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 for foreign currency exchange Market for loanable funds S=I+NFI Supply of loanable funds comes from 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 • Closed economy Interest rate = • Interest rate is world interest rate determined by NFI exists demand and because S is not supply of loanable equal to I funds NX is also • S=I, NFI=0 determined by the • NX=0 difference in S and I 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 and 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.