. Examples of Transmission of LF and FEM Shocks • Loanable Funds Shocks: • S↓, SLF↓, r↑,NCO↓,S$↓, eP/P*↑,NX↓ • S↑, SLF↑, r↓,NCO↑,S$↑, eP/P*↓,NX↑ • I↑, DLF↑, r↑,NCO↓,S$↓, eP/P*↑,NX↓ • I↓, DLF↓, r ↓,NCO↑,S$↑, eP/P*↓,NX↑ • Exchange Rate Shocks • D$↑, S$ is constant from NCO, eP/P*↑, until quantity of D$↓, but NX are constant, r is constant • D$↓, S$ is constant from NCO, eP/P*↓, until quantity of D$↑, but NX are constant, r is constant