Chapter 33A Macroeconomic  Theory of the Open Economy
Key Termstrade policycapital flight
ModelSimplified version of reality
Variables    Net Exports Net Capital Outflow Real Exchange RatesNominal Exchange Rates
FocusTrade BalanceExchange Rate
Two Markets Loanable funds marketForeign currency market
Loan Market  Savers and Borrowers      S = I + NCO                Savings =Domestic Investment + Net Capital Outflow       ...
Two ThingsInvest at home Invest abroad
NCO > 0  Less Invest at home  More Invest abroad Investing more in othercountries than your own
NCO < 0 More Invest at home  Less Invest abroadOther countries want to invest in your country
Supply and Demand of Loanable Funds Depends on the real interest rate
Remember     Nominal Rate =Real Rate + Inflation Rate
Nominal = Real + Inflation       N=R+I             Country A   Country B Country C  Nominal      10%         13%        12%...
Interest Rates      High  Encourage SaversDiscourage Borrowers       Low Discourage SaversEncourage Borrowers
Interest Rates             Low      High SaversBorrowers
Which Investment?               Saudi   U.A.E.Nominal Rate   10%     12%  Inflation      4%      7% Real Rate      6%      5%
Market for Loanable Funds   Real Interest                    Too high   Rate               More supply than demand        ...
Foreign Currency     Exchange Market           NCO = NXNet Capital Outflow = Net Exports
Foreign Currency    Exchange Market            If NX > 0   Selling more than buying    What to do with cash?    Must buy f...
Foreign Currency Exchange Market       If NX < 0Buying more than sellingMust sell domestic assets  to pay for purchases
Foreign Currency     Exchange MarketAt the Equilibrium Exchange Rate:    Demand for currency from  foreigners from net exp...
Market for  Foreign Currency Exchange                        High rates discourage exports  Real                          ...
LinkingThe Loanable Funds Market       S = I + NCO            withForeign Currency Exchange          Market       NCO = NX
Where did the riyals    come from?     Saudi SaversLoanable Funds Market  Where did I buy the       riyals?Foreign Currenc...
S = I + NCOdemand sideNCO = NXsupply side
Net Capital OutflowDepends on Real Interest Rate  RealInterest  Rate           NCO is negative 0 NCO is positive           ...
Linking              Loanable Funds Market                                       Net Capital Outflow    Real               ...
Policy              Loanable Funds Market                                       Net Capital Outflow    Real                ...
Eco 202 ch 33 macroeconomic theory open economy
Eco 202 ch 33 macroeconomic theory open economy
Eco 202 ch 33 macroeconomic theory open economy
Eco 202 ch 33 macroeconomic theory open economy
Eco 202 ch 33 macroeconomic theory open economy
Eco 202 ch 33 macroeconomic theory open economy
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Eco 202 ch 33 macroeconomic theory open economy

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Eco 202 ch 33 macroeconomic theory open economy

  1. 1. Chapter 33A Macroeconomic Theory of the Open Economy
  2. 2. Key Termstrade policycapital flight
  3. 3. ModelSimplified version of reality
  4. 4. Variables Net Exports Net Capital Outflow Real Exchange RatesNominal Exchange Rates
  5. 5. FocusTrade BalanceExchange Rate
  6. 6. Two Markets Loanable funds marketForeign currency market
  7. 7. Loan Market Savers and Borrowers S = I + NCO Savings =Domestic Investment + Net Capital Outflow Supply = Demand
  8. 8. Two ThingsInvest at home Invest abroad
  9. 9. NCO > 0 Less Invest at home More Invest abroad Investing more in othercountries than your own
  10. 10. NCO < 0 More Invest at home Less Invest abroadOther countries want to invest in your country
  11. 11. Supply and Demand of Loanable Funds Depends on the real interest rate
  12. 12. Remember Nominal Rate =Real Rate + Inflation Rate
  13. 13. Nominal = Real + Inflation N=R+I Country A Country B Country C Nominal 10% 13% 12% Real 8% 10% 5% Inflation 2% 3% 7%
  14. 14. Interest Rates High Encourage SaversDiscourage Borrowers Low Discourage SaversEncourage Borrowers
  15. 15. Interest Rates Low High SaversBorrowers
  16. 16. Which Investment? Saudi U.A.E.Nominal Rate 10% 12% Inflation 4% 7% Real Rate 6% 5%
  17. 17. Market for Loanable Funds Real Interest Too high Rate More supply than demand push rate down Supply From national savings Equilibrium Rate Demand For domestic and foreign Too low investment More demand than supply push rate up Equilibrium Quantity Quantity of Loanable Funds
  18. 18. Foreign Currency Exchange Market NCO = NXNet Capital Outflow = Net Exports
  19. 19. Foreign Currency Exchange Market If NX > 0 Selling more than buying What to do with cash? Must buy foreign assetsRemember foreign currency is a foreign asset
  20. 20. Foreign Currency Exchange Market If NX < 0Buying more than sellingMust sell domestic assets to pay for purchases
  21. 21. Foreign Currency Exchange MarketAt the Equilibrium Exchange Rate: Demand for currency from foreigners from net exports = Supply of currency from citizens from net capital outflow
  22. 22. Market for Foreign Currency Exchange High rates discourage exports Real SupplyExchange From net capital outflow Vertical - does not depend on Rate exchange rate Equilibrium Rate Low rates stimulate exports Too high Demand More supply than demand For net exports Pressure to push rate down Too low More demand than supply Pressure to push rate up Equilibrium Quantity Quantity of Riyals Exchanged into Foreign Currency
  23. 23. LinkingThe Loanable Funds Market S = I + NCO withForeign Currency Exchange Market NCO = NX
  24. 24. Where did the riyals come from? Saudi SaversLoanable Funds Market Where did I buy the riyals?Foreign Currency Market Currency Tradersmove funds between the two markets
  25. 25. S = I + NCOdemand sideNCO = NXsupply side
  26. 26. Net Capital OutflowDepends on Real Interest Rate RealInterest Rate NCO is negative 0 NCO is positive NCI is positive NCI is negative Cash comes in Cash goes out
  27. 27. Linking Loanable Funds Market Net Capital Outflow Real Supply Real Interest Interest Rate RateEquilibrium Interest Rate Demand Demand Quantity of Loanable Funds Quantity of Loanable FundsLoanable Funds Market Interest Rate Real Exchange Rate Supply Equilibrium Exchange RateForeign Currency Market Demand Exchange Rate Quantity of Riyals Foreign Currency Exchange Market
  28. 28. Policy Loanable Funds Market Net Capital Outflow Real Supply Real Interest Interest Rate RateEquilibrium Interest Rate Demand Demand Quantity of Loanable Funds Quantity of Loanable Funds Government deficits Real Supply push up interest rates Exchange Rate which increase Equilibrium exchange rates Exchange Rate which increase trade Demand deficits Quantity of Riyals Foreign Currency Exchange Market
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