N.

GREGORY MANKIW
PRINCIPLES OF

ECONOMICS
Eight Edition

CHAPTER A Macroeconomic Theory

32 of the Open Economy
PowerPoint Slides prepared by:
V. Andreea CHIRITESCU
Eastern Illinois University
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 Model of the Open Economy
• Model of the open economy
– To highlight the forces that determine the
economy’s trade balance and exchange
rate
– Looking simultaneously at the market for
loanable funds and the market for foreign-
currency exchange
– Examine how various events and policies
affect the economy’s trade balance and
exchange rate
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 Market for Loanable Funds, Part 1
• In an open economy, S = I + NCO
Saving = Domestic investment + Net capital
outflow
• Supply of loanable funds
– From national saving (S)
• Demand for loanable funds
– From domestic investment (I)
– And net capital outflow (NCO)

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 Market for Loanable Funds, Part 2
• When NCO > 0, net outflow of capital
– Net purchase of capital overseas
• Adds to the demand for domestically
generated loanable funds
• When NCO < 0, net inflow of capital
– Capital resources coming from abroad
• Reduce the demand for domestically
generated loanable funds

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 Market for Loanable Funds, Part 3
• Loanable funds – interpreted as
– Domestically generated flow of resources
available for capital accumulation
• Purchase of a capital asset
– Adds to the demand for loanable funds
– Asset located at home: I
– Asset located abroad: NCO

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 Market for Loanable Funds, Part 4
• Higher real interest rate
– Encourages people to save: increases
quantity of loanable funds supplied
– Discourages investment: decreases quantity
of loanable funds demanded
– Discourages Americans from buying foreign
assets: reduces U.S. net capital outflow
– Encourages foreigners to buy U.S. assets:
reduces U.S. net capital outflow

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 Market for Loanable Funds, Part 5
• Supply of loanable funds
– Slopes upward
• Demand of loanable funds
– Slopes downward
• At equilibrium interest rate
– Amount that people want to save
– Exactly balances the desired quantities of
domestic investment and net capital
outflow
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 Figure 1 The Market for Loanable Funds

The interest rate in an open economy, as in a closed economy, is determined by the supply
and demand for loanable funds. National saving is the source of the supply of loanable funds.
Domestic investment and net capital outflow are the sources of the demand for loanable funds.
At the equilibrium interest rate, the amount that people want to save exactly balances the
amount that people want to borrow for the purpose of buying domestic capital and foreign
assets.

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 Foreign-Currency Exchange, Part 1
• The market for foreign-currency exchange
– Identity: NCO = NX
– Net capital outflow = Net exports
• If trade surplus, NX > 0
– Exports > Imports
– Net sale of goods ad services abroad
– Americans use the foreign currency to buy
foreign assets
• Capital is flowing abroad, NCO > 0
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 Foreign-Currency Exchange, Part 2
• If trade deficit, NX < 0
– Imports > Exports
– Some of this spending is financed by
selling American assets abroad
• Foreign capital is flowing into U.S.
• NCO < 0

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 Foreign-Currency Exchange, Part 3
• Supply of foreign-currency exchange
– Net capital outflow
• Quantity of dollars supplied to buy foreign
assets
– Supply curve is vertical
• Quantity of dollars supplied for net capital
outflow
• Does not depend on the real exchange rate

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 Foreign-Currency Exchange, Part 4
• Demand for foreign-currency exchange
– Net exports
• Quantity of dollars demanded to buy U.S. net
exports of goods and services
– Demand curve is downward sloping
– A higher real exchange rate
• Makes U.S. goods more expensive
• Reduces the quantity of dollars demanded to
buy those goods

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 Foreign-Currency Exchange, Part 5
• Equilibrium real exchange rate
– Demand for dollars
• By foreigners
• Arising from U.S. net exports of goods and
services
– Exactly balances supply of dollars
• From Americans
• Arising from U.S. net capital outflow

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 Figure 2 The Market for Foreign-Currency Exchange

The real exchange rate is determined by the supply and demand for foreign-currency exchange.
The supply of dollars to be exchanged into foreign currency comes from net capital outflow.
Because net capital outflow does not depend on the real exchange rate, the supply curve is
vertical. The demand for dollars comes from net exports. Because a lower real exchange rate
stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net
exports), the demand curve slopes downward. At the equilibrium real exchange rate, the number
of dollars people supply to buy foreign assets exactly balances the number of dollars people
demand to buy net exports.
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 Equilibrium in the Open Economy,
Part 1
• Identities
– Market for loanable funds: S = I + NCO
– Market for foreign-currency exchange:
NCO = NX
• Net-capital-outflow curve
– Link between
• Market for loanable funds
• Market for foreign-currency exchange

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 Figure 3 How Net Capital Outflow Depends on the
Interest Rate

Because a higher domestic real interest rate makes domestic assets more attractive, it
reduces net capital outflow. Note the position of zero on the horizontal axis: Net capital outflow
can be positive or negative. A negative value of net capital outflow means that the economy is
experiencing a net inflow of capital.

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 Equilibrium in the Open Economy,
Part 2
• Market for loanable funds
– Supply: national saving
– Demand: domestic investment and net
capital outflow
– Equilibrium real interest rate, r
• Net capital outflow
– Slopes downward
– Equilibrium interest rate, r

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 Equilibrium in the Open Economy,
Part 3
• Market for foreign-currency exchange
– Supply: net capital outflow
– Demand: net exports
– Equilibrium real exchange rate, E
• Equilibrium real interest rate, r
– Price of goods and services in the present
• Relative to goods and services in the future

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 Equilibrium in the Open Economy,
Part 4
• Equilibrium real exchange rate, E
– Price of domestic goods and services
• Relative to foreign goods and services
• E and r adjust simultaneously
– To balance supply and demand
– In both markets
• Loanable funds
• Foreign-currency exchange

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 Equilibrium in the Open Economy,
Part 5
• E and r adjust simultaneously
– Determine
• National saving
• Domestic investment
• Net capital outflow
• Net exports

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 Figure 4 The Real Equilibrium in an Open Economy

In panel (a), the supply and demand for

loanable funds determine the real interest
rate.
In panel (b), the interest rate determines
net capital outflow, which provides the
supply of dollars in the market for foreign-
currency exchange.
In panel (c), the supply and demand for
dollars in the market for foreign-currency
exchange determine the real exchange rate.

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 Government Budget Deficits, Part
1
• Government budget deficits
– When government spending exceeds
government revenue
– Negative public saving
– Reduces national saving
– Reduces supply of loanable funds
– Increase in interest rate
– Reduces net capital outflow

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 Government Budget Deficits, Part
2
• Government budget deficits
– Crowd-out domestic investment
– Decrease in supply of foreign-currency
exchange
– Currency appreciates
– Net exports fall
– Push the trade balance toward deficit

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 Figure 5 The Effects of a Government Budget Deficit

When the government runs a budget deficit, it reduces

the supply of loanable funds from S1 to S2 in panel (a).
The interest rate rises from r1 to r2 to balance the supply
and demand for loanable funds. In panel (b), the higher
interest rate reduces net capital outflow. Reduced net
capital outflow, in turn, reduces the supply of dollars in the
market for foreign-currency exchange from S1 to S2 in
panel (c). This fall in the supply of dollars causes the real
exchange rate to appreciate from E1 to E2. The
appreciation of the exchange rate pushes the trade
balance toward deficit.

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 Trade Policy, Part 1
• Trade policy
– Government policy
– Directly influences the quantity of goods
and services
• That a country imports or exports
– Tariff: tax on imports
– Import quota: limit on quantity of imports
– Voluntary export restrictions

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 Trade Policy, Part 2
• Macroeconomic impact of trade policy
(import quota)
– Decrease imports
– Increase in net exports
– Increase in demand for dollars in the
market for foreign-currency exchange
– Real exchange rate appreciates
• Discourage exports

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 Trade Policy, Part 3
• Macroeconomic impact of trade policy
(import quota)
– No change in real interest rate
– No change in net capital outflow
– No change in net exports
• Decrease in imports
• Decrease in exports

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 Figure 6 The Effects of an Import Quota

When the U.S. government imposes a quota on the

import of Japanese cars, nothing happens
in the market for loanable funds in panel (a) or to
net capital outflow in panel (b). The only effect is a
rise in net exports (exports minus imports) for any
given real exchange rate. As a result, the demand
for dollars in the market for foreign-currency
exchange rises, as shown by the shift from D1 to D2
in panel (c). This increase in the demand for dollars
causes the value of the dollar to appreciate from E1
to E2. This appreciation of the dollar tends to reduce
net exports, offsetting the direct effect of the import
quota on the trade balance.

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 Trade Policy, Part 4
• Macroeconomic impact of trade policy
– Trade policies do not affect the U.S. trade
balance
• NX = NCO = S – I
– Trade policies affect specific
• Firms
• Industries
• Countries

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 Political Instability and Capital Flight,
Part 1
• Political instability
– Leads to capital flight
• Capital flight
– Large and sudden reduction in the
demand for assets located in a country

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 Political Instability and Capital Flight,
Part 2
• Mexico - capital flight affects both markets
– 1994, political instability
– Investors – capital flight
• Sell Mexican assets, buy U.S. assets, “safe
haven”
– Net-capital-outflow curve – increases
• Supply of pesos in the market for foreign-
currency exchange – increases
– Demand curve in the market for loanable
funds – increases
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 Political Instability and Capital Flight,
Part 3
• Mexico - capital flight affects both markets
– Interest rate in Mexico – increases
• Reduce domestic investment
• Slows capital accumulations
• Slows economic growth
– The peso depreciates
• Exports – cheaper
• Imports – more expensive
• Trade balance moves toward surplus

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 Figure 7 The Effects of Capital Flight
If people decide that Mexico is a risky
place to keep their savings, they will
move their capital to safe havens such
as the United States, resulting in an
increase in Mexican net capital outflow.
Consequently, the demand for loanable
funds in Mexico rises from D1 to D2, as
shown in panel (a), driving up the
Mexican real interest rate from r1 to r2.
Because net capital outflow is higher for
any interest rate, that curve also shifts
to the right from NCO1 to NCO2 in panel
(b). At the same time, in the market for
foreign-currency exchange, the supply
of pesos rises from S1 to S2, as shown
in panel (c). This increase in the supply
of pesos causes the peso to depreciate
from E1 to E2, so the peso becomes less
valuable compared to other currencies.

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 Political Instability and Capital Flight,
Part 4
• Mexico - capital flight affects both markets
– U.S. market
• Fall in U.S. net capital outflow
• The dollar appreciates in value
• U.S. interest rates fall
• Relatively small impact on the U.S. economy
– Because the economy of the United States is so
large compared to that of Mexico

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 Capital flows from China, Part 1
• Nation that experiences capital flight
– Outflow of capital
– Its currency weaken in foreign exchange
markets (depreciation)
– Increases the nation’s net exports
• Nation that experiences inflow of capital
– Its currency strengthen (appreciation)
– Pushes its trade balance toward deficit

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 Capital flows from China, Part 2
• A nation’s government (policy):
– Encourages capital to flow to another
country
• By making foreign investments itself
– Effect?
• Nation encouraging capital outflows: weaker
currency and trade surplus
• For the recipient of capital flows: stronger
currency and trade deficit

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 Capital flows from China, Part 3
• Ongoing policy disputes: U.S. and China
– China – tried to depress its currency (renminbi)
in foreign exchange markets
• Promote its export industries
• Accumulate foreign assets: from 2000 to
2012, increased from $160 billion to $4
trillion (including U.S. government bonds)
– Chinese goods - less expensive
• Contributes to the U.S. trade deficit
• Hurts American producers who make
products that compete with imports from
China
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 Capital flows from China, Part 4
• Ongoing policy disputes: U.S. and China
– U.S. government
• Encouraged China to stop influencing the
exchange value of its currency
– American consumers of Chinese imports
• Benefit from lower prices
– Inflow of capital from China
• Lowers U.S. interest rates
• Increases investment in the U.S. economy

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 Capital flows from China, Part 5
• Chinese policy of investing in U.S.
economy
– Creates winners and losers among
Americans
– Net impact on U.S. economy - probably
small
• Motives behind the policy
– China - wants to accumulate a reserve of
foreign assets - national “rainy-day fund”
– Misguided policy
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 ASK THE EXPERTS
Currency Manipulation
“Economic analysis can identify whether
countries are using their exchange rates to
benefit their own people at the expense of
their trading partners’ welfare.”

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