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The market for foreign-currency exchange

Mankiw's model of an open economy: the market for loanable funds and the market for foreign-currency exchange, linked by net capital outflow.

FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated

General education, not financial advice.

After this lesson you can
  • Describe supply and demand in the open-economy market for loanable funds
  • Describe supply and demand in the market for foreign-currency exchange
  • Explain how net capital outflow links the two markets

Builds toward: Invest on your own. Understand low-cost funds, read a fund factsheet, and spot a sales pitch.

The economy behind your investments: lesson 15 of 16
  1. The economy behind your investments
  2. Financial markets and intermediaries 5 min
  3. The market for loanable funds 5 min
  4. Banks and the money supply 5 min
  5. The quantity theory of money 5 min
  6. The aggregate-demand curve 5 min
  7. Monetary policy and aggregate demand 5 min
  8. Aggregate supply and the business cycle 5 min
  9. Fiscal policy and the multiplier 5 min
  10. The Phillips curve 5 min
  11. Expectations and the cost of lower inflation 5 min
  12. Rules or discretion 6 min
  13. Deficits and the case for balance 7 min
  14. Exchange rates and purchasing-power parity 5 min
  15. Exports, imports and capital flows 5 min
  16. The market for foreign-currency exchange 5 min
  17. Policies and shocks in an open economy 5 min

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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 19

What it is

Mankiw's open-economy model uses two markets and two prices, viewed from the US with the dollar as the home currency.

1. The market for loanable funds (price: the real interest rate)

  • Supply: national saving (S).
  • Demand: domestic investment (I) plus net capital outflow (NCO), since S = I + NCO. Funds can be used to build capital at home or to buy assets abroad.
  • Net capital outflow depends on the real interest rate. A higher home interest rate makes home assets more attractive, so home residents buy fewer foreign assets and foreigners buy more home assets: NCO falls.

2. The market for foreign-currency exchange (price: the real exchange rate)

  • Supply of dollars: net capital outflow. People supply dollars when they want to buy foreign assets. NCO is set by the real interest rate, not the exchange rate, so this supply curve is vertical.
  • Demand for dollars: net exports. Foreigners need dollars to buy US goods. A lower real exchange rate makes US goods cheaper, raising net exports, so the demand curve slopes downwards.
  • The real exchange rate adjusts until the dollars supplied for net capital outflow equal the dollars demanded for net exports: NCO = NX.

Quick check

Tap an answer to check it.

  1. The home real interest rate rises. What happens to net capital outflow?

    Show answer

    It falls: home assets become more attractive. NCO depends negatively on the real interest rate.

Why it matters

Net capital outflow is the link. The interest rate set in the loanable-funds market determines NCO. That NCO is the supply of dollars in the foreign-exchange market, which, together with the demand from net exports, sets the real exchange rate. So:

  • An event that changes saving or investment changes the interest rate, then NCO, then the exchange rate and net exports.
  • An event that changes the demand for net exports at each exchange rate changes the exchange rate but, if saving and investment are unchanged, not NCO, so net exports end up where they were.

Mankiw notes that the two markets set two relative prices: the real interest rate is the price of goods today relative to goods in the future; the real exchange rate is the price of home goods relative to foreign goods.

Worked example

Tracing a rise in national saving (for example, households save more):

  1. Loanable funds: supply rises, so the real interest rate falls.
  2. A lower interest rate makes foreign assets more attractive: NCO rises.
  3. Foreign exchange: more dollars are supplied (the vertical supply curve shifts right), so the real exchange rate falls (the dollar depreciates).
  4. Cheaper home goods raise net exports, by the same amount as NCO rose.

Domestic investment also rises (the interest rate fell), and both I and NCO absorb the extra saving: S = I + NCO.

A rise in saving lowers the interest rate and raises net capital outflow, so more dollars are supplied and the real exchange rate fallsThe market for foreign-currency exchange in Mankiw's open-economy model. The supply of dollars is net capital outflow, a vertical line because it depends on the interest rate, not the exchange rate. The demand for dollars comes from net exports and slopes down. When net capital outflow rises (NCO 1 to NCO 2), the real exchange rate falls, making home goods cheaper and raising net exports by the same amount.Quantity of dollarsReal exchange rateDemand (net exports)NCO 1NCO 2
A rise in saving lowers the interest rate and raises net capital outflow, so more dollars are supplied and the real exchange rate falls
Text description

The market for foreign-currency exchange in Mankiw's open-economy model. The supply of dollars is net capital outflow, a vertical line because it depends on the interest rate, not the exchange rate. The demand for dollars comes from net exports and slopes down. When net capital outflow rises (NCO 1 to NCO 2), the real exchange rate falls, making home goods cheaper and raising net exports by the same amount.

Common mistake

Thinking the supply of dollars in the foreign-exchange market depends on the exchange rate. In Mankiw's model it is set by net capital outflow, which depends on the real interest rate, so the supply curve is vertical.

Key terms

market for loanable funds
here, the market where national saving meets demand from domestic investment and net capital outflow
market for foreign-currency exchange
the market where net capital outflow (supply of dollars) meets net exports (demand for dollars)
real interest rate
the price of goods today relative to goods in the future
real exchange rate
the price of home goods relative to foreign goods
net capital outflow
home purchases of foreign assets minus foreign purchases of home assets

Practise the key terms

Tap a card to turn it over. 5 cards.

FrontBack
market for loanable fundshere, the market where national saving meets demand from domestic investment and net capital outflow
market for foreign-currency exchangethe market where net capital outflow (supply of dollars) meets net exports (demand for dollars)
real interest ratethe price of goods today relative to goods in the future
real exchange ratethe price of home goods relative to foreign goods
net capital outflowhome purchases of foreign assets minus foreign purchases of home assets

Practice

Sort it

Which group does this belong to?

  1. An American buys shares in a German firm

    Show answer

    Supply of dollars. Part of net capital outflow

  2. A Japanese family buys American software

    Show answer

    Demand for dollars. Part of US exports

  3. A US fund buys Mexican government bonds

    Show answer

    Supply of dollars. Net capital outflow

  4. A French company buys US aircraft

    Show answer

    Demand for dollars. Net exports

Work it through

In an open economy, national saving is 500 and domestic investment is 420 at the equilibrium interest rate.

Quick quiz

Tap an answer to check it.

  1. Why does the demand curve for dollars slope downwards in Mankiw's model?

    Show answer

    A lower real exchange rate makes home goods cheaper, raising net exports. Demand for dollars comes from net exports.

  2. What links the two markets?

    Show answer

    Net capital outflow. The interest rate sets NCO, which is the supply of dollars.

In short

  • Loanable funds: supply = saving; demand = investment + NCO; price = real interest rate.
  • Foreign exchange: supply of dollars = NCO (vertical); demand = NX; price = real exchange rate.
  • A higher interest rate lowers NCO.
  • NCO links the markets, and NX = NCO in equilibrium.

Mastery check

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Check yourself

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  1. In the open-economy market for loanable funds, what are the two sources of demand?

    Show answer

    Domestic investment and net capital outflow.

  2. Why is the supply of dollars in the foreign-exchange market vertical?

    Show answer

    It equals net capital outflow, which depends on the interest rate, not the exchange rate.

  3. What two prices does the model determine?

    Show answer

    The real interest rate and the real exchange rate.

Further reading