Chapter 19

Chapter 19 is titled “a macroeconomic theory of the open economy” and introduces a new model that shows the supply and demand for loanable funds and for foreign-currency exchange. If I were to test on three questions about this chapter they would be…

1. Do you believe that overall the government budget deficit is only bad for the economy?
   1. Adequate response: This answer should express opinions of the benefits and negatives of the deficit and give some explanation that, at the very least, it reduces national saving and therefore reduces the supply of loanable funds.
   2. Very good response: A better response would build upon this by expressing both the benefits and negatives of the deficit and that although there is a reduction in loanable funds and also crowd out domestic investment, cause the currency to appreciate and push the trade balance towards deficit, there is also the benefit that that it raises real interest rates which causes net capital outflow to fall. This is a better answer because it shows it isn’t all good or bad but there are trade-offs.
2. What variable links these the two markets of foreign-currency exchange and loanable funds together and why?
   1. Adequate response: This answer would need to express net capital outflow to receive any points.
   2. Very good response: This answer would clearly express net capital outflow and would ideally present the two equations S=I+NCO and NCO=NX. In the market of loanable funds supply comes from S and demand comes from NCO and I, with the real interest rate balancing supply and demand. In the market for foreign-currency exchange supply is NCO and demand is NX, with the real exchange rate balancing supply and demand.
3. How does trade policy affect the trade balance?
   1. Adequate response: This must express that trade policies do not affect the trade balance to receive any points.
   2. Very good response: This would explain that trade policies do not affect the trade balance and would continue to describe that this is because there is an increase in the demand for dollars which causes the real exchange rate to appreciate. However, nothing happens in the market for loanable funds and therefore there is no change in the real interest rate, meaning that there is no change in net capital outflow. Because there is no change in net capital outflow, and NCO=NX, there is no change in net exports.