# Equilibrium in an open economy

### From Baripedia

In this chapter we will characterize the macroeconomic equilibrium in an open economy = simultaneous equilibria in the market for loanable funds and in the foreign exchange market.

In an open economy, as in a closed economy, the equalisation of demand and supply of lendable funds defines the equilibrium real interest rate. The functioning of the market for loanable funds remains the same, although in an open economy economic agents demand funds either to make investments within the country or to purchase assets abroad.

Moreover, for the system to be in equilibrium, the net supply of domestic money must equal the net demand for domestic money. The equilibrium condition in the foreign exchange market will define the real equilibrium exchange rate.

NB: in the following, we will once again take a long-term view and assume that output is fixed at its full employment level.

# Equilibrium real exchange rate

## Determination of the real exchange rate

As we saw in the previous chapter, net exports are a function of the real exchange rate: the lower the real exchange rate, the cheaper domestic goods are relative to foreign goods and the higher the net exports (inverse relationship: consumers demand more domestic goods and less foreign goods) → NX(ε ).

From national accounts identities we also know that the trade balance must at all times be equal to the net capital outflow (Net Capital Outflow = NCO = - BMC) → NX(ε) = NCO.

The real exchange rate adjusts to maintain equilibrium NX(ε) = NCO.

NB: the function representing the net capital outflow is vertical because investment decisions do not depend on the real exchange rate.

Balance mechanism:

si ${\displaystyle \epsilon =\epsilon _{1}}$ → oversupply of domestic currency on the foreign exchange market => real depreciation (ε↓);
si ${\displaystyle \epsilon =\epsilon _{2}}$ → excess demand for domestic currency on the foreign exchange market => real appreciation (ε↑).

NB: if the vertical axis crosses the horizontal axis to the left of point Z → NCO > 0 and BC > 0; if the vertical axis crosses the horizontal axis to the right of point Z → NCO < 0 and BC < 0.

# Equilibrium real interest rate

## Savings and investment in the open economy

The functioning of the market for loanable funds and the determinants of the savings and investment function in a closed economy are discussed in Chapter 6.

In an open economy, the functioning of the market for loanable funds is the same. Simply, in an open economy, economic agents ask for funds either to make investments within the country or to buy assets abroad => in an open economy, national savings must cover domestic investment and the net flow of capital abroad (NB.: 'net flow' => either + or -).

Even in an open economy it is the real interest rate that balances the market for loanable funds.

## NCO(r)

The net outflow of capital is a decreasing function of the real interest rate and is added to domestic investment decisions in determining the demand for loanable funds.

When the domestic interest rate is high, only highly profitable investment projects are financed (whether in the domestic country or abroad) → low demand for funds; vice versa when the cost of borrowing is low → high demand for funds (also to finance investment projects abroad).

At the same time, when the domestic interest rate is high (low), many (few) foreign investors will want to acquire domestic securities → inward capital ↑ (↓).

## Equilibrium of the loanable funds market

The supply of loanable funds emanates from household savings decisions (an increasing function of the real interest rate).

The demand for loanable funds stems from domestic investment decisions and the NCO (decreasing function of the real interest rate).

# Macroeconomic equilibrium in an open economy

## Equilibrium in an open economy

In the market for loanable funds, the supply comes from domestic savings and the demand comes from domestic investment and net capital flows abroad.

In the foreign exchange market, supply comes from net capital flows abroad and demand comes from net exports.

Capital flow is the variable that links these two markets. For an economy as a whole to be in equilibrium, :

${\displaystyle NCO(r)=NX(\epsilon )}$

Simultaneous equilibrium in the loanable funds market and the foreign exchange market

Prices in the lending market (r) and the foreign exchange market (ε) adjust simultaneously to balance demand and supply in these two markets and determine national savings, domestic investment, net capital flows and net exports.

## Budgetary policy

When the government finances public spending through a budget deficit, just as in a closed economy, it subtracts some of the loanable funds that would otherwise be available to finance private investment (crowding out).

In an open economy, the resulting increase in the domestic interest rate has an impact on capital flows: the NCO will fall because, on the one hand, the cost of borrowing has become more expensive and fewer investments are financed, including those made abroad (less capital outflows) and, on the other hand, foreign agents will want to buy more domestic assets (e.g. government bonds) because they pay high interest (more capital inflows) => NCO ↓. The drop in NCO has as a counterpart a reduction in the trade balance (appreciation of the real exchange rate) which could eventually become negative.

Often a budget deficit is accompanied by a trade deficit (e.g. the expansionary fiscal policy of the United States in the early 1980s, which resulted in a budget deficit and a trade deficit). This is why we speak of "twin deficits". But, be careful, there is nothing automatic in all this: a variation in savings or investment decisions could compensate the ↑ (or ↓) demand for funds from the State (example: the recovery of the public deficit in the Clinton years was not accompanied by a trade surplus because, in the meantime, domestic investments have ↑ and private savings have remained constant).

## Fiscal policy: effects on balance

Fiscal policy: an increase in public spending (or a tax cut) reduces national savings → shift of the supply curve to the left (1) → increase in the real interest rate (2) → crowding out of domestic investments + decrease in net investments abroad (3) → decrease in the supply of money on the foreign exchange market (4) → appreciation of the real exchange rate (5) → domestic goods become more expensive → new equilibrium corresponding to a lower quantity of net exports.

## Commercial policy

A set of government interventions that influence the amount of goods and services imported or exported. Two types:

• Tariff (or customs duty) = tax on imports;
• Import quota = limitation on the quantity imported.

From a microeconomic point of view, the effects of these two barriers to trade are equivalent in terms of price changes (↑), quantities imported (↓) and the impact on consumer (↓) and producer (↑) surplus. The only possible difference concerns the revenues for the government (in the case of a quota, the government only appropriates quota rents if import licences are distributed on the basis of an auction).

From a macroeconomic point of view, as trade policies have no impact on domestic savings and investment, they have no consequences on the trade balance: the real exchange rate adjusts to keep the trade balance unchanged.

## Trade policy: effects on the balance

Trade policy: introduction of a quota → shift of the NX curve to the right (1): at parity of ε (${\displaystyle \epsilon ^{1}}$) net exports are higher → increase in demand for money and appreciation of the national currency (2) → domestic goods become more expensive (${\displaystyle \epsilon ^{2}}$) which compensates for the initial increase in net exports → new equilibrium corresponding to an unchanged level of net exports! No influence on the trade balance!

## Macroeconomic instability

In situations of serious political and/or economic instability investors may be particularly concerned about the security of their investments and may decide to withdraw their capital from countries in difficulty.

This can cause a sudden and significant flight of capital and a fall in demand for the country's securities (cf. the case of Argentina in the early 2000s, Mexico in the mid-1990s, or, more recently, Greece).

Large capital flight raises the interest rate and depreciates the local currency (except in the case of a monetary union).

## Macroeconomic instability: effects on equilibrium

Instability: a situation of macroeconomic instability increases capital outflows (1). This has two effects: on the one hand, the demand for loanable funds increases (2) and the real interest rate rises (3) and, on the other hand, the supply of money on the foreign exchange market increases (4), the currency depreciates (5) and the CB improves.

# Summary

A country's net exports depend on the real exchange rate: a depreciation makes the domestic country's goods cheaper and as a result net exports increase.

Macroeconomic equilibrium in an open economy is achieved by a real exchange rate such that the supply of domestic currency that can be exchanged for foreign currency for investment abroad equals the net demand for domestic currency from foreigners who wish to purchase goods and services from the domestic country (NCO = NX).

In the market for lendable funds, the real interest rate adjusts to equalize the supply of funds from savings with the demand from domestic investment and the net flow of capital abroad (S = I+NCO).

Any policy that reduces domestic savings reduces the supply of loanable funds, raises the interest rate, reduces net outward capital, appreciates the national currency and lowers net exports.

A free trade restriction increases net exports, increases demand for the national currency, appreciates the currency and brings the trade balance back to its initial level.

A situation of political instability can cause a significant outflow of capital and thereby cause an increase in the real interest rate and a fall in the exchange rate.