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.)

Real Interest Rates and Net Capital Outflow

Last post I was talking about the identity of Net Exports equaling Net Capital Outflow or in fancy math NX=NCO. I stopped the post short because I wanted to talk about real interest rates before proceeding to build a model for how NCO affects NX and vice versa.

Intuitively NCO will be affected by the real interest rate in the domestic country (wherever you are currently) and the real interest rate in the foreign country with whom you are doing trade. But what exactly is the real interest rate and how does it differ from the nominal interest rates? Well to answer the last question first the real interest rate is the nominal interest rate adjusted for inflation. A man named Fisher first studied and brought this effect to the attention of the economic community.

One more thought on why you should care about nominal interest rates versus real ones. Nominal interest rates affect how much interest your money earns over time. Real interest rates however will track how much purchasing power your money gains or loses over time. Its the same as when we talked about inflation here.

To figure out the relationship for real interest rates, nominal interest rates and inflation we will need three variables. Fisher used r, i and π. Basically he said that i =r + π. However, to really get at the derivation we need to add one to each term. So it should be written as

(1 + i)= (1 + r) * (1 +π)

So then depending on what you know it easy to derive the unknown, usually this will be the real rate of interest. So we can put

((1 + i)/(1 + π)) - 1 = r

So if you know that your savings account gained 4 % last year and CPI calculated by the BLS raised by 2%, we can deduce that the real rate of interest is 1.96%. So your purchasing power of your account moving from 100 to 104, really netted you an increase of about 1.96 dollars of increased purchasing power.

Now back to the beginnings of a model. So now we have a model of the the economy where:
Y = GDP
C = Consumption
G = Government Purchases
I = Investments
NX = Net Exports (Exports - Imports)

Y= C + G + I + NX

So before when it was a closed economy we could just state that Savings equals Investment. Now with our new variables, or toys, or tools (which ever you prefer) we should investigate how NCO and NX are affected by real interest rates.

In the early post we reformed our formula to look like this:

Y - C - G = I and S = Y - C - G

but as I said we will now add NX. So it looks like this:

Y - C - G = I + NX

Thus we can state that Savings equals Investments plus Net Exports, or

S = I + NX and we know that NX = NCO, therefore

S = I + NCO

So it becomes apparent that the entire reason we use the term net capital outflow is because national savings will equal domestic investments plus net capital outflow.

We can theorize what happens in some different circumstances. So if Savings is greater than domestic investments, I, then its capital will be exiting the country through NCO. Restated that the country is buying assets abroad. On the other hand when Savings is less than domestic investment it is because foreign capital is helping meet the demand of domestic investment by purchasing our assets.

One last way of viewing this is through the Net Exports account. So if Germany (domestic) is running a trade surplus by selling more goods to foreign countries than it buys (NX +) than its capital must be leaving its country to purchase foreign assets (NCO +). Likewise when New Zealand purchases more foreign goods than it sells(NX -), it must then sell its assets to bring in capital (NCO -).

Finally, we should consider how a current account deficit should work and whether it is a good or bad thing. So the current account deficit occurs when we import more than we sell, thus our net capital account decreases and the current account deficit widens. But there are a couple of variables at play. Is the current account increasing because investment has increased as a percentage of GDP? Or is the current account growing because the government is running a budget deficit, thus dis-saving for the domestic economy. (S = (Y - t - C) + (t - G), where an increase in G keeping everything else static will decrease national savings) Both of these situations put the deficit in completely different lights.

NX, what I've been missing

So, quite a few of my posts were about the model of the economy with no imports or exports. This was so that I could more easily investigate nuances of taxation, savings and investments. However, as most economies are not closed off to each other the model is only good for introductory looks at an economy. So to add to our burden we must now investigate the flow of goods and its effects on money and monetary policy.

1st the basics
Exports - goods/services produced domestically that are sold to foreign countries
Imports - goods/services produced abroad and consumed domestically.
Net Exports - the positive or negative value when comparing a country's imports and exports. If it imports more than it exports it has a trade deficit.

Conversely, if it exports more than it imports it has a trade surplus. This is called a country's trade balance. There are numerous factors that affect why a country should run a deficit or surplus some include:

• exchange rates
• tax policies
• wealth of citizens
• price of goods
• and, preference of citizens

The above chart shows the US trade balances from 1960 to 2008. The blue area is when the US ran a trade surplus and the red area is when it has run a trade deficit. The purple area is the null area where imports and exports equal each other. (Also in later years it is merely the exports as imports dwarf exports from 1976 onwards.) It is plainly obvious that the trade has become an increasingly large proportion of the economy. It is also true that the imports have become a larger portion of the economy than exports, you can draw your own reasons from the ones listed above as to why imports have grown more rapidly than exports.

Most economists would posit that trade has increased because of the better supply chains that have been initiated from standardized Twenty-foot equivalent units, that can be transferred onto trains, ships and trucks almost effortlessly, to universal product codes have helped make the world a global economy. Telecommunications and technology have intertwined to support the logistics of multinational corporations. Increasingly technocrats have listened to economists' advice that free trade will bring gains to all sides. All have contributed to why trade has grown to a larger portion of GDP.

There is another way that countries trade with each other and it is with financial instruments. A term called net capital outflow (NCO) works exactly like NX. So instead of an import it would be a purchase of a financial asset by a foreigner; conversely a purchase of a financial asset by a US citizen would be an export. So when a foreigner purchases either a factory or US treasury bill that represents a decrease in net capital outflow. The purchase of a factory would be a foreign direct investment and the purchase of the treasury security would be a foreign portfolio investment.

The reason it is important to consider NCO and NX together is that they form an identity, that is, NCO=NX and vice versa. They must equal each other. Here is an example to help think about why it is so.

Say you purchase a BMW from Germany, you even make a vacation of it. So you bring an import to the United States and in exchange you give the German company US dollars. That is net exports have decreased for the United States and decreased the net capital outflow.

Now BMW cannot use the US dollars to pay their employees. So maybe they would instead use their new dollars to buy an automobile assembly robot in the United States. This would increase the net capital outflow of the US and also increase exports, thereby increasing NX.

Tomorrow I will explore how this affects savings and then work on a model to show how this is affected by real interest rates.