Eco 202 ch 33 macroeconomic theory open economy

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Eco 202 ch 33 macroeconomic theory open economy

  1. 1. Chapter 33 ! A Macroeconomic Theory of the Open Economy
  2. 2. Key Terms trade policy capital flight
  3. 3. Model Simplified version of reality
  4. 4. Variables Net Exports Net Capital Outflow Real Exchange Rates Nominal Exchange Rates
  5. 5. Focus Trade Balance Exchange Rate
  6. 6. Two Markets Loanable funds market Foreign currency market
  7. 7. Loan Market Savers and Borrowers S = I + NCO Savings = Domestic Investment + Net Capital Outflow ! Supply = Demand
  8. 8. Two Things Invest at home Invest abroad
  9. 9. NCO > 0 Less Invest at home More Invest abroad ! Investing more in other countries than your own
  10. 10. NCO < 0 More Invest at home Less Invest abroad ! Other 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% 12% Real 8% 10% Inflation 3% 7%2% 13% 5%
  14. 14. Interest Rates High Encourage Savers Discourage Borrowers Low Discourage Savers Encourage Borrowers
  15. 15. Low High Savers Borrowers Interest Rates
  16. 16. Saudi U.A.E. Nominal Rate 10% 12% Inflation Real Rate Which Investment? 4% 7% 6% 5%
  17. 17. Real Interest Rate Quantity of Loanable Funds Equilibrium Rate Equilibrium Quantity Market for Loanable Funds Demand For domestic and foreign investment Supply From national savings Too high More supply than demand push rate down Too low More demand than supply push rate up
  18. 18. Foreign Currency Exchange Market NCO = NX Net 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 assets Remember foreign currency is a foreign asset
  20. 20. Foreign Currency Exchange Market If NX < 0 Buying more than selling Must sell domestic assets to pay for purchases
  21. 21. Foreign Currency Exchange Market At the Equilibrium Exchange Rate: Demand for currency from foreigners from net exports = Supply of currency from citizens from net capital outflow
  22. 22. Real Exchange Rate Quantity of Riyals Exchanged into Foreign Currency Equilibrium Rate Equilibrium Quantity Market for Foreign Currency Exchange Demand For net exports Supply From net capital outflow Vertical - does not depend on exchange rate Low rates stimulate exports High rates discourage exports Too low More demand than supply Pressure to push rate up Too high More supply than demand Pressure to push rate down
  23. 23. Linking The Loanable Funds Market S = I + NCO with Foreign Currency Exchange Market NCO = NX
  24. 24. Where did the riyals come from? Saudi Savers Loanable Funds Market Where did I buy the riyals? Foreign Currency Market Currency Traders move funds between the two markets
  25. 25. S = I + NCO demand side ! NCO = NX supply side
  26. 26. Real Interest Rate 0 Net Capital Outflow Depends on Real Interest Rate NCO is positive NCI is negative NCO is negative NCI is positive Cash comes in Cash goes out
  27. 27. Linking Real Interest Rate Quantity of Loanable Funds Equilibrium Interest Rate Demand Supply Loanable Funds Market Real Interest Rate Quantity of Loanable Funds Demand Net Capital Outflow Real Exchange Rate Quantity of Riyals Equilibrium Exchange Rate Demand Supply Foreign Currency Exchange Market Loanable Funds Market Interest Rate Foreign Currency Market Exchange Rate
  28. 28. Policy Real Interest Rate Quantity of Loanable Funds Equilibrium Interest Rate Demand Supply Loanable Funds Market Real Interest Rate Quantity of Loanable Funds Demand Net Capital Outflow Real Exchange Rate Quantity of Riyals Equilibrium Exchange Rate Demand Supply Foreign Currency Exchange Market Government deficits push up interest rates which increase exchange rates which increase trade deficits

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