Chapter 32: A Macroeconomic Theory of the Open Economy

• The goal of this chapter is to highlight the forces that determine the economy’s trade balance and exchange rate.

Chapter 32.1: Supply and Demand for Loanable Funds and for Foreign-Currency Exchange

• 32.1a: The Market for Loanable Funds

  • The market for loanable funds is an assumption that the financial system consists of only one market (this is an assumption)

  • Remember: S = I + NCO

    • Saving = Domestic investment + Net capital outflow

  • Loanable funds should be seen as the domestically generated flow of resources available for capital accumulation

  • When NCO > 0, the country experiences a net outflow of capital. The net purchase of capital oversees adds to the demand for domestically generated loanable funds

  • When NCO < 0, the country experiences a net inflow of capital. The capital resources coming from abroad reduce the demand for domestically generated loanable funds.

  • The real interest rate determines the quantity of loanable funds supplied and the quantity of loanable funds demanded

    • A higher real interest rate means a higher return to saving. It also means a higher cost of borrowing to finance capital projects

  • A rise in a country’s real interest rate reduces its net capital outflow.

  • In an open economy the demand for loanable funds comes from those who want to buy domestic capital goods AND those who want to buy foreign assets.

  • If the interest rate is below the equilibrium level, the quantity of loanable funds supplied is less than the quantity demanded. If the interest rate is above the equilibrium level, the quantity of loanable funds supplied is greater than the quantity demanded.

  • Atthe equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net capital outflow.