- 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.
- We start with the loanable funds market…
The Market for Loanable Funds
- An identity from the preceding chapter:
- Supply of loanable funds = saving.
- A dollar of saving can be used to finance
o the purchase of domestic
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
o Canadians purchase more foreign assets.
o Canadians purchase fewer domestic assets.
o NCO rises.
The Market for Loanable Funds
- The supply and demand for loanable funds depend on the real interest rate.
- A higher real interest rate encourages people to save and raises the quantity of loanable funds
- 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.
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)
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.
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,
S = I + NCO
o NX is the demand for dollars: Foreigners need dollars
to buy Canadian net exports. S - I = NX
o NCO is the supply of dollars: Canadian residents provide/give dollars when they buy foreign
- What price balances the supply and demand in the market for foreign-currency exchange?
- Answer: the real exchange rate (E) = e x P
- Recall: P*
The Canadian real exchange rate (E) measures the quantity of foreign goods & services that trade
for one unit of Canadian goods & services.
o E is the real value of a dollar in the market for foreign-
- The demand curve for dollars (NX) is downward sloping
because a higher exchange rate makes domestic goods more
- The supply curve (NCO) is vertical because the quantity of
dollars supplied for net capital outflow is unrelated to the real
- An increase in E makes Canadian goods more expensive to
foreigners, reduces foreign demand for Canadian goods – and
- An increase in E does not affect NCO or the supply of dollars.
- 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.
Disentangling Supply and Demand
- When a Canadian resident buys imported goods, does the transaction affect supply or demand in
the foreign exchange market? - The demand for dollars decreases. The increase in imports reduces NX, which we think of as the
demand for dollars.
(So, NX is really the net demand for dollars.)
- When a foreigner buys a Canadian asset, does the transaction affect supply or demand in the
foreign exchange market?
- The supply of dollars falls. The transaction reduces NCO, which we think of as