OpenMarket Macroeconomics:

1
Chapter 17

• Open-Market Macroeconomics
• Basic Concepts

2
Outline

• Trade in US Economy Past Present
• Role of Net Foreign Investment
• Exchange Rates

3
Open or Closed Economies

• Closed Economy
• No exports, no imports, and no capital flows.
• Open Economy
• Economy interacts freely with others.

4
Why Countries Trade

• Countries gain by specializing according to
  comparative advantage

5
The Flow of Goods

• Exports
• Domestically produced goods sold abroad.
• Example Boeing building and selling planes to
  Air France, Etc.

6
The Flow of Goods

• Imports
• Foreign produced goods and services sold to
  domestic residents.
• Example Computer monitors made in Korea and
  wine from France to U.S.

7
The Flow of Goods

• Net Exports (NX) or Trade Balance
• The value of exports minus the value of imports.
  
• Trade Deficit
• A situation when net exports (NX) are negative.
  (i.e. Exports lt Imports)
• Trade Surplus
• A situation when net exports (NX) are positive.
  (i.e. Exports gt Imports)

8
Trade Colonial America

• By the late Colonial period, US had two major
  manufacturing industries
• 1 Shipbuilding 2 Iron Manufacture
• In which did US have a comparative advantage?

9
Trade Colonial America

• Why did iron manufacture flourish in Colonial
  America, even though Britain had a clear
  comparative advantage?

10
US TRADE EARLY YEARS

• Why did international trade play a critical role
  in US economy before 1820?
• Why was trade between coastal towns and interior
  (especially the Ohio River Valley ) so small
  before 1820?

• Pittsburgh!

11
Early U.S. Trade

• What innovations made interior trade possible by
  1820?
• The 1840 Census ranked New Orleans as the third
  largest US city with 100,000 people.
• By 1850 it faces a relative decline? Why so?

12
US Trade Since 1950

• What innovations have led to increased U.S. trade
  since 1950?

13
US Trade Since 1950

• Innovations since 1950?
• 1)Super-cargo planes ships
• 2)Improved Telecommunications

14
US Trade Since 1950

• How does government influence trade?
• Tariffs
• Quotas
• Embargo

15
Factors That Influence a Countrys Exports,
Imports, and Net Exports

• Consumers tastes for domestic and foreign goods.
• Prices of goods at home and abroad.
• Exchange rates at which people can use domestic
  currency to buy foreign currencies.
• Costs of transporting goods from country to
  country.
• Govt Policies toward international trade.

16
Net Foreign Investment (NFI)

• If domestic residents purchase more foreign
  financial assets than foreigners purchase
  domestic assets, there is a net capital outflow
  from domestic economy.
• This is positive NFI
• The opposite of this is a net capital inflow into
  the U.S. This is negative NFI

17
Net Foreign Investment (NFI)
ID gt IF gt NFID

18
Net Foreign Investment (NFI)
ID gt IF gt NFID

ID lt IF gt NFID
19
The Equality of Net Exports and Net Foreign
Investment

• For an economy as a whole
• NX NFI
• Why? Every transaction that affects one side must
  also affect the other side by the same.

20
A Key Identity

• NX NFI

21
A Key Identity
Last Chapter with Math!

• Y C I G NX
• Y - C - G I NX
• S I NX
• But NX NFI So
• S I NFI

22
A Key Identity

• S I NFI

23
A Key Identity

• S I NFI 50b 50b 0
• 30b 45b - 15b

24
Saving

Domestic Investment
GDP
15
NFI
National Saving
1980
25
Real and Nominal Exchange Rates

• International transactions influenced by
  international prices.
• Two most important
• Nominal Exchange rate
• Real Exchange Rate

26
The Nominal Exchange Rate

• Nominal exchange rate rate a currency of one
  country exchanges for currency of another.
• Expressed two ways
• 1. Units of foreign currency per one U.S. dollar
• 2. In units of U.S. dollars per one unit of the
  foreign currency

27
The Nominal Exchange Rate

• Example If exchange rate between Mexican peso
  and U.S. dollar is ten to one, then 1 U.S.
  dollar 10 pesos or 1 Peso 0.10 dollar
• Next year if 1 U.S. dollar 15 pesos then
  dollar has appreciated.
• Peso has depreciated.

28
Nominal Exchange Rates

• Country Oct 96 May 99 Feb 02 Nov 02
• Canada 1.354 1.458 1.605 1.575
• Mexico 7.544 9.290 9.109 10.223
• France 5.166 6.152 7.559 0.996
• Britain 0.644 0.617 0.708 0.633
• Germy 1.530 1.834 2.254 0.996
• Brazil 1.027 1.654 2.439 3.696
• Argnta --- --- --- 1.775
• Franc and Mark no longer currency, the Euro is
  their currency

29
Nominal Exchange Rates

• Country Oct 96 Nov 98 May 99
• Canada 1.354 1.533 1.458
• Mexico 7.544 10.07 9.290
• France 5.166 5.545 6.152
• Britain 0.644 0.601 0.617
• Germany 1.530 1.654 1.834
• Brazil 1.027 ------- 1.654

30
Nominal Exchange Rates

• Country May 99 Nov 99 Feb 00
• Canada 1.458 1.463 1.450
• Mexico 9.290 9.475 9.433
• France 6.152 6.321 6.648
• Britain 0.617 0.616 0.628
• Germany 1.834 1.885 1.982
• Brazil 1.654 1.921 1.773

31
Nominal Exchange Rates

• Country Nov 99 Feb 00 Nov 00
• Canada 1.463 1.450 1.531
• Mexico 9.475 9.433 9.571
• France 6.321 6.648 7.637
• Britain 0.616 0.628 0.692
• Germany 1.885 1.982 2.277
• Brazil 1.921 1.773 1.919

32
Nominal Exchange Rates

• Country Feb 00 Nov 00 Feb 01
• Canada 1.450 1.531 1.507
• Mexico 9.433 9.571 9.753
• France 6.648 7.637 6.988
• Britain 0.628 0.692 0.678
• Germany 1.982 2.277 2.084
• Brazil 1.773 1.919 2.000

33
Nominal Exchange Rates

• Country Nov 00 Feb 01 Nov 01
• Canada 1.531 1.507 1.593
• Mexico 9.571 9.753 9.213
• France 7.637 6.988 7.305
• Britain 0.692 0.678 0.686
• Germany 2.277 2.084 2.178
• Brazil 1.919 2.000 2.582

34
Nominal Exchange Rates

• Country Oct 96 May 99 Feb 02 Feb 02
• Japan 111.7 121.8 133.7 120.5
• Thaild 25.43 36.99 53.96 43.40
• Phlpnes 26.27 37.69 51.25 53.36
• Malysa 2.503 3.800 3.800 3.799
• S Korea 828.9 1206.2 1311.7 1204.2
• Indonsia 2321 7820 10,325 9025
• Israel --- --- --- 4.669
• Kuwait --- --- --- .3011

35
Nominal Exchange Rates

• Country Oct 96 Nov 98 May 99
• Japan 111.7 115.0 121.8
• Thailand 25.43 37.01 36.99
• Philippines26.27 40.33 37.69
• Malaysia 2.503 3.800 3.800
• S Korea 828.9 1318.7 1206.2
• Indonesia 2321 8000 7820

36
Nominal Exchange Rates

• Country May 99 Nov 99 Feb 00
• Japan 121.8 104.9 108.8
• Thailand 36.99 38.39 37.40
• Philippines37.69 40.10 40.48
• Malaysia 3.800 3.800 3.800
• S Korea 1206 1185 1115
• Indonesia 7820 6775 7300

37
Nominal Exchange Rates

• Country Nov 99 Feb 00 Nov 00
• Japan 104.9 108.8 108.1
• Thailand 38.39 37.40 43.82
• Philippines40.10 40.48 51.00
• Malaysia 3.800 3.800 3.800
• S Korea 1185 1115 1135
• Indonesia 6775 7300 9175

38
Nominal Exchange Rates

• Country Feb 00 Nov 00 Feb 01
• Japan 108.8 108.1 114.7
• Thailand 37.40 43.82 42.46
• Philippines40.48 51.00 49.10
• Malaysia 3.800 3.800 3.800
• S Korea 1115 1135 1262
• Indonesia 7300 9175 9550

39
Nominal Exchange Rates

• Country Nov 00 Feb 01 Nov 01
• Japan 108.1 114.7 121.8
• Thailand 43.82 42.46 44.67
• Philippines51.00 49.10 51.95
• Malaysia 3.800 3.800 3.800
• S Korea 1135 1262 1291
• Indonesia 9175 9550 10925

40
Asian Financial Crisis Steps

• 1 Rapid Asian Growth in 80s 90s
• 2 Western Banks Lend to region
• 3 Often funds denominated in western currencies
• 4 Some loan funds used unwisely
• 5 Currency traders speculate against Asian
  currencies

41
Asian Financial Crisis

• 6 Foreign Investment in Asia Slows
• 7 Central Banks Fail to Prop Up Falling
  Currencies in Thailand, S Korea, especially
  Indonesia
• 8 Asian Borrowers Default on Loans Denominated
  in Western Currencies
• 9 Hurts Banks World-Wide, esp Japan

42
Asian Financial Crisis

• 10 World Stock Markets Drop - 10/27/97 12th
  Worst Day for DJIA
• WORST POINT DROP TO THAT DATE
• Stocks Decline 7.18

43
Asian Financial Crisis

• 10 Russia suffers economic meltdown in early
  Spring
• 11 Asian Economies in Recession by Summer 1998
• 12 Foreign Markets for Western exports contract

44
Asian Financial Crisis

• 13 Fear of Global recession causes Fed to lower
  discount rate 10/98
• 14 No Recession
• 15 Query What news story knocked the Asian
  Financial Crisis off the front page of US
  Newspapers in 1998?

45
The Real Exchange Rate

• Real exchange rate ratio at which goods of one
  country exchange for goods of another.
• Compares prices of domestic goods and foreign
  goods.
• Example Case of German beer is twice as
  expensive as American beer. Real exchange rate
  is 1/2.

46
The Real Exchange Rate

• Real exchange rate ratio at which goods of one
  country exchange for goods of another.
• Compares prices of domestic goods and foreign
  goods.

47
Calculating the Real Exchange Rate

• Real exchange rates are derived from nominal
  rates. Computing the real exchange rate involves

48
Calculating the Real Exchange Rate

• Real exchange rates are derived from nominal
  rates. Computing the real exchange rate involves

Nominal Exchange Rate x Domestic Price
Real Exchange Rate

Foreign Price
49
Real Exchange Rate

• Example 1 case beer 10 in US
• and 1 case beer 2000 yen
• now if 100 yen 1 then
• Real Exchange Rate
• 100 yen / x 10 in US 1000 yen in
  US
• -----------------------------------
  ----------------------
• 2000 yen in Japan 2000 yen Japan
• So 1/2 Japanese case per 1 US case

50
Real Exchange Rate (E)

• Real exchange rate price of basket of goods
  services available domestically relative to
  basket of available abroad

• Do tell!

51
Real Exchange Rate Macro View

• E e x P / P
• where e nominal exchange rate
• P domestic price level (based upon some market
  basket)
• P foreign price level (based upon that same
  market basket)
• When E is high market basket expensive in US.
  When E depreciates US goods cheaper

52
Real Exchange Rate Macro View

• E e x P / P
• Suppose E (real exchange rate) held constant
• Rearranging above, we get
• e E P/ P
• Nominal exchange rate rises when foreign price
  level rises relative to US

53
Real Exchange Rate Macro View

• e E P/ P
• Nominal exchange rate (e) rises when foreign
  price level rises relative to US
• Example
• If E 50, P 100 P 100 then.
• e 50 x 100/100 50
• If E 50, P 200 P 100 then.
• e 50 x 200/100 100

54
The Real Exchange Rate

• Real exchange rate determines countrys exports
  imports.
• When countrys real exchange rate low, its goods
  are relatively cheap
• People buy countrys goods, so
• Its exports increase

55
Purchasing Power Parity

• Getting near End!

56
Purchasing-Power Parity

• Purchasing-Power Parity Theory
• States that a unit of any currency should buy
  same quantity of goods in all countries.
• Based upon The Law of One Price

57
The Law of One PriceA good must sell for the
same price in all locations.

• Why?
• If the law were not true, profit opportunities
  would exist
• Buy low in one market and sell high in another.
• Example Buying coffee in U.S. or Japan

58
Purchasing Power Parity

• If a Big Mac costs 2 in the US and 200 yen in
  Japan, then 100 yen 1
• If a Big Mac costs 2 in the US and 300 yen in
  Japan, then 150 yen 1

59
Limitations of The Purchasing-Power Parity

• Two things may keep nominal exchange rate (e)
  from exactly equalizing purchasing power
• 1. Many goods are not easily traded among
  countries.
• 2. Traded goods are not always perfect
  substitutes.

• The End!