Chapter 32 talks about the supply and demand for loanable funds and foreign currency exchange. Supply and demand is balanced by the real exchange rate in foreign currency exchanges. Since net capital outflow is part of demand for loanable funds and supplies the foreign currency exchange, it connects the two markets.
Two markets are central to the macroeconomics of open economies, which are the market for loanable funds and the market for foreign currency exchange. In the market for loanable funds, the real interest rate adjust to balance the supply of loanable funds (from national saving) and the demand for loanable funds (from domestic investment and net capital outflow). The real exchange rate adjust to balance the supply and the demand for dollars in the market for currency exchange. Furthermore, since net capital outflow is part of the demand for loanable funds and the supply for the foreign currency exchange, it connects the two markets.
A policy that reduces national saving such as a government budget deficit reduces the supply of loanable funds and increases interest rate. More interest rate leads to a smaller amount of net capital outflow, reducing the supply of dollars in the market for foreign currency exchange. The dollar therefore appreciates and net exports fall.
Restrictive trade policies are sometimes advocated to alter the trade balance, they do not always have that effect, A trade restriction increases net exports for a given exchange rate and,m therefore, increases the demand for dollars in the market for foreign currency exchange. An a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods.
When investors change their attitudes towards holding assets in a country, the effects on the economy can be profound, Political instability can lead to capital flight, increasing interest rates and depreciating the currency.
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