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Lecture

ECN 204 Lecture Notes - Loanable Funds, Real Interest Rate, Foreign Exchange Market


Department
Economics
Course Code
ECN 204
Professor
Paul Missios

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Chapter 13: A Macroeconomic Theory of the Open Economy
-Canada’s net capital outflow has been negative for the past 40 years, over that period foreigners have
purchases more Canadian assets than Canadians purchased foreign assets as a result many firms located
in Canada are owned by foreigners = prompted government legislation limiting foreign
-In 1999, Canada’s NCO turned positive and remained so till 2008, Canadians were buying more foreign
assets than foreigners were buying Canadian assets = Canadians savings are going abroad
The Market for Loanable Funds
Market for Loanable Funds: coordinates the economy’s saving, investment, and the flow of loanable
funds abroad called Net Capital Outflow
Identity: Saving (S) = Domestic Investment (I) + Net Capital Outflow (NCO)
Positive NCO: the amount of national saving EXCEEDS the amount needed to finance the
purchase of domestic capital; the amount left over can finance purchase of asset abroad. If S > I
Negative NCO: the amount of national saving is INSUFFICIENT to finance the purchase of
domestic capital; the shortfall can be met by the savings of foreigners. If S < I
Supply of loanable funds = Savings. A dollar of saving can be used to finance the purchase of domestic
capital and the purchase of foreign assets
Demand for loanable funds = I + NCO
Demand for loanable funds comes from domestic investment (I)
-The quantity of loanable funds supplied and the quantity of loanable funds demanded DEPEND on the
real interest rate. Higher interest rate encourages people to save = raise quantity of loanable funds
made available by national saving, makes borrowing to finance capital more costly thus discourages
investment and reduces the quantity of loanable funds demanded
Net Capital Outflow: is determined by the difference between the supply of loanable funds due to
national saving (S) and the demand for loanable funds (I) at the world interest rate.
Net Exports: are determined by the difference between the supply of loanable funds due to national
saving (S) and the demand for loanable funds (I) at the world interest rate.
NCO=NX
How NCO Depends on the Real Interest Rate
GRAPH: The real interest rate, r, is the real return on domestic assets. A
fall in r makes domestic assets less attractive to foreign assets. Canadians
purchase more foreign assets and purchase fewer domestic assets = NCO
rises
-The supply and demand for loanable funds depend on the real interest
rate. A higher real interest rate encourages people to save and raise the
quantity of loanable funds supplied. The interest rate adjusts to bring the
supply and demand for loanable funds into balance. At the equilibrium
interest rate, the amount that people want to save exactly balances the
desired quantities of domestic investment and net foreign investment.
-S depends positively on the real interest rate, r and I depends negatively on r

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Exercise 1
Question: Suppose the government runs a budget deficit (previously, the budget was balanced). Use the
appropriate diagrams to determine the effect on the real interest rate and net capital outflow.
Answer: A budget deficit reduces savings and the
supply of loanable funds, causing r to rise. The
higher r makes US bonds more attractive relative
to foreign bonds, which reduce NCO. The LF
market determines r (in left graph), then this
value of r determines NCO (in right graph)
-In a small open economy with perfect capital mobility like Canada, the domestic interest rate will equal
the world interest rate. As a result, the quantity of loanable funds made available by the savings of
Canadians does not have to equal the quantity of loanable funds demanded for domestic investments.
The difference between these two amounts is net capital outflow (NCO).
Positive NCO Negative NCO

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The Market for Foreign-Currency Exchange
Market of Foreign-Currency Exchange: coordinates people who want to exchange the domestic
currency for the currency of other country.
-The market for foreign currency exchanges exists because people want to trade with people in other
countries, but they want to be paid in their own currency.
-The two sides of the foreign currency exchange market are represented by Net Exports and Net Capital
Outflow. NCO represents the imbalance between the purchases and sales of capital assets; NX
represents the imbalance between exports and imports of goods and services.
Identity: NCO = NX
NX= demand for dollars, Foreigners need dollars to buy Canadian net exports
NCO = supply of dollars, Canadian residents sell dollars to obtain foreign currency they need to buy
foreign assets
Identity: S = I + NCO and NX = S I
NX= S I: states that the imbalance between the domestic supply of loanable funds that is due for
national saving (S) and the demand for loanable funds for domestic investment (I) must equal the
imbalance between exports and imports (NX).
-The difference between national saving and domestic investment represents NCO/NX which represents
the quantity of dollars supplied in the market for foreign currency exchange for the purpose of buying
foreign assets.
-The real exchange rate balances the supply and demand in the market for foreign currency exchange.
-E is the real value of a dollar in the market for foreign currency exchange. The Canadian real exchange
rate (E) measures the quantity of foreign goods and services that trade for one unit of Canadian g&s
-When Canada’s real exchange rate appreciates, Canadian goods become more expensive relative to
foreign goods making the Canadian goods less attractive to consumers at home and abroad = exports
from Canada falls, imports rises therefore net export falls.
-The demand curve for foreign currency is downward sloping because a higher exchange rate makes
domestic goods more expensive. The supply curve is vertical because the quantity of dollars supplied for
net capital outflow does not depend on the real exchange rate. (it depends on real INTEREST rate)
-The real exchange rate adjusts to balance the
supply and demand for dollars. At the
equilibrium real exchange rate, the demand for
dollars to buy net exports exactly balances the
supply of dollars to be exchanged into foreign
currency to buy assets abroad
-If the real exchange rate was BELOW
equilibrium level, the quantity of dollars
supplied would be less than the quantity
demanded. The resulting shortage of dollars
would push the value of the dollar up
-If the real exchange rate was ABOVE the
equilibrium level, the quantity of dollars supplied would exceed the quantity demanded = the surplus of
dollars would drive the value of the dollar down.
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