19.2 Equilibrium in the Open Economy

19.2 a. Net Capital Outflow: The Link between the Two Markets

Net Capital Outflow (NCO) he net amount of assets invested in a foreign country measured during a set period of time, usually measured yearly. If the value is positive, this indicates that a country invests more in other countries than other countries invest in it; the negative value would be the opposite [6].

In the market for loanable funds, net capital outflow is one of the sources of demand. In the foreign-currency exchange market, net capital outflow is the source of the supply of dollars. This means that net capital outflow is the variable that links the two markets [2].

Example: When looking to invest in foreign countries, a person will finance their investment by obtaining resources from their local market of loanable funds, the NCO is a source of demand. When they exchange currency to purchase, the NCO is a source of supply.

^{Net Capital Outflow [7]}

19.2 b. Simultaneous Equilibrium in Two Markets

The real interest rate is determined in the market for loanable funds. This real interest rate determines the level of net capital outflow. Because net capital outflow must be paid for with foreign currency, the quantity of net capital outflow determines the supply of dollars. The equilibrium real exchange rate brings into balance the quantity of dollars supplied and the quantity of dollars demanded. Thus, the real interest rate and the real exchange rate adjust simultaneously to balance supply and demand in the two markets. As they do so, they determine the levels of national saving, domestic investment, net capital outflow, and net exports [2].

^{Simultaneous Equations in Two Markets [8]}