Chapter 32: Theory of the Open Economy
•Market for loanable funds
-open economy
+S=I+NCO
-Supply of loanable funds
+from national saving (S)
-Demand for loanable funds
+from domestic investment (I)
+and Net Capital Outflow (NCO)
•loanable funds are domestically generated flow of resources available for capital accumulation
•purchase of capital asset
-adds to demand for loanable funds
•Higher real interest rate
-encourages saving
-discourages investment
-discourages Americans from buying foreign assets
-encourages foreigners to buy US assets
•supply of loanable funds slopes upward
•demand slopes downward
•at equilibrium interest rate
-amount that people want to save
-exactly balances the desired quantities of domestic investment and net capital outflow
•market for foreign-currency exchange
-NCO=NX
•if trade surplus NX>0
-foreigners buy more US goods and services than Americans buy foreign
-Americans use foreign currenvy
+buy foreign assets
~capital is flowing abroad, NCO>0
•if trade deficit NX<0
-Some of this spending
+financed by selling of American assets
•supply of foreign-currency exchange
-Net capital outflow
-quantity of dollars supplied - buy foreign assets
-supply curve -- vertical
+quantity of dollars supplied for net capital outflow
+doesn't depend on real exchange rate
•demand for foreign-currency exchange
-net exports
-quantity of dollars demanded - buys US net exports of goods and services
+higher real exchange rate
•equilibrium exchange rate
-demand for dollars by foreigners arising from us net exports
-exactly balances supply of dollars from Americans arising from us net capital outflow
•NCO: link between 2 markets
•Identities
-S=I+NCO
-NCO=NX
•Government Budget deficits
-negative public saving
-reduces national saving
-reduces supply of loanable funs
-increase in interest rate
-crowd out domestic investment
-decrease in foreign supply of foreign-currency exchange
-exchange rate appreciates
-net exports fall
-push trade balance toward deficit
