32-1 Supply and Demand for Loanable Funds and for Foreign-Currency Exchange

The Market for Loanable Funds

• An assumption that the financial system has only one market = market for loanable funds

• S = I + NCO

  • Saving = Domestic investment + net capital outflow

• The supply of loanable funds comes from S, the demand comes from I and NCO.

• When NCO>0, there is a net outflow of capital, and demand for domestically generated loanable funds rises. When NCO<0, there is a net inflow of capital and the demand for domestically generated loanable funds falls.

• A higher real interest rate is a higher return in saving, raises the quantity of loanable funds supplied, and a higher cost of borrowing.

• A rise in the real interest rate of a country reduces that country's net capital outflow.

• The interest rate attempts to adjust at equilibrium. At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net capital outflow.

The Market for Foreign-Currency Exchange

• NCO = NX

  • Net capital outflow = Net exports

• The real exchange rate balances the supply and demand in the market for foreign-currency exchange

• When real exchange “appreciates”, the country’s goods are more expensive than other foreign goods and vice versa.

• An appreciation of the real exchange rate reduces the quantity of dollars demanded in the market for foreign-currency exchange

• Net capital outflow does NOT depend on the exchange rate. The real exchange rate moves to ensure equilibrium in the market.

• At the equilibrium real exchange rate, the demand for dollars by foreigners arising from the U.S. net exports of goods and services exactly balances the supply of dollars from Americans arising from U.S. net capital outflow

32-2 Equilibrium in the Open Economy

Net Capital Outflow: The Link between the Two Markets

• S = I + NCO

• NCO = NX

• Net capital outflow links the two markets. The key determinant of net capital outflow is the real interest rate

Simultaneous Equilibrium in Two Markets

• The equilibrium real interest rate balances the quantity of loanable funds supplied and the quantity of loanable funds demanded

23-3 How Policies and Events Affect an Open Economy

Government Budget Deficits

• When a government budget deficit represents a negative public saving, national saving is decreased. Supply of loanable funds decreases, the interest rate increases, and the amount of investing decreases. Net capital outflow also falls

• In an open economy, government budget deficits raise real interest rates, crowd out domestic investment, cause the currency to appreciate, and push the trade balance toward deficit.

Trade Policy

• Trade policy: government policy that directly influences the number of goods and services that a country imports or exports

  • Tariff → tax on imported goods

  • Import quota → limit on the quantity of a good produced abroad that can be sold domestically

• The first step for analyzing is to determine which curve shifts. The second step is to determine the direction in which it shifts. The third step is to compare the old equilibria with the new ones.

• Trade policies do not affect the trade balance on a macroeconomic scale. It affects firms, industries, and countries

  • NX = NCO = S - I

Political Instability and Capital Flight

• Capital flight: a large and sudden reduction in the demand for assets located in a country

• Political instability makes people cautious of the economy, so they move assets out of the country and abroad, causing capital flight.

• Capital flight from Mexico increases Mexican interest rates and decreases the value of the Mexican peso in the market for foreign currency exchange

• In cases of capital flight, interest rates grew sharply and the currency value fell sharply