Shifts the supply loanable funds the left panel figure

Chapter 15

A macroeconomic theory of the open economy

Learning objectives

In this chapter you will:

Learning outcomes

After accomplishing these objectives, you should be able to:

Chapter review

Introduction

composed of two markets – the market for loanable funds and the market for foreign-currency exchange. These markets simultaneously determine the interest rate and the exchange rate (and also the level of overall investment and the trade balance).

Supply and demand for loanable funds and foreign -currency

C h a p t er 1 5 ∙ A m ac r oe c o n o m ic t h e o ry of t h e o p e n ec o n o m y	205

The supply and demand for loanable funds in panel (a) determine the real interest rate. The real interest rate from panel (a) determines the quantity of NFI in panel (b). The quantity of NFI is the supply of dollars in the foreign-currency exchange market in panel (c). This supply curve in conjunction with the demand for dollars (determined by NX) in the foreign-currency exchange market determines the real exchange rate in panel (c).

How policies and events affect an open economy

•

206

•

Helpful hints

•

Remember the difference between I and NFI. I is the purchase of capital equipment by domestic residents. In terms of I, the real interest rate is a cost of borrowing (r). As r increases, I will fall. NFI is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreign residents. In this case, r is a return on investment. If r increases in the domestic economy, there will be more foreign investment in the domestic economy and less foreign investment by domestic residents, hence NFI will fall.

To find the change in the current account balance (CAB = NX + NY + NT), remember that CAB = NFI (net foreign investment). When we use our model to discover the impact of a government policy or an economic event on the economic variables in an open economy, there is no way to directly read the CAB from any of the graphs. However, the quantity of NFI is always directly measurable from panel (b) of figure 1. Since NFI = CAB, whenever there is an increase in NFI, there is an equivalent increase in CAB (which is an improvement in the trade balance). Whenever NFI declines, there is an equivalent decline in CAB.

	207

Key concepts

Choose a definition for each key term.

_____capital flight

Definitions

Practice problems

1	This problem is composed of the examples in the chapter, except the source of the change has been reversed. Use the model described by figure 1 to answer the following questions.

Suppose the government eliminates a quota on the import of Japanese cars. Describe the sequence of events

in the model by describing the shifts in the curves in figure 1 and discuss the movements in the relevant macroeconomic variables.

	a
	b
	c	Suppose the government passes an investment tax credit that increases domestic investment at each real interest rate. How would this change the important economic variables in the model?
	d	Compare your answer in part (a) (an increase in saving at each real interest rate) to your answer in part (c) (an increase in domestic investment at each real interest rate). Are there any differences?

	a
	b
	c
	d	If the Japanese are selling fewer cars, what must be true about Japanese imports and exports of other items?
	Suppose Indonesia is perceived to be politically unstable, which induces capital flight to Australia.
	a	Describe what happens in the foreign-currency exchange market from the perspective of Indonesia.
	b
	c
	d
	e

Short-answer questions

1 2	Explain the source of the demand for dollars in the market for foreign-currency exchange.

5Why might certain companies and unions support tariffs and import quotas even if they know that these restrictions cannot alter the trade balance?

	209

8What would a decrease in the saving of Australian residents do to the Australian trade balance and the dollar exchange rate? Explain.

9Why are the budget and trade deficits referred to as the ‘twin deficits?’

_____ 5If labour unions convince Australians to ‘buy Australian’, it will improve (move toward surplus) the Australian trade balance.

_____ 6If a country’s net foreign investment (NFI) is positive, it is an addition to its demand for loanable funds. _____ 7An increase in the government’s budget deficit shifts the supply of loanable funds to the right.

_____ 12An increase in the government budget deficit reduces net exports.

_____ 13Capital flight causes a decrease in NFI and NX.

b An increase in a country’s net foreign investment shifts the supply of loanable funds to the left.

c An increase in domestic investment shifts the demand for loanable funds to the right.

An increase in the government budget deficit:

increases the real interest rate and crowds out investment.

An increase in private saving shifts the supply of loanable funds to the left.

A decrease in the government budget deficit increases the real interest rate.

decreases Australian net foreign investment as Australian residents and foreigners prefer to invest in Australia.

decreases Australian net foreign investment as Australian residents and foreigners prefer to invest abroad.

c appreciate and would increase Australian net exports.

d appreciate but the total value of Australian net export stays the same.

d increases Australian net exports and Australian net foreign investment the same amount.

7 The phrase ‘twin deficits’ refers to:

C h a p t er 1 5 ∙ A m ac r oe c o n o m ic t h e o ry of t h e o p e n ec o n o m y	211

d An increase in Australian net exports increases the demand for dollars and the dollar appreciates.

9Which of the following statements regarding the market for foreign-currency exchange is true?

10If Australia removes a quota on the importing of clothing produced in China, which of the following is true

regarding the market for foreign-currency exchange?

11If Australia removes a quota on the importing of clothing produced in China, which of the following is true

regarding Australia’s net exports?

12Suppose, due to political instability, Mexicans suddenly choose to purchase US assets as opposed to Mexican

assets. Which of the following statements is true regarding US net foreign investment?

13Suppose, due to political instability, Mexicans suddenly choose to purchase US assets as opposed to Mexican

assets. Which of the following statements is true regarding value of the dollar and US net exports?

212

c decreases Australian net exports and Australian net foreign investment the same amount.

d increases Australian net exports and Australian net foreign investment the same amount.

d None of the above.

16Which of the following events would cause the NFI curve for Australia to shift to the right (i.e. more NFI at each

d a decrease in foreign real interest rates.

17An example of a trade policy is:

18An export subsidy should have the opposite effect of:

a a tariff.

a Australian residents wishing to buy foreign-produced autos

b lenders of loanable funds

b decreases a country’s net exports and decreases its long-run growth path.

c increases a country’s net exports and decreases its long-run growth path.

	213

Hong Kong has a capitalistic economic system. It was leased from China by Great Britain for 100 years. In 1997 it

was returned to China, a socialist republic.

	Which Canadian industries, those engaged in exporting or importing, were pleased with Hong Kong’s investment in Canada? Why? What impact did Hong Kong’s return to China have on the growth rate of Canada in the years immediately following 1997?

5 tariff

1 import quota

a	Panel (a), supply of loanable funds shifts right, real interest rate decreases. NFI increases, increasing the supply of dollars in the foreign-currency exchange market and causing the real exchange rate to depreciate. Saving and domestic investment have increased and the trade balance has moved toward surplus.

b
c

c NFI is unchanged; therefore NX as a total is unchanged.

d If NX are constant, they must be importing less or exporting more of other items.

	The supply of Indonesian rupiahs shifts right and the value of the Indonesian rupiah falls. The supply of Australian dollars shifts left and the value of the Australian dollar rises.

1 It is negatively sloped because a higher real interest rate reduces the desire to borrow funds to purchase capital

domestically, and it discourages Australian residents from buying foreign assets and encourages foreign residents

payments back to Australia.

5Because trade restrictions can improve the sales of some domestic companies facing competition from imports,

exchange rate.

8It increases the Australian real interest rate, decreases NFI, decreases the supply of dollars on the foreign-currency

C h a p t er 1 5 ∙ A m ac r oe c o n o m ic t h e o ry of t h e o p e n ec o n o m y	215

10Trade restrictions don’t alter the total value of NX. An increase in trade restrictions reduces both imports and exports by the same amount. The composition of NX may alter however.

1	6		11	16 c
2	7		12 b	17
3	8	d	13 a	18 a
4	9		14 d
5	10 d		15 c	20 c

Advanced critical thinking

	It increased NFI of Hong Kong because foreigners did not buy assets in Hong Kong and Hong Kong residents bought assets abroad – capital flight. Investors feared that China would nationalise much of Hong Kong’s industry. This decreased Canada’s NFI, shifted the demand for loanable funds curve to the left and lowered the real interest