FIGURE 6-20 (a) The Market for Loanable Funds Real interest rate, s (b) Net Capital Outflow 1. A fall in saving ... 1+ CF 2.... raises the interest rate, - 3. ... which lowers net capital outflow, ... CFT) Loanable funds, S, 1 + CF CF : CF Net capital outflow, CF (c) The Market for Foreign Exchange Real exchange rate, A Reduction in National Saving in the Large Open Economy Panel (a) shows that a reduction in national saving lowers the supply of loanable funds. The equilibrium interest rate rises. Panel (b) shows that the higher interest rate lowers the net capital out- flow. Panel (c) shows that the reduced capital outflow means a reduced sup- ply of dollars in the market for foreign- currency exchange. The reduced supply of dollars causes the real exchange rate to appreciate and net exports to fall. raises the exchange rate, 5. ... and reduces net exports. NX(E) Net exports, NX NXNX, 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. Note that the impact of fiscal policy in this model combines its impact in the closed economy and its impact in the small open economy. As in the closed economy, a fiscal expansion in a large open economy raises the interest rate and crowds out investment. As in the small open economy, a fiscal expansion causes a trade deficit and an appreciation in the exchange rate. One way to see how the three types of economy are related is to consider the identity S = 1 + NX In all three cases, expansionary fiscal policy reduces national saving S. In the closed economy, the fall in Scoincides with an equal fall in I, and NX stays con- stant at zero. In the small open economy, the fall in S coincides with an equal fall in NX, and I remains constant at the level fixed by the world interest rate. Policies in the Large Open Economy We can now consider how economic policies influence the large open economy. Figure 6-19 shows the three diagrams we need for the analysis. Panel (a) shows the equilibrium in the market for loanable funds; panel (b) shows the relationship 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 6-20 shows what happens. The policy reduces national saving S, thereby reducing the supply of loanable funds and raising the equilibrium interest rate r. The higher interest rate reduces both domestic investment I and the net capital FIGURE 6-19 (a) The Market for Loanable Funds (b) Net Capital Outflow Real interest rate, S 1 + CF CF(r) Net capital outflow, CF Loanable funds, S, I + CF (c) The Market for Foreign Exchange Real exchange rate, CF The Equilibrium in the Large Open Economy Panel (a) shows that the market for loanable funds determines the equilibrium interest rate. Panel (b) shows that the interest rate deter- mines the net capital outflow, which in turn determines the supply of dol- lars to be exchanged into foreign cur- rency Panel (c) shows that the real exchange rate adjusts to balance this supply of dollars with the demand coming from net exports. NX() Net exports, NX Question 4: Model of the Large Open Economy (15 Points] (a) Major improvements in computer information technology in the 1990s fueled an increase in investment demand in the United States (a large open economy). Graphically illustrate the effect of an increase of U.S. investment using the Large Open Economy Model developed in the appendix of Ch. 6 (Hint: In your model you will need to draw three diagrams). Clearly label the axes and curves in each of your graphs in the model. Clearly indicate the direction of any shifts in the curves. In your model, label the initial equilibrium points as Point A and label the new equilibrium points as Point B. [11 Points] (b) Using your model drawn in Part (a), indicate what effect the increase in investment will have on the following economic variables in the United States: [4 Points] (i) real interest rate (iii) real exchange rate (ii) net capital outflow (iv) net exports FIGURE 6-20 (a) The Market for Loanable Funds Real interest rate, s (b) Net Capital Outflow 1. A fall in saving ... 1+ CF 2.... raises the interest rate, - 3. ... which lowers net capital outflow, ... CFT) Loanable funds, S, 1 + CF CF : CF Net capital outflow, CF (c) The Market for Foreign Exchange Real exchange rate, A Reduction in National Saving in the Large Open Economy Panel (a) shows that a reduction in national saving lowers the supply of loanable funds. The equilibrium interest rate rises. Panel (b) shows that the higher interest rate lowers the net capital out- flow. Panel (c) shows that the reduced capital outflow means a reduced sup- ply of dollars in the market for foreign- currency exchange. The reduced supply of dollars causes the real exchange rate to appreciate and net exports to fall. raises the exchange rate, 5. ... and reduces net exports. NX(E) Net exports, NX NXNX, 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. Note that the impact of fiscal policy in this model combines its impact in the closed economy and its impact in the small open economy. As in the closed economy, a fiscal expansion in a large open economy raises the interest rate and crowds out investment. As in the small open economy, a fiscal expansion causes a trade deficit and an appreciation in the exchange rate. One way to see how the three types of economy are related is to consider the identity S = 1 + NX In all three cases, expansionary fiscal policy reduces national saving S. In the closed economy, the fall in Scoincides with an equal fall in I, and NX stays con- stant at zero. In the small open economy, the fall in S coincides with an equal fall in NX, and I remains constant at the level fixed by the world interest rate. Policies in the Large Open Economy We can now consider how economic policies influence the large open economy. Figure 6-19 shows the three diagrams we need for the analysis. Panel (a) shows the equilibrium in the market for loanable funds; panel (b) shows the relationship 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 6-20 shows what happens. The policy reduces national saving S, thereby reducing the supply of loanable funds and raising the equilibrium interest rate r. The higher interest rate reduces both domestic investment I and the net capital FIGURE 6-19 (a) The Market for Loanable Funds (b) Net Capital Outflow Real interest rate, S 1 + CF CF(r) Net capital outflow, CF Loanable funds, S, I + CF (c) The Market for Foreign Exchange Real exchange rate, CF The Equilibrium in the Large Open Economy Panel (a) shows that the market for loanable funds determines the equilibrium interest rate. Panel (b) shows that the interest rate deter- mines the net capital outflow, which in turn determines the supply of dol- lars to be exchanged into foreign cur- rency Panel (c) shows that the real exchange rate adjusts to balance this supply of dollars with the demand coming from net exports. NX() Net exports, NX Question 4: Model of the Large Open Economy (15 Points] (a) Major improvements in computer information technology in the 1990s fueled an increase in investment demand in the United States (a large open economy). Graphically illustrate the effect of an increase of U.S. investment using the Large Open Economy Model developed in the appendix of Ch. 6 (Hint: In your model you will need to draw three diagrams). Clearly label the axes and curves in each of your graphs in the model. Clearly indicate the direction of any shifts in the curves. In your model, label the initial equilibrium points as Point A and label the new equilibrium points as Point B. [11 Points] (b) Using your model drawn in Part (a), indicate what effect the increase in investment will have on the following economic variables in the United States: [4 Points] (i) real interest rate (iii) real exchange rate (ii) net capital outflow (iv) net exports