A Macroeconomic Theory of the Open Economy

These vocabulary flashcards cover the key concepts, identities, and policy impacts within the macroeconomic model of an open economy, specifically focusing on the loanable funds and foreign-currency exchange markets.

Market for Loanable Funds

The financial system where all savers and borrowers interact, and the real interest rate adjusts to balance the supply (from national saving) and the demand (from domestic investment and net capital outflow).

Fundamental Identity for Loanable Funds

The relationship expressed as $S = I + NCO$, where $S$ is national saving, $I$ is domestic investment, and $NCO$ is net capital outflow.

Supply of Loanable Funds

Comes from national saving ($S$); a higher real interest rate encourages more saving, which increases the quantity of funds supplied.

Demand for Loanable Funds

Comes from domestic investment ($I$) and net capital outflow ($NCO$); it is reduced by higher interest rates which make domestic borrowing more expensive and domestic assets more attractive than foreign ones.

Market for Foreign-Currency Exchange (US context)

The market where the real exchange rate adjusts to balance the supply of dollars (from $NCO$) and the demand for dollars (from net exports, $NX$).

Fundamental Identity for Foreign-Currency Exchange

The relationship expressed as $NCO = NX$, where net capital outflow equals net exports.

Net Capital Outflow (NCO)

The variable that connects the market for loanable funds and the market for foreign-currency exchange; it is negatively related to the real interest rate ($r$).

Budget Deficit Mechanism

A deficit reduces national saving, shifting the supply of loanable funds to the left, which increases the real interest rate and reduces $NCO$.

Crowding Out

The reduction in domestic investment caused by higher real interest rates resulting from a government budget deficit.

Twin Deficits

The phenomenon where a government budget deficit leads to a trade deficit because the reduced $NCO$ causes the real exchange rate to appreciate, making domestic goods more expensive and falling $NX$.

Import Quota

A trade policy that restricts the quantity of a specific good (such as EU steel) allowed into a country, shifting the demand for dollars to the right and causing exchange rate appreciation without changing the overall trade balance.

Capital Flight

A large and sudden movement of funds out of a country due to increased perceived risk, such as occurred in Mexico in $1994$, leading to higher interest rates and currency depreciation.

Real Exchange Rate

The relative price of domestic and foreign goods that adjusts to balance the supply and demand for currency in the foreign-currency exchange market.