Wednesday, September 30, 2009

Economists do it with models! Part 2

This post involves a lot of pictures from PowerPoint. I will add notes to each image.

The above picture shows a "normal" supply and demand curve. National savings (the supply) will increase with an increase in the real interest rate. Thus it slopes upward. Investment and NCO acting as the demand component works in the opposite manner. As The real interest rate rises the amount of loanable funds is low, lower and the quantity rises, thus it slopes downwards. ( Loanable funds are usually used to invest in capital assets, either at home or abroad, thus its relation to I + NCO)

The demand curve (in blue) represents the demand for dollars which is 100% correlated to NX. We know that NX must equal NCO from earlier discussions. Imagine you buying that BMW again. You are giving BMW US dollars but they must pay their labor in Euros. So what do they do with their US dollars, probably buying a factory in South Carolina, otherwise known as purchasing a capital asset.

The real exchange rate will be where this market is in equilibrium. The supply curve is vertical because the Quantity of Dollars is not affected by the real exchange rate, it is affected by the real interest rate. The amount of NX will affect the demand for dollars which are necessary to make transactions between foreign countries. When the exchange rate is lower will stimulate a demand for dollars, thus the demand curve slopes downward.

The real rate of interest will affect NCO. If the rate is low in relation to the Euro then more funds will leave the country. When the rate is higher (relatively) in the US then funds will flow back into the country.

The NCO graph ties together the demand for dollars/real exchange rate graph and the loanable funds/real interest rate graphs so that analysis of policy decisions can be made.

This example shows China as the home country. It wishes to lessen its trade balance by removing its subsidy to Chinese export companies. By decreasing the amount of net exports no matter what the exchange causes the demand for Yuan to fall (move leftward.) The real exchange rate drops to R2, however, it does not affect the amount of capital leaving the country. (note this example assumes that the Yuan is a fully convertible currency) NCO is only affected by changes in the real rate of interest in relation to the rest of the world.

A second example where the US is the home country. How would it be affected by having the Chinese purchase less Treasury securities? First we would see NCO increase, which would cause the domestic real interest rate to rise. This would have a secondary affect of...

Increasing the supply of dollars in the foreign exchange market. The increase in dollars would lower the real exchange rate. All in all the US would export more, import less due to the change in exchange rate. It would also save more as the real rate of interest would rise.

I added that if this had been undertaken in an orderly fashion after the dot-bomb debacle, perhaps instead of invading Iraq, there might not have been such a huge financial crisis with its epicenter in the US housing market. Instead the Chinese have continued to purchase US treasury securities keeping the real rate of interest low. This allowed a borrowing binge and an asset price appreciation in the United States housing market. Instead of appropriating the funds in more productive sectors, citizens were buying and flipping houses back and forth to each other in a Ponzi-esque fashion.

You can also imagine this set of graphs analyzing government budgets, ( a deficit will draw down on the supply of loanable funds, crowding out private investment), trade policy (quotas help one industry at the expense of all exporting industries via a higher exchange rate) and Capital Crises (it is the same analysis of China pulling its investment example from above.)

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