1. Chapter 33
!
A Macroeconomic
Theory of the
Open Economy

2. Key Terms
trade policy
capital flight

5. Model
Simplified version of reality

6. Variables
Net Exports
Net Capital Outflow
Real Exchange Rates
Nominal Exchange Rates

8. Focus
Trade Balance
Exchange Rate

9. Two Markets
Loanable funds market
Foreign currency market

10. Loan Market
Savers and Borrowers
S = I + NCO
Savings =
Domestic Investment + Net Capital Outflow
!
Supply = Demand

11. Two Things
Invest at home
Invest abroad

12. NCO > 0
Less Invest at home
More Invest abroad
!
Investing more in other
countries than your own

13. NCO < 0
More Invest at home
Less Invest abroad
!
Other countries want to
invest in your country

14. Supply and Demand
of Loanable Funds
Depends on the
real interest rate

15. Remember
Nominal Rate =
Real Rate + Inflation Rate

16. Nominal = Real + Inflation
N = R + I
Country A Country B Country C
Nominal 10% 12%
Real 8% 10%
Inflation 3% 7%2%
13%
5%

17. Interest Rates
High
Encourage Savers
Discourage Borrowers
Low
Discourage Savers
Encourage Borrowers

18. Low High
Savers
Borrowers
Interest Rates

19. Saudi U.A.E.
Nominal Rate 10% 12%
Inflation
Real Rate
Which Investment?
4% 7%
6% 5%

20. 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

21. Foreign Currency
Exchange Market
NCO = NX
Net Capital Outflow = Net Exports

22. 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

25. Foreign Currency
Exchange Market
If NX < 0
Buying more than selling
Must sell domestic assets
to pay for purchases

26. 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

27. 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

28. Linking
The Loanable Funds Market
S = I + NCO
with
Foreign Currency Exchange
Market
NCO = NX

30. 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

31. S = I + NCO
demand side
!
NCO = NX
supply side

32. 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

33. 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

34. 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