Ch 32. A Macroeconomic Theory of the Open Economy

.title[
# Ch 32. A Macroeconomic Theory of the Open Economy
]
.subtitle[
## Macroeconomics for Students of Accounting, Finance and Digital Applications
]
.author[
### Lyuben Ivanov, PhD; Georgy Ganev, PhD
]
.institute[
### Sofia University St Kliment Ohridski
]
.date[
### May 16, 2024
]

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.pull-right[
_We had to make ourselves a small but nevertheless useful part in the international system of the exchange of goods and services, of investments, banking and finance, transportation and communications..._
<hr style="background-color: black; margin: 0em 0em 0em 0em;">
Lee Kuan Yew (1996) &nbsp;
]

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<hr>

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# Loanable Funds Framework

Saving S is the source of loanable funds, forming their supply.

When society saves a lev, it has two possible uses:
- to be invested and form capital inside the country (I)
- to go abroad to buy a foreign asset and form net capital outflow (NCO).

At higher real interest rates at home NCO is smaller than at
lower real interest rates at home (other things equal).

Domestic investment (I) and NCO are uses of funds and form
the demand for them.

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# Loanable Funds Market

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# Currency Market

The participants in this market exchange units of one currency for
units of another currency at some rate of exchange.

Both sides of these transactions involve nominal quantities of money
and there is no “physical volume”.

Net export (NX) forms the demand for currency.

Net capital outflow (NCO) forms the supply of currency.

The link between exchange rate and demand for currency is inverse.

There is no link between the current exchange rate and the supply of
currency.

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# Quick Quiz

We just said that there is no link
between the exchange rate and the quantity of a
national currency supplied to the international currency
markets, because this quantity is entirely determined by
other factors.

Graphically, this means that the currency
supply curve is: 
&nbsp; &nbsp; &nbsp; A. horizontal 
&nbsp; &nbsp; &nbsp; B. vertical 
&nbsp; &nbsp; &nbsp; C. upward sloping 
&nbsp; &nbsp; &nbsp; D. depends

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# Quick Quiz Answer

Graphically, this means that the currency
supply curve is: 
&nbsp; &nbsp; &nbsp; A. horizontal 
&nbsp; &nbsp; &nbsp; B. vertical 
&nbsp; &nbsp; &nbsp; C. upward sloping 
&nbsp; &nbsp; &nbsp; D. depends

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# Currency Market

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# Real Interest Rate Determination

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# Unifying The Frameworks

The key for understanding the model is understanding the
direction of causality within it.

The main and leading market is the loanable funds market,
events there cause effects in the other markets.

--
What happens on the loanable funds market causes the net
capital outflow, and then the level of net capital outflow causes the net export and its
corresponding exchange rage.

Nothing happening on the currency market without also
independently affecting the loanable funds market can cause
any change in the other components of the model.

In the graphic presentation of the model, causality goes strictly
clockwise.

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# Unifying The Frameworks

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<hr>

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<hr>

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# Budget Deficit

An increase in budget deficit means a shift of the loanable funds
supply curve to the left (dis-saving).

This leads to a new, higher domestic real interest rate.

Due to the inverse link between domestic interest rates and net
capital outflow, this means a drop in NCO.

The drop in NCO means a shift of the currency supply curve to the
left.

The real exchange rate has to increase to equilibrate quantities
supplied and demanded in the currency market.

Due to the appreciation of the currency, net export decreases.

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# Budget Deficit

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<hr>

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# Export Stimulus

Even if effective, a protectionist or export-stimulating policy
affects neither the demand, nor the supply of loanable
funds, since they depend on the desire of domestic
economic agents to save and invest.

Therefore this policy cannot influence the domestic real
interest rate.

Thus net capital outflow is also unaffected.

The result is that the supply of the domestic currency
remains the same, only the demand for it changes.

Ultimately the effect of this policy is the appreciation of the
domestic currency, but without any effect on the trade
balance.

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# Export Stimulus

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# Quick Quiz

Imagine a country’s government
engages in a set of policies aimed at stimulating exports
and simultaneously discouraging imports. Imagine
further that these policies are effective and do in fact
increase net exports.

Then, ceteris paribus and
according to the long-run open economy model studied
here, this means that the net exports of this country
will: 
&nbsp; &nbsp; &nbsp; A. increase 
&nbsp; &nbsp; &nbsp; B. decrease 
&nbsp; &nbsp; &nbsp; C. remain unchanged 
&nbsp; &nbsp; &nbsp; D. depends

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# Quick Quiz Answer

Then, ceteris paribus and
according to the long-run open economy model studied
here, this means that the net exports of this country
will: 
&nbsp; &nbsp; &nbsp; A. increase 
&nbsp; &nbsp; &nbsp; B. decrease 
&nbsp; &nbsp; &nbsp; C. remain unchanged 
&nbsp; &nbsp; &nbsp; D. depends

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<hr>

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# Capital Flight

Let for some reason the confidence of savers (domestic and foreign)
decrease.

Other things equal, this means that for every level of real interest rates
the desire to invest capital at home decreases, and the desire to invest
abroad increases.

For each level of real interest rates net capital outflow becomes larger. 
On the loanable funds market this means a new, higher real interest rate
and larger quantities of loanable funds exchanged.

The increase in net capital outflow increases the supply of domestic
currency so that the outflowing capital may acquire foreign assets.

--
 
The final effect is that the domestic currency depreciates and net export
increases.

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# Capital Flight

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# Questions?

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# Thank You!

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