Economics Chapter 29 A macroeconomic theory of the open economy
Supply and demand for loanable funds and for foreign currency exchange
To understand the forces at work in an open economy, we focus on supply and demand in 2 markets:
- market for loanable funds (economy’s savings, investment and the flow of loanable funds abroad)
- market for foreign currency exchange
The market for loanable funds
All savers go to this market to deposit their savings and all borrowers go here to get their loans.
There is 1 interest rate, which is both the return to saving and the cost of borrowing.
To understand this market in an open economy, remember this:
S = I + NCO
Supply of loanable funds = national saving (S)
Demand of loanable funds = domestic investment (I) and net
capital outflow (NCO)
The interest rate adjusts to bring all into balance:
Interest rate below equilibrium -> quantity supplied is less as
quantity demanded -> shortage of loanable funds -> interest rate
goes up.
Interest rate above equilibrium -> quantity supplied is bigger than quantity demanded -> surplus of
loanable funds -> interest rate goes down.
The market for foreign currency exchange
Remember the following formula:
NCO = NX
Net capital outflow represents the quantity of money supplied
for the purpose of buying foreign assets.
Net exports represent the quantity of money demanded for the
purpose of buying net exports of goods and services.
The real exchange rate adjusts to bring all into balance:
Real exchange rate below equilibrium -> quantity of money
supplied is less than quantity demanded -> shortage of money ->
value of money goes up.
Real exchange rate above equilibrium -> quantity of money supplied is bigger than quantity
demanded -> surplus of money -> value of money goes down.
Equilibrium in the open economy
How are these two markets related to each other?
Net capital outflow: the link between the two markets
Supply and demand for loanable funds and for foreign currency exchange
To understand the forces at work in an open economy, we focus on supply and demand in 2 markets:
- market for loanable funds (economy’s savings, investment and the flow of loanable funds abroad)
- market for foreign currency exchange
The market for loanable funds
All savers go to this market to deposit their savings and all borrowers go here to get their loans.
There is 1 interest rate, which is both the return to saving and the cost of borrowing.
To understand this market in an open economy, remember this:
S = I + NCO
Supply of loanable funds = national saving (S)
Demand of loanable funds = domestic investment (I) and net
capital outflow (NCO)
The interest rate adjusts to bring all into balance:
Interest rate below equilibrium -> quantity supplied is less as
quantity demanded -> shortage of loanable funds -> interest rate
goes up.
Interest rate above equilibrium -> quantity supplied is bigger than quantity demanded -> surplus of
loanable funds -> interest rate goes down.
The market for foreign currency exchange
Remember the following formula:
NCO = NX
Net capital outflow represents the quantity of money supplied
for the purpose of buying foreign assets.
Net exports represent the quantity of money demanded for the
purpose of buying net exports of goods and services.
The real exchange rate adjusts to bring all into balance:
Real exchange rate below equilibrium -> quantity of money
supplied is less than quantity demanded -> shortage of money ->
value of money goes up.
Real exchange rate above equilibrium -> quantity of money supplied is bigger than quantity
demanded -> surplus of money -> value of money goes down.
Equilibrium in the open economy
How are these two markets related to each other?
Net capital outflow: the link between the two markets
