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ECN 204 (348)
Lecture

Chapter #13 ECN.docx

8 Pages
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Department
Economics
Course Code
ECN 204
Professor
Christopher Gore

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Chapter #13 - The previous chapter explained the basic concepts and vocabulary of the open economy: net exports (NX), net capital outflow (NCO), and exchange rates. - This chapter ties these concepts together into a theory of the open economy. - We will use this theory to see how govt policies and various events affect the trade balance, exchange rate, and capital flows. The Market for Loanable Funds - All savers go to this market to deposit their savings and all borrowers go to this market to get their loans - In this market this is only one interest rate, which is both the return to saving and the cost of borrowing - The identity emphasized that in an open economy, the amount that a nation saves does not have to equal the amount it spends to purchase domestic capital - The supply and demand of loanable funds is correlated accordingly to interest rates o Higher real interest rate encourages people to save and raises the quantity of loanable funds made available by national saving o Higher interest rate makes borrowing to finance capital projects more costly which discourages investment and reduces the quantity of loanable funds demanded - Supply of loanable funds = national saving o In an open economy, the curve shows the Canadian savings available at each interest rate o In a closed economy we would need to consider only the supply of loanable funds made available by the savings of Canadians o In perfect capital mobility, the interest rate is equal to the world interest rate, and we need to also consider the role played by the savings of foreigners - A dollar of saving can be used to finance o the purchase of domestic capital o the purchase of a foreign asset - So, demand for loanable funds = I + NCO o S depends positively on the real interest rate, r. o I depends negatively on r. - What about NCO? How NCO Depends on the Real Interest Rate - The real interest rate, r, is the real return on domestic assets. - A fall in r makes domestic assets less attractive relative to foreign assets. o Canadians purchase more foreign assets. o Canadians purchase fewer domestic assets. o NCO rises. The Market for Loanable Funds - If we ignore differences in tax treatments and default risk, the domestic interest rate will equal the world interest rate - The supply and demand for loanable funds depend on the real interest rate. - A higher real interest rateencourages people to save and raises the quantity of loanable funds supplied. - The interest rate adjusts to bring the supply and demand for loanable funds into balance. - Demand is a downward slope curve because a higher interest rate decreases the quantity of loanable funds demanded - Supply curve slopes upward because a higher interest rate increase the quantity of loanable funds supplied - At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment. The Loanable Funds Market Diagram Example: Budget deficits and capital flows - Suppose the government runs a budget deficit (previously, the budget was balanced). - Use the appropriate diagrams to determine the effects on the real interest rate and net capital outflow. The Market for Loanable Funds - 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 investment. - The difference between these two amounts is net capital outflow (NCO) In panel (a) , the world interest rate is greater than the Canadian interest rate would be if this were a closed economy. Because there is perfect capital mobility, the Canadian interest rate is given by the world interest rate. At this interest rate, the demand for loanable funds in Canada (I) is $100 billion, and the supply of loanable funds that Canadians make available (S) is $150 billion. At this world interest rate, the supply of Canadians savings is more than enough to satisfy the demand for loanable funds in Canada. The excess supply of loanable funds, $50 billion, is therefore available to purchase foreign assets. In this situation, net capital outflow (NCO) is $50 billion. Note that S = I + NCO, as required by our accounting identity. In panel (b), the world interest rate is shown as being less than the interest rate would be if this were a closed economy. At this world interest rate, the demand for loanable funds in Canada (I) is now $130 billion, and the supply of loanable funds that Canadians make available (S) is $90 billion. At this world interest rate, the supply of Canadians savings is not enough to satisfy the demand for loanable funds in Canada. The excess demand for loanable funds, $40 billion, must therefore be satisfied by the savings of foreigners. In this situation, NCO takes on a negative value: - $40 billion. We have defined net capital outflow as the amount of foreign assets that Canadians purchase minus the amount of Canadian assets that foreigners buy. A negative value simply indicates a net purchase of Canadian assets by foreigners.)Note that, once again, S = I +NCO, as required by our accounting identity.These two diagrams show that the market for loanable funds in a small open economy with perfect capital mobility is different from that in a closed economy. In particular, the interest rate is no longer determined by the demand and supply of loanable funds. Instead, the interest rate is equal tothe 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 investment. The difference between these two amounts is net capital outflow. 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. NCO = NX Net capital outflow = Net exports we can also state this result as follows: 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. These two statements are equivalent because net exports must equal net capital outflow. The Market for Foreign-Currency Exchange - The market for foreign-currency exchange exists because people want to trade with people in other countries, but they want to be paid in their own currency. - This means that, for a Canadian to purchase a g&s or financial asset from someone in another country, the Canadian must purchase the other countrys currency as well and vise-versa o The two sides of the foreign-currency exchange market are represented by NCO and NX. o NCO represents the imbalance between the purchases and sales of capital assets. o NX represents the imbalance between exports and imports of goods and services. - Another identity from the preceding chapter: - In the market for foreign-currency exchange, o NX is the demand for dollars: Foreigners need dollars to buy
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