ECN Chapter 13
Supply and Demand For Loanable Funds and Foreign Currency Exchange
The Market for Loanable Funds
• (S) Canada’s national saving: the supply for loanable funds
• (I) Domestic Investment: The demand for loanable funds
• (NCO) Net capital outflow: The purchase of foreign assets
• S = I + NCO
• Net capital outflow comes from what is left over from canada’s savings after
financing domestic capital. This money is used to buy foreign assets
• 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 supplied.
• The interest rate adjusts to bring the supply and demand for loanable funds into
• At the equilibrium interest rate, the amount that people want to save exactly
balances the desired quantities of domestic investment and net foreign investment.
• 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
• The difference between these two amounts is net capital outflow (NCO)
• The higher the world interest rate means positive NCO because foreign assets
become more attractive to Canadians
The Market for Foreign Currency Exchange
The market for foreigncurrency exchange 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 foreigncurrency exchange market are represented by
NCO and NX.
• NCO represents the imbalance between the purchases and sales of capital
• NX represents the imbalance between exports and imports of goods and
• NCO = NX
• In the market for foreigncurrency exchange,
• NX is the demand for dollars:
Foreigners need dollars to buy Canadian net exports.
• NCO is the supply of dollars:
Canadian residents provide/give dollars when they buy foreign assets.
• S = I + NCO
S I = NX • What price balances the supply and demand in the market for foreign
• Answer: the real exchange rate (E) =
The Canadian real exchange rate (E) measures
the quantity of foreign goods & services
that trade for one unit of Canadian goods & services.
• E is the real value of a dollar in the market for foreigncurrency exchange.
• The demand curve for dollars (NX) is downward sloping because a higher
exchange rate makes domestic goods more expensive.
• The supply curve (NCO) is vertical because the quantity of dollars
supplied for net capital outflow is unrelated to the real exchange rate.
• The real exchange rate adjusts to balance the supply and demand for
• 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.
The Effects of a Budget Deficit
National saving falls
The real interest rate rises
Domestic investment and net capital outflow
The real exchange rate appreciates
Net exports fall (or, the trade deficit increases)
Equilibrium in the Open Economy
Net capital outflow is the variable that links these two markets
S = I + NCO
NCO = NX
In the market for loanable funds, supply comes from national saving and
demand comes from domestic investment and net capital outflow.
In the market for foreigncurrency exchange, supply comes from net
capital outflow and demand comes from net exports.
Prices in the loanable funds market and the foreigncurrency exchange
market adjust simultaneously to balance supply and demand in these two
As they do, they determine the macroeconomic variables of national
saving, domestic investment, net capital outflow, and net exports.
How Policies and Events Affect an Open Economy
Three steps in using the model to analyze these events
• Determine which of the supply and demand curves each