eco 202 ch 33 macroeconomic theory open economy
TRANSCRIPT
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Chapter 33
A Macroeconomic Theory of the
Open Economy
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Key Termstrade policycapital flight
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Model
Simplified version of reality
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Variables
Net ExportsNet Capital OutflowReal Exchange Rates
Nominal Exchange Rates
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Focus
Trade BalanceExchange Rate
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Two Markets
Loanable funds marketForeign currency market
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Loan Market
Savers and BorrowersS = I + NCO
Savings =
Domestic Investment + Net Capital Outflow
Supply = Demand
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Two Things
Invest at homeInvest abroad
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NCO > 0
Less Invest at homeMore Invest abroad
Investing more in other countries than your own
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NCO < 0
More Invest at homeLess Invest abroad
Other countries want to invest in your country
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Supply and Demandof Loanable Funds
Depends on the real interest rate
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Remember
Nominal Rate = Real Rate + Inflation Rate
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Nominal = Real + InflationN = R + I
Country A Country B Country C
Nominal 10% 12%
Real 8% 10%
Inflation 3% 7%2%
13%
5%
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Interest RatesHigh
Encourage SaversDiscourage Borrowers
LowDiscourage Savers
Encourage Borrowers
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Low High
Savers
Borrowers
Interest Rates
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Saudi U.A.E.
Nominal Rate 10% 12%
Inflation
Real Rate
Which Investment?
4% 7%
6% 5%
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RealInterest
Rate
Quantity of Loanable Funds
EquilibriumRate
EquilibriumQuantity
Market for Loanable Funds
DemandFor domestic and foreigninvestment
SupplyFrom national savings
Too highMore supply than demand
push rate down
Too lowMore demand than supply
push rate up
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Foreign Currency Exchange Market
NCO = NXNet Capital Outflow = Net Exports
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Foreign Currency Exchange Market
If NX > 0Selling more than buyingWhat to do with cash? Must buy foreign assets
Remember foreign currency is a foreign asset
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Foreign Currency Exchange Market
If NX < 0Buying more than sellingMust sell domestic assets
to pay for purchases
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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
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RealExchange
Rate
Quantity of Riyals Exchanged into Foreign Currency
EquilibriumRate
Equilibrium Quantity
Market for Foreign Currency Exchange
DemandFor net exports
SupplyFrom net capital outflowVertical - does not depend on exchange rate
Low rates stimulate exports
High rates discourage exports
Too lowMore demand than supplyPressure to push rate up
Too highMore supply than demand
Pressure to push rate down
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Linking The Loanable Funds Market
S = I + NCOwith
Foreign Currency Exchange Market
NCO = NX
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Where did the riyals come from?
Saudi SaversLoanable Funds Market
Where did I buy the riyals?
Foreign Currency Market
Currency Tradersmove funds between the
two markets
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S = I + NCOdemand side
NCO = NXsupply side
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RealInterest
Rate
0
Net Capital OutflowDepends on Real Interest Rate
NCO is positiveNCI is negative
NCO is negativeNCI is positiveCash comes in Cash goes out
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LinkingReal
InterestRate
Quantity of Loanable Funds
EquilibriumInterest
Rate
Demand
Supply
Loanable Funds Market
RealInterest
Rate
Quantity of Loanable Funds
Demand
Net Capital Outflow
RealExchange
Rate
Quantity of Riyals
EquilibriumExchange
Rate
Demand
Supply
Foreign Currency Exchange Market
Loanable Funds MarketInterest Rate
Foreign Currency MarketExchange Rate
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PolicyReal
InterestRate
Quantity of Loanable Funds
EquilibriumInterest
Rate
Demand
Supply
Loanable Funds Market
RealInterest
Rate
Quantity of Loanable Funds
Demand
Net Capital Outflow
RealExchange
Rate
Quantity of Riyals
EquilibriumExchange
Rate
Demand
Supply
Foreign Currency Exchange Market
Government deficitspush up interest rates
which increase exchange rates
which increase trade deficits