I n t h I s c h a p t e r y o u w I l L

capital flight.
To see the implications of capital
flight for the Mexican economy, we again follow our three steps for analyzing a
change in equilibrium, but this time we apply our model of the open economy
from the perspective of Mexico rather than the United States.
Consider first which curves in our model capital flight affects. When investors
around the world observe political problems in Mexico, they decide to sell some of
their Mexican assets and use the proceeds to buy U.S. assets. This act increases
Mexican net foreign investment and, therefore, affects both markets in our model.
Most obviously, it affects the net-foreign-investment curve, and this in turn influ-
ences the supply of pesos in the market for foreign-currency exchange. In addition,
because the demand for loanable funds comes from both domestic investment and
net foreign investment, capital flight affects the demand curve in the market for
loanable funds.
c a p i t a l f l i g h t
a large and sudden reduction in
the demand for assets located
in a country

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C H A P T E R 3 0
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 9 3
Now consider which way these curves shift. When net foreign investment in-
creases, there is greater demand for loanable funds to finance these purchases.
Thus, as panel (a) of Figure 30-7 shows, the demand curve for loanable funds shifts
to the right from 
D
1
to 
D
2
. In addition, because net foreign investment is higher for
(a) The Market for Loanable Funds in Mexico
(b) Mexican Net Foreign Investment
Real
Interest
Rate
Real
Interest
Rate
(c) The Market for Foreign-Currency Exchange
Quantity of
Pesos
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
r
1
r
1
D
1
D
2
E
2
E
1
Demand
r
2
r
2
S
1
S
2
Supply
NFI
2
NFI
1
1. An increase 
in net foreign
investment . . . 
3. . . . which 
increases
the interest
rate.
2. . . . increases the demand
for loanable funds . . . 
4. At the same
time, the increase
in net foreign
investment
increases the
supply of pesos . . . 
5. . . . which 
causes the
peso to
depreciate.
F i g u r e 3 0 - 7
T
HE
E
FFECTS OF
C
APITAL
F
LIGHT
. If people decide that Mexico is a risky place to keep
their savings, they will move their capital to safer havens such as the United States,
resulting in an increase in Mexican net foreign investment. Consequently, the demand for
loanable funds in Mexico rises from 
D
1
to 
D
2
, as shown in panel (a), and this drives up the
Mexican real interest rate from 
r
1
to 
r
2
. Because net foreign investment is higher for any
interest rate, that curve also shifts to the right from 
NFI
1
to 
NFI
2
in panel (b). At the same
time, in the market for foreign-currency exchange, the supply of pesos rises from 
S
1
to 
S
2
,
as shown in panel (c). This increase in the supply of pesos causes the peso to depreciate
from 
E
1
to 
E
2
, so the peso becomes less valuable compared to other currencies.

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6 9 4
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
any interest rate, the net-foreign-investment curve also shifts to the right from