Question

Consider an open economy with international trade.

a) Using a three-panel diagram, show the equilibrium conditions in the market for loanable funds and market for foreign exchanges. Label your axes. Describe the demand and supply of each market. Explain how these markets are linked.

b) Suppose the economy is equilibrium in both markets. Using the three-panel diagram you produced in part a), analyze the effect of President Trump’s decision to impose 15% tariffs on $112 billions of Chinese imports, effective on September 1, 2019. More specifically, discuss the implications on the US’s real GDP, real exchange rate, real interest rate, and net exports. Will the tariffs help to reduce the overall trade deficit? If not, propose a plausible policy that could help to reduce trade deficits in the long-run.

Answer 1

Part a)

The Market for Loanable Funds

Whenever a nation saves a dollar of income, it can use that dollar to finance the purchase of domestic capital or to finance the purchase of an asset abroad. The supply of loanable funds comes from national saving. The demand for loanable funds comes from domestic investment and net capital outflow. The real interest rate is the price of borrowing funds and is therefore on the vertical axis; the quantity of loanable funds is on the horizontal axis.

The supply of loanable funds is upward sloping because of the positive relationship between the real interest rate and the quantity of loanable funds supplied. The demand for loanable funds is downward sloping because of the inverse relationship between the real interest rate and the quantity of loanable funds demanded.

The interest rate adjusts to bring the supply and demand for loanable funds into balance. If the interest rate was below r*, the quantity of loanable funds demanded would be greater than the quantity of loanable funds supplied. This would lead to upward pressure on the interest rate. If the interest rate was above r*, the quantity of loanable funds demanded would be less than the quantity of loanable funds supplied. This would lead to downward pressure on the interest rate. At the equilibrium interest rate, the amount that people want to save is exactly equal to the desired quantities of domestic investment and net capital outflow.

the Market for Foreign Exchange

The imbalance between the purchase and sale of capital assets abroad must be equal to the imbalance between exports and imports of goods and services. Net capital outflow represents the quantity of dollars supplied for the purpose of buying assets abroad. Net exports represent the quantity of dollars demanded for the purpose of buying U.S. net exports of goods and services.

The real exchange rate adjusts to balance the supply and demand for dollars. If the real exchange rate was lower than real e*, the quantity of dollars demanded would be greater than the quantity of dollars supplied and there would be upward pressure on the real exchange rate. If the real exchange rate was higher than real e*, the quantity of dollars demanded would be less than the quantity of dollars supplied and there would be downward pressure on the real exchange rate. At the equilibrium real exchange rate, the demand for dollars to buy net exports exactly balances the supply of dollars to be exchanged into foreign currency to buy assets abroad

Net Capital Outflow: The Link between the Two Markets

In the market for loanable funds, net capital outflow is one of the sources of demand. In the foreign-currency exchange market, net capital outflow is the source of the supply of dollars. This means that net capital outflow is the variable that links the two markets. The key determinant of net capital outflow is the real interest rate.

When the real interest rate is high, owning domestic assets is more attractive and thus, net capital outflow is low. This inverse relationship implies that net capital outflow will be downward sloping.

Part b)

A tariff is a tax imposed by a government on goods and services imported from other countries that serves to increase the price and make imports less desirable, or at least less competitive, versus domestic goods and services. Tariffs along with quotas are the most commonly used trade policy instruments.

Tariff does not affects the demand or supply for loanable funds. Thus, the real interest rate in the market for loanable funds will be unaffected.

Tariff will lower imports and thus increase net exports. Since net exports are the source of demand for dollars in the market for foreigncurrency exchange, the demand for dollars will increase. The real exchange rate will rise making U.S. goods relatively more expensive than foreign goods. Exports will fall, imports will rise, and net exports will fall. In the end, the tariff reduces both imports and exports but net exports remain the same.

Therefore, trade policies donot affect trade balance. Since trade policies do not affect national saving or domestic investment, they cannot affect net exports. Trade policies do have effects on firms, industries, and countries. But these effects are more microeconomic than macroeconomic.