Macroeconomics

F I G U R E

5 - 1 7

Real interest

rate, r

Loanable funds, S, I 

+ CF

S

I(r)

+ CF(r)

Equilibrium

real interest 

rate

The Market for Loanable Funds in the Large

Open Economy

At the equilibrium interest rate,

the supply of loanable funds from saving S balances

the demand for loanable funds from domestic

investment I and capital investments abroad CF.

F I G U R E

5 - 1 8

Real exchange

rate,

e

Net exports, NX

Equilibrium

real exchange 

rate

CF

NX(

e)

The Market for Foreign-Currency Exchange

in the Large Open Economy

At the equilibri-

um exchange rate, the supply of dollars from

the net capital outflow, CF, balances the

demand for dollars from our net exports of

goods and services, NX.

---

The real exchange rate is determined as in Figure 5-18, and the price levels are

determined by monetary policies here and abroad, as we discussed in Chapter 4.

Forces that move the real exchange rate or the price levels also move the nom-

inal exchange rate.

Policies in the Large Open Economy

We can now consider how economic policies influence the large open econo-

my. Figure 5-19 shows the three diagrams we need for the analysis. Panel (a)

shows the equilibrium in the market for loanable funds; panel (b) shows the rela-

tionship between the equilibrium interest rate and the net capital outflow; and

panel (c) shows the equilibrium in the market for foreign exchange.

Fiscal Policy at Home 

Consider the effects of expansionary fiscal policy—

an increase in government purchases or a decrease in taxes. Figure 5-20 shows

what happens. The policy reduces national saving S, thereby reducing the sup-

ply of loanable funds and raising the equilibrium interest rate r. The higher inter-

est rate reduces both domestic investment I and the net capital outflow CF. The

fall in the net capital outflow reduces the supply of dollars to be exchanged into

foreign currency. The exchange rate appreciates, and net exports fall.

C H A P T E R   5

The Open Economy

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