A Macroeconomic Theory of the Open-Economy Outline

A Macroeconomic Theory of the Open-Economy

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

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.

Supply and demand in the open economy § Market for loanable funds § Market foreign currency exchange

Market for loanable funds § S=I+NFI § Supply of loanable funds 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).

Market for loanable funds: Conclusions § § 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 supply of loanable funds • S=I, NFI=0 • NX=0

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

The Market for Foreign-Currency Exchange § § § Real Exchange Rate (RER) adjusts to balance the demand 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?

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.

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.

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.

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?

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

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

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.

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.

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.

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.