Macroeconomics

CF

= CF(r).

This equation states that the net capital outflow is a function of the domestic

interest rate. Figure 5-15 illustrates this relationship. Notice that CF can be either

positive or negative, depending on whether the economy is a lender or borrow-

er in world financial markets.

To see how this CF function relates to our previous models, consider 

Figure 5-16. This figure shows two special cases: a vertical CF function and a

horizontal CF function.

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The Large Open Economy

A P P E N D I X

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The closed economy is the special case shown in panel (a) of Figure 5-16. In

the closed economy, there is no international borrowing or lending, and the

interest rate adjusts to equilibrate domestic saving and investment. This means

that CF

= 0 at all interest rates. This situation would arise if investors here and

abroad were unwilling to hold foreign assets, regardless of the return. It might

also arise if the government prohibited its citizens from transacting in foreign

financial markets, as some governments do.

The small open economy with perfect capital mobility is the special case shown

in panel (b) of Figure 5-16. In this case, capital flows freely into and out of the coun-

try at the fixed world interest rate r*. This situation would arise if investors here and

abroad bought whatever asset yielded the highest return and if this economy were

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Classical Theory: The Economy in the Long Run