a & b imply r = r* c implies r* is exogenous
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Investment: The Demand for Loanable Funds
S, I
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Macroeconomics, European Edition
Three thought experiments
1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand
S
rc I (r )
S, I
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Mankiw • Taylor
But in a small open economy…
the exogenous world interest rate determines investment…
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Mankiw • Taylor
GDP = expenditure on domestically produced g & s
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Macroeconomics, European Edition
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Macroeconomics, European Edition
Mankiw • Taylor
International capital flows
• Net capital outflows = S –I = net outflow of “loanable funds” = net purchases of foreign assets the country’s purchases of foreign assets minus foreign purchases of domestic assets • When S > I, country is a net lender • When S < I, country is a net borrower
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National Saving: The Supply of Loanable Funds
r
As in Chapter 3, national saving does not depend on the interest rate
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Macroeconomics, European Edition
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Saving and Investment in a Small Open Economy
• An open-economy version of the loanable funds model from chapter 3. • Includes many of the same elements:
Chapter 5: The Open Economy
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Chapter objectives
• accounting identities for the open economy • small open economy model
– what makes it “small” – how the trade balance and exchange rate are determined – how policies affect the trade balance & exchange rate
r
Investment is still a downward-sloping function of the interest rate, but the exogenous world interest rate…
r*
…determines the country’s level of investment. I (r )
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Euro Exchange rates as of April 28th, 2006
country U.S.A. Japan U.K. Switzerland Norway Poland Turkey
Preliminaries, cont.
NX = net exports (the “trade balance”) = EX – IM • If NX > 0, country has a trade surplus equal to NX • If NX < 0, country has a trade deficit equal to – NX
r
NX2
S1
r 2* r
* 1
NX1
I (r )
S, I
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3. An increase in investment demand
r
S
r*
EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.
S
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S, I
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Assumptions re: capital flows
a. domestic & foreign bonds are perfect
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1. Fiscal policy at home
r
An increase in G or decrease in T reduces saving.
S
NX2
r
*
NX1
I (r )2 I (r )1
I1
Macroeconomics, European Edition
I2
Mankiw • Taylor
S, I
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The nominal exchange rate
e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency (e.g. Yen per Euro or Pound)
I (r* )
S, I
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If the economy were closed…
r
…the interest rate would adjust to equate investment and saving:
r
NX
S
…and the r* difference between saving r c and investment determines net capital outflows and net exports
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I (r ) I1
Mankiw • Taylor
EX = exports = foreign spending on domestic goods IM = imports = C f + I f + G f = spending on foreign goods
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substitutes (same risk, maturity, etc.)
b. perfect capital mobility:
no restrictions on international trade in assets
c. economy is small:
cannot affect the world interest rate, denoted r*
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Imports and Exports as a percentage of output:
Percentage of GDP 35 30 25 20 15 10 5 0 Canada France Germany Imports Italy Japan Exports