Open-Economy Macroeconomics: Basic Concepts

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Open-Economy Macroeconomics Basic Concepts

• Chapter 30

2013-12-8
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IN THIS CHAPTERYOU WILL . . .

• 1.Learn how net exports measure the international
  flow of goods and services
• 2. Learn how net capital outflows measures
• the international flow of capital
• 3. Consider why net exports must always equal net
  capital outflows

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IN THIS CHAPTERYOU WILL . . .

• 4. See how saving, domestic investment, and net
  capital outflows are related
• 5.Learn the meaning of the nominal exchange
• rate and the real exchange rate
• 6.Examine purchasing power parity as a theo
• ry of how exchange rates are determined

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Open and Closed Economies

• A closed economy is one that does not interact
  with other economies in the world.
• There are no exports, no imports, and no capital
  flows.

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Open and Closed Economies

• An open economy is one that interacts freely with
  other economies around the world.

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An Open Economy

• An open economy interacts with other countries in
  two ways.
• It buys and sells goods and services in world
  product markets.
• It buys and sells capital assets in world
  financial markets.

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The Flow of Goods Exports, Imports, Net Exports

• Exports are domestically produced goods and
  services that are sold abroad.
• Imports are foreign produced goods and services
  that are sold domestically.
• Net Exports are exports minus imports.

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The Flow of Goods Exports, Imports, Net Exports

• A trade deficit is a situation in which net
  exports (NX) are negative.
• Imports gt Exports
• A trade surplus is a situation in which net
  exports (NX) are positive.
• Exports gt Imports
• Balanced trade refers to when net exports are
  zero exports and imports are exactly equal.

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The Internationalization of the U.S. Economy
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1950
1955
1960
1965
1970
1975
1980
1990
1985
1995
2000
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The Internationalization of the U.S. Economy

• Imports and exports of goods and services have
  risen.
• This increase in international trade is partly
  due to improvements in transportation.
• The increase in international trade has also been
  influenced by advances in telecommunications.
• Technological progress has also fostered
  international trade by changing the kinds of
  goods that economies produce.
• The governments trade policies have also been a
  factor in increasing international trade.

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The Flow of Capital Net capital outflows

• Net capital outflows refers to the purchase of
  foreign assets by domestic residents minus the
  purchase of domestic assets by foreigners.
• A U.S. resident buys stock in the Toyota
  corporation and a Mexican buys stock in the Ford
  Motor corporation.

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The Flow of Capital Net Foreign Investment

• When a U.S. resident buys stock in Telmex, the
  Mexican phone company, the purchase raises U.S.
  net capital outflows When a Japanese residents
  buys a bond issued by the U.S. government, the
  purchase reduces the U.S. net capital outflows

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The Flow of Capital Net capital outflows

• Recall that capital abroad takes two forms.
• 1. If McDonalds opens up a fast food outlet in
  Russia, that is an example of foreign direct
  investment.
• In this case the American owner is actively
  managing the investment.

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The Flow of Capital Net Foreign Investment

• 2. Alternatively, if an American buys stock in a
  Russian corporation, that is an example of
  foreign portfolio investment.
• In this case the American owner has a more
  passive role.
• In both cases, U.S. residents are buying assets
  located in another country, so both purchases
  increase U.S. net capital outflows.

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Variables that Influence Net capital outflows

• The real interest rates being paid on foreign
  assets.
• The real interest rates being paid on domestic
  assets.
• The perceived economic and political risks of
  holding assets abroad.
• The government policies that affect foreign
  ownership of domestic assets.

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The Equality of Net Exports and Net Capital
Outflows

• Net exports (NX) and net Capital Outflows (NCO)
  are closely linked.
• For an economy as a whole, NX and NCO must
  balance each other so that
• NCO NX
• This holds true because every transaction that
  affects one side must also affect the other side
  by the same amount.

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SAVING, INVESTMENT, AND THEIR RELATIONSHIP TO
THE INTERNATIONAL FLOWS

• A nations saving and investment are, crucial
• to its long-run economic growth.
• The economys gross domestic product (Y) is
  divided among four components consumption (C),
  investment (I ), government purchases (G), and
  net exports (NX). We write this as
• Y C I G NX.

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SAVING, INVESTMENT, AND THEIR RELATIONSHIP TO THE
INTERNATIONAL FLOWS

• Recall that national saving is the income of the
  nation that is left after paying for current
  consumption and government purchases. National
  saving (S) equals Y - C - G. If we rearrange the
  above equation to reflect this fact, we obtain
  
• Y C - G I
  NX
• S
  I NX.

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SAVING, INVESTMENT, AND THEIR RELATIONSHIP TO THE
INTERNATIONAL FLOWS

• Because net exports (NX) also equal net capital
  outflow (NCO), we can write this equation as
• S I NCO
• Saving Domestic investment Net capital outflow

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SAVING, INVESTMENT, AND THEIR RELATIONSHIP TO THE
INTERNATIONAL FLOWS

• This equation shows that a nations saving
  must equal its domestic investment plus its net
  capital outflow. In other words, when U.S.
  citizens save a dollar of their income for the
  future, that dollar can be used to finance
  accumulation of domestic capital or it can be
  used to finance the purchase of capital abroad.

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SAVING, INVESTMENT, AND THEIR RELATIONSHIP TO THE
INTERNATIONAL FLOWS

• In a closed economy, net capital outflow is
  zero (NCO 0), so saving equals investment (S I
  ). By contrast, an open economy has two uses for
  its saving domestic investment and net capital
  outflow.

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Nominal Exchange Rates

• The nominal exchange rate is the rate at which a
  person can trade the currency of one country for
  the currency of another.

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Nominal Exchange Rates

• The nominal exchange rate is expressed in two
  ways
• In units of foreign currency per one U.S. dollar.
• And in units of U.S. dollars per one unit of the
  foreign currency.

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Nominal Exchange Rates

• Assume the exchange rate between the Japanese yen
  and U.S. dollar is 80 yen to one dollar.
• One U.S. dollar trades for eighty yen.
• One yen trades for 1/80 (0.0125) of a dollar.

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Nominal Exchange Rates

• If a dollar buys more foreign currency, there is
  an appreciation of the dollar.
• If it buys less there is a depreciation of the
  dollar.

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REAL EXCHANGE RATES

• The real exchange rate is the rate at which a
  person can trade the goods and services of one
  country for the goods and services of another.

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REAL EXCHANGE RATES

• Like the nominal exchange rate, we express the
  real exchange rate as units of the foreign item
  per unit of the domestic item.
• But in this instance the item is a good rather
  than a currency.

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The relationship between nominal exchange rate
and real exchange rate

• We can summarize this calculation for the real
  exchange rate with the following formula
• Real exchange rate Nominal exchange rate
  Domestic price
• 
  Foreign price

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The relationship between nominal exchange rate
and real exchange rate

• Example
• Suppose that a bushel of American rice sells
  for 100, and a bushel of Japanese rice sells for
  16,000 yen. What is the real exchange rate
  between American and Japanese rice?

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The relationship between nominal exchange rate
and real exchange rate

• Real exchange rate (80 yen per dollar) (100
  per bushel of American rice)
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  16,000 yen per bushel of Japanese
  rice
• 8,000 yen per
  bushel of American rice
• 16,000 yen per bushel of
  Japanese rice
• 1/2 bushel of Japanese
  rice per bushel of American rice.

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The relationship between nominal exchange rate
and real exchange rate

• By using a price index for a U.S. basket (P),
  a price index for a foreign basket (P), and the
  nominal exchange rate between the U.S. dollar and
  foreign currencies (e), we can compute the
  overall real exchange rate between the United
  States and other countries as follows
• Real exchange rate (e P)/P.

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How Do Changes in Exchange Rates Affect People?

• Businesses
• Appreciation of the US dollar will hurt US
  exports and thus US business.
• Depreciation of the US dollar will help US
  exports and thus US businesses.

• Tourists
• Appreciation of the US dollar will help US
  tourists by increasing their purchasing power.
• Depreciation of the US dollar will hurt US
  tourists by decreasing their purchasing power.

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Purchasing-Power Parity

• The purchasing-power parity theory is the
  simplest and most widely accepted theory
  explaining the variation of currency exchange
  rates.

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Basic Logic of Purchasing-Power Parity

• The theory of purchasing-power parity is based on
  a principle called the law of one price.
• According to the law of one price, a good must
  sell for the same price in all locations.

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Basic Logic of Purchasing-Power Parity

• If the law of one price were not true,
  unexploited profit opportunities would exist.
• The process of taking advantage of differences in
  prices in different markets is called arbitrage.

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Money, Prices, and the Nominal Exchange Rate
During the German Hyperinflation
Indexes (Jan. 1921 100)
1,000,000,000,000,000
10,000,000,000
100,000
1
.00001
.0000000001
1921
1922
1923
1924
1925