ECON — Module 11: Open Economy Macroeconomics

What is net capital outflow (NCO), and what does it represent?

NCO = domestic residents' purchases of foreign assets MINUS foreigners' purchases of domestic assets. Positive NCO: more money flowing OUT of the country (net capital exporter). Negative NCO: more money flowing IN (net capital importer). NCO links the loanable funds market and the foreign exchange market.

In the open-economy model, what is the fundamental accounting identity linking NCO and NX?

NX = NCO. Net exports equal net capital outflow. If a country exports more than it imports, it must be acquiring foreign assets (lending to the world). If it imports more, foreigners are acquiring domestic assets (borrowing from the world). The current account and capital account always balance.

An increase in NCO shifts which curve in the foreign exchange market, and in which direction?

It shifts the SUPPLY curve of domestic currency to the RIGHT. When NCO rises, domestic residents are buying more foreign assets — to do this they must SELL domestic currency and buy foreign currency. More domestic currency is supplied to the forex market. Result: the domestic currency DEPRECIATES.

A decrease in NCO — what happens to the forex supply curve and the exchange rate?

Supply of domestic currency shifts LEFT (fewer people converting domestic to foreign currency). With less domestic currency supplied, the exchange rate APPRECIATES. Chain: NCO↓ → currency supply↓ → appreciation. Common mistake: students think it affects the DEMAND curve — NCO affects the supply side (domestic residents selling their currency).

What is the correct chain of logic for the forex market in the open economy?

Loanable funds market → determines real interest rate → affects NCO (higher domestic interest rate → lower NCO, as domestic assets become more attractive) → NCO determines supply of domestic currency in forex market → supply and demand for currency determine the real exchange rate.

The government abolishes the tax on savings interest. Trace the full open-economy effect on the exchange rate.

1. Saving incentive increases → supply of loanable funds shifts RIGHT. 2. Real interest rate FALLS. 3. Lower domestic interest rate makes domestic assets less attractive → NCO RISES (more capital flows out). 4. More domestic currency supplied in forex market → supply shifts RIGHT. 5. Exchange rate DEPRECIATES.

The government raises the tax on corporate investment. Trace the full open-economy effect on the exchange rate.

1. Investment less attractive → demand for loanable funds shifts LEFT. 2. Real interest rate FALLS. 3. Lower interest rate → domestic assets less attractive → NCO RISES. 4. More domestic currency supplied in forex market → supply shifts RIGHT. 5. Exchange rate DEPRECIATES. Common mistake: students say supply of loanable funds shifts — it's DEMAND that shifts (investors borrow less).

What determines the supply and demand for domestic currency in the forex market?

Supply of domestic currency: comes from domestic residents wanting to buy foreign assets (NCO) or import goods. Demand for domestic currency: comes from foreigners wanting to buy domestic goods (exports) or domestic assets. The exchange rate adjusts to equilibrate supply and demand.

What is the real exchange rate, and how does it differ from the nominal exchange rate?

Nominal exchange rate: units of foreign currency per unit of domestic currency (e.g. 70 yen per NZD). Real exchange rate: adjusts for relative price levels between countries — measures the relative price of domestic vs foreign goods. Formula: real ER = nominal ER × (domestic price level ÷ foreign price level).

If the real exchange rate appreciates, what happens to NX and why?

NX FALLS. Appreciation means domestic goods are relatively more expensive compared to foreign goods. Foreigners buy fewer domestic exports (expensive). Domestic consumers buy more imports (relatively cheap). X falls, M rises → NX = X − M falls.

A country runs a large government budget deficit. Trace the full open-economy effect.

1. Government borrowing rises → demand for loanable funds shifts RIGHT (or public saving falls → supply shifts LEFT). 2. Real interest rate RISES. 3. Higher interest rate → domestic assets more attractive → NCO FALLS (capital flows in, not out). 4. Less domestic currency supplied in forex → supply shifts LEFT. 5. Exchange rate APPRECIATES. 6. Appreciation → NX falls. This is "crowding out" extended to an open economy.

What is the difference between NCO shifting the supply curve vs demand curve in the forex market?

NCO affects SUPPLY of domestic currency only. When NCO rises, domestic residents supply more of their own currency to buy foreign assets — this is a supply-side effect. Demand for domestic currency comes from foreigners buying domestic goods or assets. Students commonly confuse the two — remember: NCO = domestic residents acting = supply side.

If a country's return on investment rises relative to the rest of the world, what happens to NCO and the exchange rate?

NCO FALLS — foreign investors want to buy domestic assets (capital inflows increase), and domestic investors have less incentive to invest abroad. Supply of domestic currency in forex falls (domestic residents keeping more currency at home). Exchange rate APPRECIATES.

What is the "crowding out" effect in an open economy, and how does it differ from a closed economy?

Closed economy crowding out: government borrowing raises interest rates → private investment falls. Open economy: additionally, higher interest rates → NCO falls → exchange rate appreciates → NX falls. So in an open economy, fiscal deficits reduce BOTH private investment AND net exports — two channels of crowding out instead of one.

What would happen in the forex market if the NZ government ran a large budget surplus (i.e. saved more)?

1. Public saving rises → supply of loanable funds shifts RIGHT. 2. Real interest rate FALLS. 3. Domestic assets less attractive → NCO RISES. 4. More NZD supplied in forex market. 5. NZD DEPRECIATES. 6. Cheaper NZD → NZ exports more competitive → NX rises.