Professional Documents
Culture Documents
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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A Macroeconomic Theory
of the Open Economy
Open Economies
A Macroeconomic Theory
of the Open Economy
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.
The goal is to explain the trade balance and
exchange rates and how government
policies can affect them
loanable funds
loanable funds
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Figure 1
The Market for Loanable Funds
Real
Interest
Rate
Equilibrium
real interest
rate
Equilibrium
quantity
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Foreign-Currency Exchange
The market for foreign-currency exchange
Identity: NCO = NX
Net capital outflow = Net exports
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Foreign-Currency Exchange
If trade deficit, NX < 0
Imports > Exports
Foreigners are holding Philippine currency
Or using pesos to buy Philippine assets
Foreign capital is flowing into the Philippines
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Horizontal axis
Quantity of pesos exchanged into foreign
currency
Vertical axis
Real exchange rate
NCO = NX
Represents the two sides of the market for
foreign exchange
Supply and demand
assets
Need to exchange pesos for foreign currency
to buy foreign assets
outflow
Does not depend on the real exchange rate;
depends on real interest rate
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Foreign-Currency Exchange
Demand for pesos for foreign exchange
Net exports
Quantity of pesos demanded to buy Philippine net
those goods
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services
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Figure 2
The Market for Foreign-Currency Exchange
Real
Exchange
Rate
Supply of pesos
(from net capital outflow)
Equilibrium real
exchange rate
Demand for pesos
(for net exports)
Equilibrium
quantity
The real exchange rate is determined by the supply and demand for foreign-currency exchange.
The supply of pesos to be exchanged into foreign currency comes from net capital outflow.
Because net capital outflow does not depend on the real exchange rate, the supply curve is
vertical. The demand for pesos comes from net exports. Because a lower real exchange rate
stimulates net exports (and thus increases the quantity of pesos demanded to pay for these net
exports), the demand curve is downward sloping. At the equilibrium real exchange rate, the
number of pesos people supply to buy foreign assets exactly balances the number of pesos
people demand to buy net exports.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
20
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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currency
Exhibit 3
How Net Capital Outflow Depends on the Interest Rate
Real
Interest
Rate
Because a higher domestic real interest rate makes domestic assets more attractive, it
reduces net capital outflow. Note the position of zero on the horizontal axis: Net capital
outflow can be positive or negative. A negative value of net capital outflow means that
the economy is experiencing a net inflow of capital.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Figure 4
The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds
Real
Interest
Rate
Supply
r1
Net capital
outflow, NCO
Demand
Quantity of
Loanable Funds
In panel (a), the supply and demand for
loanable funds determine the real interest
rate. In panel (b), the interest rate
determines net capital outflow, which
provides the supply of pesos in the market
for foreign-currency exchange. In panel (c),
the supply and demand for pesos in the
market for foreign-currency exchange
determine the real exchange rate.
Supply
E1
Demand
Quantity of Pesos
(c) The Market for Foreign-Currency Exchange
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
27
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Exhibit 5
r2
r1
2. . . . which
increases the
real interest
rate . . .
S2
B
S1
A
Real
Interest
Rate
r2
3. . . . which in
turn reduces net
capital outflow.
r1
Demand
NCO
Real Exchange
Rate
E2
E1
5. . . . Which
causes the real
exchange rate
to appreciate.
S2 S1
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Trade Policy
Trade policy
Government policy
Directly influences the quantity of goods
and services
That a country imports or exports
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Trade Policy
Macroeconomic impact of trade policy
Decrease imports
Increase in net exports
Increase in demand for dollars in the
market for foreign-currency exchange
Real exchange rate appreciates
Discourage exports
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Trade Policy
Macroeconomic impact of trade policy
No change in real interest rate
No change in net capital outflow
No change in net exports
Decrease in imports
Decrease in exports
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Figure 6
The Effects of an Import Quota
(b) Net Capital Outflow
Supply
Real
Interest
Rate
r1
r1
Demand
3. Net exports,
however, remain
the same.
NCO
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Trade Policy
Macroeconomic impact of trade policy
Trade policies do not affect the U.S. trade
balance
NX = NCO = S I
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Capital flight
Large and sudden reduction in the
demand for assets located in a country
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Figure 7
The Effects of Capital Flight
1. An increase
in net capital
outflow . . .
r1
r1
3. . . . Which
increases
the interest
rate.
2. . . . increases the
demand for loanable funds .
..
Quantity of Loanable Funds
NCO1
NCO2
If people decide that Mexico is a risky place to keep their Real Exchange
4. At the same
savings, they will move their capital to safer havens such Rate
S1
S2 time, the increase
as the U.S., resulting in an increase in Mexican net capital
in net capital
outflow. Consequently, the demand for loanable funds in
outflow increases
Mexico rises from D1 to D2, as shown in panel (a), and this
the supply of
drives up the Mexican real interest rate from r 1 to r2.
E1
pesos . . .
Because net capital outflow is higher for any interest rate,
E
2
that curve also shifts to the right from NCO 1 to NCO2 in
5. . . . which
panel (b). At the same time, in the market for foreignDemand
causes the peso
currency exchange, the supply of pesos rises from S 1 to
to depreciate
S2, as shown in panel (c). This increase in the supply of
Quantity of Pesos
pesos causes the peso to depreciate from E 1 to E2, so the (c) The Market for Foreign-Currency Exchange
becomes
less valuable
compared
other
currencies.
peso
2011 Cengage
Learning.
All Rights Reserved.
Maytonot
be copied,
scanned, or duplicated, in whole or in part, except for use as
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Effect?
Nation encouraging capital outflows
Weaker currency
Trade surplus
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