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Policies and shocks in an open economy

What budget deficits, import quotas and capital flight do to interest rates, exchange rates and the trade balance in Mankiw's open-economy model.

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

General education, not financial advice.

After this lesson you can
  • Trace the effects of a budget deficit through both markets
  • Explain why an import quota doesn't change the trade balance
  • Explain the effects of capital flight

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 16 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 applies his two-market model to three events.

1. A government budget deficit.

  • Lower public saving reduces national saving, so the supply of loanable funds falls and the real interest rate rises.
  • The higher interest rate lowers net capital outflow (and crowds out domestic investment, as in a closed economy).
  • Fewer dollars are supplied for buying foreign assets, so the real exchange rate appreciates.
  • Home goods become dearer abroad, so net exports fall: the trade balance moves towards deficit.

Because the budget deficit and the trade deficit tend to move together, the US deficits of the 1980s were nicknamed the twin deficits. Mankiw cautions that they aren't identical twins: other things also affect the trade deficit.

Quick check

Tap an answer to check it.

  1. A government increases its budget deficit. What happens to the real exchange rate?

    Show answer

    It appreciates. Less saving raises the interest rate, cutting NCO and the supply of dollars.

Why it matters

2. An import quota (or a tariff), for example limiting imported cars to protect home carmakers.

  • At any exchange rate, imports are lower, so net exports would be higher: the demand for dollars rises.
  • Saving and investment are unchanged, so the interest rate and NCO don't change, and the supply of dollars stays put.
  • The real exchange rate appreciates, making other home goods dearer abroad and imports cheaper.
  • Result: net exports are unchanged (NX must still equal the unchanged NCO). The quota helps the protected industry, but total imports and exports both fall: other exporters sell less, and other imports rise. Mankiw's conclusion: trade policies affect particular firms and industries, but not the overall trade balance.

3. Capital flight. In 1994, political instability in Mexico, including the assassination of a prominent politician, led investors to move funds to safer countries. From Mexico's side:

  • Investors want to hold fewer Mexican assets, so Mexico's net capital outflow rises at any interest rate.
  • Higher demand for loanable funds (to finance NCO) raises Mexico's interest rate.
  • More pesos are supplied in the foreign-exchange market, so the peso depreciates.
  • Mexican goods become cheaper abroad, so Mexico's net exports rise.

Capital flight raises interest rates and weakens the currency, which can hurt borrowers and the wider economy.

Worked example

Fill in the direction of each effect (↑ up, ↓ down, — unchanged):

EventRateFXNX
Deficit↑↑↓
Quota—↑—
Capital flight↑↓↑

(Rate: the real interest rate. FX: the real exchange rate. NX: net exports.)

  • The deficit works through saving (loanable funds).
  • The quota works through net exports (foreign exchange only).
  • Capital flight works through net capital outflow, which appears in both markets.

Common mistake

Expecting an import quota to cut a trade deficit. In Mankiw's model, the trade balance equals net capital outflow, which depends on saving and investment. A quota pushes up the exchange rate, so other exports fall and other imports rise, leaving net exports unchanged.

Key terms

trade policy
a government policy that directly affects the quantity of goods a country imports or exports
import quota
a limit on the quantity of a good produced abroad that can be sold at home
twin deficits
the tendency of a budget deficit and a trade deficit to move together
capital flight
a large and sudden movement of funds out of a country

Practise the key terms

Tap a card to turn it over. 4 cards.

FrontBack
trade policya government policy that directly affects the quantity of goods a country imports or exports
import quotaa limit on the quantity of a good produced abroad that can be sold at home
twin deficitsthe tendency of a budget deficit and a trade deficit to move together
capital flighta large and sudden movement of funds out of a country

Practice

Sort it

Which group does this belong to?

  1. The home government's budget deficit grows

    Show answer

    Exchange rate rises. Lower NCO means fewer dollars supplied

  2. The home country imposes import quotas

    Show answer

    Exchange rate rises. Demand for dollars rises

  3. Investors pull money out of the home country

    Show answer

    Exchange rate falls. Capital flight raises NCO

  4. Home saving rises sharply

    Show answer

    Exchange rate falls. Lower interest rates raise NCO

Quick quiz

Tap an answer to check it.

  1. An import quota on cars is introduced. What happens to net exports overall?

    Show answer

    They stay the same: the exchange rate appreciates and offsets the quota. NX must equal NCO, which hasn't changed.

  2. After capital flight, what happens to the country's interest rate and currency?

    Show answer

    The interest rate rises and the currency depreciates. Higher NCO raises demand for loanable funds and the supply of the home currency.

  3. What were the "twin deficits"?

    Show answer

    The US budget deficit and trade deficit of the 1980s, which moved together. A budget deficit lowers saving, raising the interest rate, which lowers NCO and NX.

In short

  • Budget deficit: interest rate up, NCO down, currency up, net exports down (twin deficits).
  • Import quota: currency up, net exports unchanged.
  • Capital flight: interest rate up, currency down, net exports up.
  • The trade balance depends on saving and investment, not on trade policy.

Mastery check

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Check yourself

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  1. Why doesn't an import quota change the trade balance in Mankiw's model?

    Show answer

    NX equals NCO, which depends on saving and investment; the quota raises the exchange rate, offsetting its effect.

  2. What happened in Mexico in 1994?

    Show answer

    Political instability caused capital flight: the interest rate rose and the peso depreciated.

  3. What does a budget deficit do to net exports?

    Show answer

    Reduces them.

Further reading