Chapter 32: A Macroeconomic Theory of the Open Economy

This chapter discusses the two markets of an open economy: the market for loanable funds and the market for foreign-currency. In the market for loanable funds, demand is I+NCO, and supply is S (savings), while in the market for foreign-currency exchange, demand is net exports and supply is held constant from NCO. The link between the two is NCO, and the real exchange rate balances both their supply and demand.
In the market for loanable funds, when NCO>0, there is net capital outflow and this adds to the demand for domestically generated loanable funds. When NCO<0, there is net capital inflow, and capital resources coming from abroad reduce the demand for domestically generated funds. The quantity or loanable funds supplied and demanded depends on the real interest rate. An increase in the real interest rate discourages Americans from buying foreign assets and encourages foreigners to buy U.S. assets therefore reducing net capital outflow.
In the market for foreign-currency exchange, it is important to remember NCO=NX. If NX>0, NCO>O (buying foreign assets w/ bank) and if NX< 0, NCO <0 (spending must be financed by selling American assets abroad). When the U.S. real exchange rate appreciates, U.S. goods become more expensive relative to foreign goods, making U.S. goods less attractive to consumers both at home and abroad.