The Theory of the Open Economy: A Complete Logical Flow

• The theory relates and determines r, NCO, EP/P*, and NX

• It begins with conditions in the loanable funds market and then the foreign exchange market.

• In each market, the demand and supply are analyzed, put together to determine equilibrium, and then the effects of shifts in demand and supply are analyzed.

• The two markets are linked together and r, NCO, EP/P*, and NX are jointly determined.

• Different policies and situations are then analyzed and their affect on r, NCO, EP/P*, and NX identified.

The Loanable Funds Market

• The supply and demand in the loanable funds market determines the real interest rate {r}– Closed Economy: S=I only domestic borrowing

and lending are allowed.– Open Economy: S=I+NCO this allows trade

and borrowing and lending from the ROW (rest of the world)

• National Saving: S → SLF is positively related to r↓(↑) → SLF ↓(↑)

• Investment and Net Capital Flow:

I+NCO → DLF is negatively related to

r ↓(↑) → DLF ↑(↓)– r ↓(↑) I ↑(↓)

• r↓(↑) PV ↑(↓) of future returns

– r ↓(↑) NCO ↑(↓)• rUS ↓(↑) US increases (decreases) demand for ROW assets and

ROW decreases (increases) demand for US assets

• The equilibrium r in the LF market brings national saving = investment +net capital outflow or S=I+NCO.

• Supply-side shocks to LF– S↓ (income taxes↑ or budget →deficit), then r↑→LF↓– S↑ (income taxes↓ or budget →surplus), then r↓→LF↑

• Demand-side shocks to LF– I↓ (tax credits↑ or expected Y↑), then r↑→LF↑– I↑ (tax credits↓ or expected Y↓), then r↓→LF↓– NCO↓ (political instability abroad↑), then r↑→LF↑ [US holds fewer ROW assets and

ROW holds more US assets]

– NCO↑ (political stability abroad↑), then r↓→LF↓[US holds more ROW assets and ROW holds less US assets]

• We have now fully described the LF market and the determination of r

The Foreign Exchange Market

• The supply and demand in the foreign exchange market determines the real interest exchange rate EP/P*

– Closed Economy: no trading, NX, or EP/P*.– Open Economy: NX=NCO this allows trade

and borrowing and lending from the ROW (rest of the world)

• Net Capital Outflow - NCO: S → S$

– If NCO↑, US is supplying more dollars, on net, to purchase foreign assets

– If NCO↓, US is supplying fewer dollars, on net, to purchase fewer foreign assets

– NCO is determined by r in the loanable funds markets and is not related to EP/P*.

– As EP/P*↓(↑), NCO remains the same

↓

• Net Exports - NX: → D$ is negatively related to EP/P*↓(↑)– If EP/P*↓, NX↑, D$↑ - US goods become cheaper, net

exports increase, and ROW needs more US dollars to purchase more goods and services

– If EP/P*↑, NX↓, D$↓ - US goods become more expensive, net exports decrease, and ROW needs fewer US dollars to purchase fewer goods and services

• Equilibrium in the foreign exchange market occurs when the EP/P* equates the D$ with the S$ or NX=NCO .

Linking the Loanable Funds and Foreign Exchange Market

• NCO link the two markets together

• Step 1: S=I+NCO or SLF=DLF →r

• Step 2: r →NCO

• Step 3: NCO →S$

• Step 4: NX →D$

• Step 5: D$=S$ →EP/P* and NX=NCO

Examples of Transmission of LF and FEM Shocks

• Loanable Funds Shocks:– S↓, SLF↓, r↑,NCO↓,S$↓, EP/P*↑,NX↓– S↑, SLF↑, r↓,NCO↑,S$↑, EP/P*↓,NX↑– I↑, DLF↑, r↑,NCO↓,S$↓, EP/P*↑,NX↓– I↓, DLF↓, r ↓,NCO↑,S$↑, EP/P*↓,NX↑

• Exchange Rate Shocks– D$↑, S$ is constant from NCO, EP/P*↑, until quantity of

D$↓, but NX are constant, r is constant– D$↓, S$ is constant from NCO, EP/P*↓, until quantity of

D$↑, but NX are constant, r is constant