Economics: The Fundamentals of Macroeconomics (feat. MS Paint)

What determines an economy's trade balance and exchange rate and more? When we analyze an open economy, we must take into account multiple markets at once.

We first look at the market for loanable funds, where there is one interest rate and the money from savers get to borrowers.
Recall that S = I + NCO, savings equals domestic investment plus net capital outflow. The left side of this equation can be regarded as the supply of loanable funds. The right side can be regarded as demand. If interest rate rises, it encourages saving and increases supply, but discourages investment or demand. Interest rate also affects NCO; if interest rate was high, other countries would be encouraged to buy assets from us, making NCO lower.

The interest rate adjusts to bring supply and demand for loanable funds into balance. Demand = supply at equilibrium interest.

For foreign-currency exchange, NCO = NX, where NCO represents supply and NX represents demand. The supply of dollars comes entirely from NCO, and demand slopes downward. Real exchange rate determines the quantity demanded. The higher the real exchange rate the less demand for exports and foreign money as people buy domestic goods instead. Note the equilibrium exchange rate,

The link between these two markets is NCO. NCO has a negative slope when compared to real interest rate. The lower the real interest rate, people are more likely to invest in foreign assets instead of domestic ones. Putting them all together, 

Now we can see how different policies affect all these variables. 

If the government budget deficits, it takes away the supply from loanable funds. Supply shifts left, real interest rate moves up and quantity of dollars moves down, and real exchange rate increases (money appreciates in value), and NCO  (also NX) is reduced.

If an import quota or tariff is set by the government, net exports must rise as imports decrease. If net exports rise, the U.S. is selling more and other countries require currency exchange, making demand of foreign-currency exchange shift right. Real exchange rates rise but do not affect NCO. This is because although appreciation encourages imports while discouraging exports, the import quota balances it out to no change. Thus, trade policies do not affect trade balance. Recall NX = S - I. NX is not affected since savings or investment aren't affected either.

Finally, in the final scenario, imagine political instability and capital flight (people selling their assets in a place expecting it to collapse). If people move their assets elsewhere, there is an increase in NCO. The money needed to finance this movement shifts demand for loanable funds to the right, driving up real interest rate. Quantity of money also shifts right and this makes money depreciate.

Whew these graphs are hard.