I N T H I S C H A P T E R
Y O U W I L L . . .
U s e t h e m o d e l
t o a n a l y z e
p o l i t i c a l i n s t a b i l i t y
a n d c a p i t a l f l i g h t
U s e t h e m o d e l
t o a n a l y z e t h e
m a c r o e c o n o m i c
e f f e c t s o f t r a d e
p o l i c i e s
B u i l d a m o d e l t o
e x p l a i n a n o p e n
e c o n o m y ’ s t r a d e
b a l a n c e a n d
e x c h a n g e r a t e
U s e t h e m o d e l
t o a n a l y z e t h e
e f f e c t s o f
g o v e r n m e n t
b u d g e t d e f i c i t s
Over the past decade, the United States has persistently imported more goods and
services than it has exported. That is, U.S. net exports have been negative. Al-
though economists debate whether these trade deficits are a problem for the U.S.
economy, the nation’s business community has a strong opinion. Many business
leaders claim that the trade deficits reflect unfair competition: Foreign firms are al-
lowed to sell their products in U.S. markets, they contend, while foreign govern-
ments impede U.S. firms from selling U.S. products abroad.
Imagine that you are the president and you want to end these trade deficits.
What should you do? Should
you try to limit imports, perhaps by imposing a
quota on the import of cars from Japan? Or should you try to influence the nation’s
trade deficit in some other way?
To understand what factors determine a country’s trade balance and how
government policies can affect it, we need a macroeconomic theory of the open
A M A C R O E C O N O M I C T H E O R Y
O F T H E O P E N E C O N O M Y
6 7 9
6 8 0
PA R T E L E V E N
T H E M A C R O E C O N O M I C S O F O P E N E C O N O M I E S
economy. The preceding chapter introduced some of the key macroeconomic vari-
ables that describe an economy’s relationship with other economies—including
net exports, net foreign investment, and the real and nominal exchange rates. This
chapter develops a model that shows what forces determine these variables and
how these variables are related to one another.
To develop this macroeconomic model of an open economy, we build on our
previous analysis in two important ways. First, the model takes the economy’s
GDP as given. We assume that the economy’s output of goods and services, as
measured by real GDP, is determined by the supplies of the factors of production
and by the available production technology that turns these inputs into output.
Second, the model takes the economy’s price level as given. We assume the price
level adjusts to bring the supply and demand for money into balance. In other
words, this chapter takes as a starting point the lessons learned in Chapters 24 and
28 about the determination of the economy’s output and price level.
The goal of the model in this chapter is to highlight those forces that determine
the economy’s trade balance and exchange rate. In one sense, the model is simple:
It merely applies the tools of supply and demand to an open economy. Yet the
model is also more complicated than others we have seen because it involves look-
ing simultaneously at two related markets—the market for loanable funds and the
market for foreign-currency exchange. After we develop this model of the open
economy, we use it to examine how various events and policies affect the econ-
omy’s trade balance and exchange rate. We will then be able to determine the gov-
ernment policies that are most likely to reverse the trade deficits that the U.S.
economy has experienced over the past decade.
S U P P LY A N D D E M A N D F O R L O A N A B L E F U N D S
A N D F O R F O R E I G N - C U R R E N C Y E X C H A N G E
To understand the forces at work in an open economy, we focus on supply and de-
mand in two markets. The first is the market for loanable funds, which coordinates
the economy’s saving and investment (including its net foreign investment). The
second is the market
for foreign-currency exchange, which coordinates people
who want to exchange the domestic currency for the currency of other countries.
In this section we discuss supply and demand in each of these markets. In the next
section we put these markets together to explain the overall equilibrium for an
open economy.
T H E M A R K E T F O R L O A N A B L E F U N D S
When we first analyzed the role of the financial system in Chapter 25, we made the
simplifying assumption that the financial system consists of only one market,
called the
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