Chapter 10 A Macroeconomic Theory of the Open Economy
10.1 Prerequisites
- Net exports are always equal to net capital outflow: \(NX=NCO\).
- National saving is always equal to domestic investment plus net capital outflow: \(S=I+NCO\).
- The loanable funds theory of the real interest rate, for closed economies
- National saving = private-sector saving + government saving
- Private-sector saving = \(Y-T-C\).
- Government saving = \(T-G\).
- The real exchange rate is the price of domestic products relative to similar foreign products
- Calculated as \(e\times P^*/P\).
- Purchasing-power parity theory of the real exchange rate
- \(e\times P^*/P=1\).
10.2 Loanable Funds Theory of the Real Interest Rate
We have seen this accounting identity before: \(S=I+NCO\).
And we have seen before that this accounting identity makes sense: A nation’s saving (\(S\)) must end up being loaned to domestic borrowers or foreign borrowers. The loans made to domestic borrowers will end up as investment spending mainly by domestic firms (\(I\)). And the loans made to foreigners will be net capital outflow (\(NCO\)). Therefore, \(S=I+NCO\).
Now, in a free-market economy, people and/or firms cannot be forced to do this or that. Therefore, desired saving by households must be equal to desired investment spending by firms and households plus desired net capital outflow.
How is this accomplished? How are these desired amounts brought into line? The theory of loanable funds says that:
- There’s a market for loanable funds
- The supply of loanable funds = desired national saving (\(S\)).
- This supply depends on many factors, including the real interest rate.
- The supply of loanable funds increases when the real interest rate increases.
- The demand for loanable funds = desired domestic investment spending (\(I\)) + desired net capital outflow (\(NCO\)).
- This demand depends on many factors, including the real interest rate.
- The demand for loanable funds decreases when the real interest rate increases.
- The real interest rate reaches an equilibrium level at which supply is equal to demand.
- In this way, we get \(S=I+NCO\) even when the variables are interpreted as the desired amounts.
We have seen this accounting identity before: \(NX = NCO\). We have seen before that the actual levels of net exports and net capital outflow must be equal: \(NX = NCO\).
But, in a free-market economy, people and/or firms cannot be forced to do this or that. Therefore, desired net exports must be equal to desired net capital outflow. How is this accomplished? How are these desired amounts brought into line?
10.3 The Market for Foreign-Currency Exchange
Just as we may imagine a market in which ice cream is exchanged for currency, or a market in which Amazon shares are exchanged for currency, we may imagine a market in which different currencies are exchanged for each other.
That’s the market for foreign-currency exchange.
We assume that in this market there is a supply and a demand for every currency. We assume that this market’s price reaches the equilibrium level at which supply and demand are equal.
The supply of the domestic currency = desired net capital outflow (\(NCO\)).
This supply depends on many factors, but not on the real exchange rate. Recall that the determination of desired net capital outflow was determined in the market for loanable funds before I even mentioned the real exchange rate.
The demand for the domestic currency = desired net exports (\(NX\)).
This demand depends on many factors, including the real exchange rate. The quantity of the domestic currency demanded decreases when the real exchange rate increases.
The real exchange rate reaches an equilibrium level at which supply is equal to demand. In this way, we get \(NX=NCO\) even when the variables are interpreted as the desired amounts.
10.4 Simultaneous Equilibrium in Two Markets
We need to join together the two markets that we’ve been discussing—the loanable-funds market and the foreign-currency exchange market—to get to a coherent understanding of long-run open-economy macroeconomics.
10.5 Effects of Policy Changes and Unforeseen Events
The point of building a macroeconomic theory of an open economy is to be able to say something that is not totally idiotic about the likely consequences of some policy change or unforeseen event.
We will now see what our theory says about the long-run effects of:
- A tax cut and/or an increase in government spending
- An import tariff or an import quota
- Political instability and capital flight
10.5.1 A Tax Cut and/or an Increase in Government Spending
Recall that:
- The supply of loanable funds = national saving (\(S\)).
- National saving = private-sector saving + government saving.
- Private-sector saving = \(Y-T-C\).
- Government saving = \(T-G\).
Therefore, a tax cut and/or an increase in government spending implies that \(T – G\) decreases. (That is, government saving decreases.) Therefore, national saving (\(S\)) decreases. This shifts the supply of loanable funds to the left.
10.5.2 An Import Tariff or an Import Quota
An import tariff is a tax on imported goods. An import quota puts a limit on the quantity of imports. Either way, imports will decrease, assuming all other factors that affect imports (such as the real exchange rate) are unchanged. Therefore, net exports (NX = exports – imports) will increase.
As a result, the demand for the domestic currency in the market for foreign-currency exchange will shift to the right.
As the curves for \(S\), \(I\), and \(NCO\) are unaffected, the market for loanable funds will be unaffected.
10.5.3 Political Instability and Capital Flight
An increase in political instability is likely to cause an increase in net capital outflow (also called capital flight, when the outflow is large), assuming all the other factors that affect \(NCO\) are unchanged.
This will shift the \(NCO\) curve to the right.
As the two main sources of the demand for loanable funds are investment (\(I\)) and net capital outflow (\(NCO\)), the demand for loanable funds will shift right.