Page 664 - The Principle of Economics

682 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
Figure 30-1
THE MARKET FOR
LOANABLE FUNDS. The interest rate in an open economy, as in a closed economy, is determined by the supply and demand for loanable funds. National saving is the source of the supply of loanable funds. Domestic investment and net foreign investment are the sources of the demand for loanable funds. At the equilibrium interest rate,
the amount that people want to save exactly balances the amount that people want to borrow for the purpose of buying domestic capital and foreign assets.
Real Interest Rate
Equilibrium real interest rate
Supply of loanable funds (from national saving)
Demand for loanable funds (for domestic investment and net foreign investment)
Equilibrium quantity
Quantity of Loanable Funds
the amount that people want to save exactly balances the desired quantities of domestic in- vestment and net foreign investment.
THE MARKET FOR FOREIGN-CURRENCY EXCHANGE
The second market in our model of the open economy is the market for foreign- currency exchange. Participants in this market trade U.S. dollars in exchange for foreign currencies. To understand the market for foreign-currency exchange, we begin with another identity from the last chapter:
NFI 􏰀NX
Net foreign investment 􏰀 Net exports.
This identity states that the imbalance between the purchase and sale of capital as- sets abroad (NFI) equals the imbalance between exports and imports of goods and services (NX). When U.S. net exports are positive, for instance, foreigners are buy- ing more U.S. goods and services than Americans are buying foreign goods and services. What are Americans doing with the foreign currency they are getting from this net sale of goods and services abroad? They must be adding to their holdings of foreign assets, which means U.S. net foreign investment is positive. Conversely, if U.S. net exports are negative, Americans are spending more on for- eign goods and services than they are earning from selling abroad; this trade deficit must be financed by selling American assets abroad, so U.S. net foreign in- vestment is negative as well.
Our model of the open economy assumes that the two sides of this identity represent the two sides of the market for foreign-currency exchange. Net foreign investment represents the quantity of dollars supplied for the purpose of buying assets abroad. For example, when a U.S. mutual fund wants to buy a Japanese