SIMULTANEOUS EQUILIBRIUM IN TWO MARKETS
We ~an now put all the pieces of our moper together in Figure 4. This figure shows how the market for loan able funds and’ “the market for foreign-currency exchange jointly determine the important macroeconomic variables of an open economy. Panel (a) of the figure shows the market- for loanable funds (taken from Figure 1). As before, national saving is the source of the supply of loanable funds. Domestic investment and net capital outflow are the source of the demand for loanable funds. The equilibrium real interest rate (‘1) brings the quantity of loanable funds supplied and the quantity of loanable funds demanded into balance. Panel (b) of the figure shows net capital outflow (taken from Figure 3). It shows how the interest rate from panel (a) determines net capital outflow. A higher interest rate at home makes domestic assets more attractive, and this in turn reduces net capital outflow. Therefore, the net-capital-outflow curve in panel (b) slopes downward. Panel (c) of the figure shows the market for foreign-currency exchange (taken from Figure 2). Because foreign assets must be purchased with .foreign currency, the quantity of net capital outflow from pan: 1 (b) determines the dollars to be exchanged into foreign currencies. The real exchange rate does not affect net capital outflow, so the supply curve is vertical. The demand for dollars comes from net exports. Because a depreciation of the real exchange rate increases net exports, the curve for exchange slopes downward. The equilibrium real exchange rate (EI) brings into balance the quantity 0 dollars supplied and the quantity of dollars demanded m the market for foreign-currency exchange. The two markets shown in Figure 4 determine two relative prices: the real interest rate and the real exchange rate. The real interest rate determined in panel (a) is the price of goods and services the present relative to goods and services in the future. The real exchange rate in panel (c) is the price of domestic goods and services re1ative to foreign goods and services. These two relative prices adjust simultaneously to balance supply and demand in these two markets. As they do so, they determine national saving, domestic investment, net capital outflow, .and net exports. In a moment, we will use this model to see how all these variables change when some policy or event causes one of these curves to shift.