Introduction to Macroeconomics

Group 4 - Open-Economy Macroeconomics: Basic Concepts

Pablo Winant

1
The International Flows of Goods and Capital

The Prices for International Transactions: Real and Nominal Exchange Rates

A first Theory of Exchange Rate Determination: Purchasing Power Parity

2
The International Flows of Goods and
Capital
The Flow of Goods and Services: Exports, Imports and Net Exports

• Net Exports:
NX = |{z}
X − |{z}
M
Exports Imports

3
The Flow of Goods and Services: Exports, Imports and Net Exports

• Net Exports:
NX = |{z}
X − |{z}
M
Exports Imports

• Net Exports a.k.a. Trade Balance (TB)

• NX > 0: positive trade balance, trade surplus
• NX < 0: negative trade balance, trade deficit

3
The Flow of Goods and Services: Exports, Imports and Net Exports

• Net Exports:
NX = |{z}
X − |{z}
M
Exports Imports

• Net Exports a.k.a. Trade Balance (TB)

• NX > 0: positive trade balance, trade surplus
• NX < 0: negative trade balance, trade deficit
• Why Trade? What influences it?

3
The Flow of Goods and Services: Exports, Imports and Net Exports

• Net Exports:
NX = |{z}
X − |{z}
M
Exports Imports

• Net Exports a.k.a. Trade Balance (TB)

• NX > 0: positive trade balance, trade surplus
• NX < 0: negative trade balance, trade deficit
• Why Trade? What influences it?
• prices differences

3
The Flow of Goods and Services: Exports, Imports and Net Exports

• Net Exports:
NX = |{z}
X − |{z}
M
Exports Imports

• Net Exports a.k.a. Trade Balance (TB)

• NX > 0: positive trade balance, trade surplus
• NX < 0: negative trade balance, trade deficit
• Why Trade? What influences it?
• prices differences
• taste for variety

3
The Flow of Goods and Services: Exports, Imports and Net Exports

• Net Exports:
NX = |{z}
X − |{z}
M
Exports Imports

• Net Exports a.k.a. Trade Balance (TB)

• NX > 0: positive trade balance, trade surplus
• NX < 0: negative trade balance, trade deficit
• Why Trade? What influences it?
• prices differences
• taste for variety
• income differences

3
The Flow of Goods and Services: Exports, Imports and Net Exports

• Net Exports:
NX = |{z}
X − |{z}
M
Exports Imports

• Net Exports a.k.a. Trade Balance (TB)

• NX > 0: positive trade balance, trade surplus
• NX < 0: negative trade balance, trade deficit
• Why Trade? What influences it?
• prices differences
• taste for variety
• income differences
• trade policies

3
The Flow of Financial Resources: Net Capital Outflow

• Net Capital Outflow (NCO)

4
The Flow of Financial Resources: Net Capital Outflow

• Net Capital Outflow (NCO)

• Foreign assets bought by residents
• minus domestic assets bought by foreigners

4
The Flow of Financial Resources: Net Capital Outflow

• Net Capital Outflow (NCO)

• Foreign assets bought by residents
• minus domestic assets bought by foreigners
• Fundamental identity:
NCO = NX

4
The Flow of Financial Resources: Net Capital Outflow

• Net Capital Outflow (NCO)

• Foreign assets bought by residents
• minus domestic assets bought by foreigners
• Fundamental identity:
NCO = NX

• when you export a good you can receive:

• foreign currency
• foreign assets (like bonds)
• or domestic currency, (but then the foreigner must have bought this currency by
selling an asset to a domestic resident)

4
The Flow of Financial Resources: Net Capital Outflow

• Net Capital Outflow (NCO)

• Foreign assets bought by residents
• minus domestic assets bought by foreigners
• Fundamental identity:
NCO = NX

• when you export a good you can receive:

• foreign currency
• foreign assets (like bonds)
• or domestic currency, (but then the foreigner must have bought this currency by
selling an asset to a domestic resident)
• double accounting from the Balance of Payments

4
Saving and Investment, and Their Relationship to the International Flows

• national saving (income - spending):

S=Y−C−G

5
Saving and Investment, and Their Relationship to the International Flows

• national saving (income - spending):

S=Y−C−G

• gdp decomposition:
Y = C + I + G + NX

5
Saving and Investment, and Their Relationship to the International Flows

• national saving (income - spending):

S=Y−C−G

• gdp decomposition:
Y = C + I + G + NX
• rearrange:
S = I + NX

5
Saving and Investment, and Their Relationship to the International Flows

• national saving (income - spending):

S=Y−C−G

• gdp decomposition:
Y = C + I + G + NX
• rearrange:
S = I + NX
• intuition: what you don’t consume (S), you can invest (I) or send abroad (NX)

5
Saving and Investment, and Their Relationship to the International Flows

• national saving (income - spending):

S=Y−C−G

• gdp decomposition:
Y = C + I + G + NX
• rearrange:
S = I + NX
• intuition: what you don’t consume (S), you can invest (I) or send abroad (NX)
• alternative equation:
S =
|{z} I
|{z} + NCO
|{z}
Saving Domestic Investment Net Capital Outflow

5
Saving and Investment, and Their Relationship to the International Flows

• national saving (income - spending):

S=Y−C−G

• gdp decomposition:
Y = C + I + G + NX
• rearrange:
S = I + NX
• intuition: what you don’t consume (S), you can invest (I) or send abroad (NX)
• alternative equation:
S =
|{z} I
|{z} + NCO
|{z}
Saving Domestic Investment Net Capital Outflow

• intuition: what you save (S) you can invest domestically (I) or abroad (NCO)

5
Summing Up

• Savings greater than investment? (S > I)

6
Summing Up

• Savings greater than investment? (S > I)

• Capital outflows NCO > 0 (S = I + NCO)

6
Summing Up

• Savings greater than investment? (S > I)

• Capital outflows NCO > 0 (S = I + NCO)
• Trade surplus: some goods are exported instead of consumed TB > 0 (S = I + NX)

6
Summing Up

• Savings greater than investment? (S > I)

• Capital outflows NCO > 0 (S = I + NCO)
• Trade surplus: some goods are exported instead of consumed TB > 0 (S = I + NX)
• Savings < than investment? (S > I)

6
Summing Up

• Savings greater than investment? (S > I)

• Capital outflows NCO > 0 (S = I + NCO)
• Trade surplus: some goods are exported instead of consumed TB > 0 (S = I + NX)
• Savings < than investment? (S > I)
• Capital inflows NCO < 0 (I = S − NCO)

6
Summing Up

• Savings greater than investment? (S > I)

• Capital outflows NCO > 0 (S = I + NCO)
• Trade surplus: some goods are exported instead of consumed TB > 0 (S = I + NX)
• Savings < than investment? (S > I)
• Capital inflows NCO < 0 (I = S − NCO)
• Trade deficit: some goods are imported TB < 0 (S = I + NX)

6
The Prices for International
Transactions: Real and Nominal
Exchange Rates
Nominal Exchange Rates

Definition (Nominal Exchage Rate)

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

7
Nominal Exchange Rates

Definition (Nominal Exchage Rate)

The rate at which a person can trade the currency of one country for the currency of
another.
Bilateral exchange rate:

• on August 1st, 1e = 1.18$ so E$/e = 1.18

7
Nominal Exchange Rates

Definition (Nominal Exchage Rate)

The rate at which a person can trade the currency of one country for the currency of
another.
Bilateral exchange rate:

• on August 1st, 1e = 1.18$ so E$/e = 1.18

• or 1$ = 0.8475e = 1/1.18 so Ee/$ = 1/E$/e

7
Nominal Exchange Rates

Definition (Nominal Exchage Rate)

The rate at which a person can trade the currency of one country for the currency of
another.
Bilateral exchange rate:

• on August 1st, 1e = 1.18$ so E$/e = 1.18

• or 1$ = 0.8475e = 1/1.18 so Ee/$ = 1/E$/e
Convention, if e is the domestic currency, we define the euro exchange rate: Ee = E$/e

7
Nominal Exchange Rates

Definition (Nominal Exchage Rate)

The rate at which a person can trade the currency of one country for the currency of
another.
Bilateral exchange rate:

• on August 1st, 1e = 1.18$ so E$/e = 1.18

• or 1$ = 0.8475e = 1/1.18 so Ee/$ = 1/E$/e
Convention, if e is the domestic currency, we define the euro exchange rate: Ee = E$/e
• quantity of foreign currency one gets in exchange of local currency

7
Nominal Exchange Rates

Definition (Nominal Exchage Rate)

The rate at which a person can trade the currency of one country for the currency of
another.
Bilateral exchange rate:

• on August 1st, 1e = 1.18$ so E$/e = 1.18

• or 1$ = 0.8475e = 1/1.18 so Ee/$ = 1/E$/e
Convention, if e is the domestic currency, we define the euro exchange rate: Ee = E$/e
• quantity of foreign currency one gets in exchange of local currency
• appreciation: E goes up. One can buy more foreign currency with it. Depreciation: E
goes down.

7
Nominal Exchange Rates

Definition (Nominal Exchage Rate)

The rate at which a person can trade the currency of one country for the currency of
another.
Bilateral exchange rate:

• on August 1st, 1e = 1.18$ so E$/e = 1.18

• or 1$ = 0.8475e = 1/1.18 so Ee/$ = 1/E$/e
Convention, if e is the domestic currency, we define the euro exchange rate: Ee = E$/e
• quantity of foreign currency one gets in exchange of local currency
• appreciation: E goes up. One can buy more foreign currency with it. Depreciation: E
goes down.
• E is international value of money.

7
Nominal Exchange Rates

Definition (Nominal Exchage Rate)

The rate at which a person can trade the currency of one country for the currency of
another.
Bilateral exchange rate:

• on August 1st, 1e = 1.18$ so E$/e = 1.18

• or 1$ = 0.8475e = 1/1.18 so Ee/$ = 1/E$/e
Convention, if e is the domestic currency, we define the euro exchange rate: Ee = E$/e
• quantity of foreign currency one gets in exchange of local currency
• appreciation: E goes up. One can buy more foreign currency with it. Depreciation: E
goes down.
• E is international value of money.
• sometimes people use the opposite convention. jut check

7
Real Exchange Rates

Definition (Real Exchage Rate)

The rate at which a person can trade the goods and services of one country for the goods
and services of another

8
Real Exchange Rates

Definition (Real Exchage Rate)

The rate at which a person can trade the goods and services of one country for the goods
and services of another
Example:

• I can exchange a pair of shoes, produced in Italy against two pairs of equivalent
shoes produced in the US.

8
Real Exchange Rates

Definition (Real Exchage Rate)

The rate at which a person can trade the goods and services of one country for the goods
and services of another
Example:

• I can exchange a pair of shoes, produced in Italy against two pairs of equivalent
shoes produced in the US.
• European real exchange rate: price of 1Eur pair of shoes
price of1US pair of shoes
(same convention as nominal x.r.).

8
Real Exchange Rates

Definition (Real Exchage Rate)

The rate at which a person can trade the goods and services of one country for the goods
and services of another
Example:

• I can exchange a pair of shoes, produced in Italy against two pairs of equivalent
shoes produced in the US.
• European real exchange rate: price of 1Eur pair of shoes
price of1US pair of shoes
(same convention as nominal x.r.).
• In practice one compares the price of a consumption basket.

8
Real Exchange Rates

Definition (Real Exchage Rate)

The rate at which a person can trade the goods and services of one country for the goods
and services of another
Example:

• I can exchange a pair of shoes, produced in Italy against two pairs of equivalent
shoes produced in the US.
• European real exchange rate: price of 1Eur pair of shoes
price of1US pair of shoes
(same convention as nominal x.r.).
• In practice one compares the price of a consumption basket.

Relation with prices:

1
Real Exchange Rate = P.E.
P?

8
A first Theory of Exchange Rate
Determination: Purchasing Power
Parity
Purchasing Power Parity

Definition (purchasing power parity)

a theory of exchange rates whereby a unit of any given currency should be able to buy the same
quantity of goods in all countries

9
Purchasing Power Parity

Definition (purchasing power parity)

a theory of exchange rates whereby a unit of any given currency should be able to buy the same
quantity of goods in all countries

• example: one local shoe against one foreign shoe

9
Purchasing Power Parity

Definition (purchasing power parity)

a theory of exchange rates whereby a unit of any given currency should be able to buy the same
quantity of goods in all countries

• example: one local shoe against one foreign shoe

• implication:
P.E
Real Exchange Rate = 1 =
P?

9
Purchasing Power Parity

Definition (purchasing power parity)

a theory of exchange rates whereby a unit of any given currency should be able to buy the same
quantity of goods in all countries

• example: one local shoe against one foreign shoe

• implication:
P.E
Real Exchange Rate = 1 =
P?

• an increase in a foreign good P? will be reflected in a change in local prices P or the

exchange rate E will adjust

9
Purchasing Power Parity

Definition (purchasing power parity)

a theory of exchange rates whereby a unit of any given currency should be able to buy the same
quantity of goods in all countries

• example: one local shoe against one foreign shoe

• implication:
P.E
Real Exchange Rate = 1 =
P?

• an increase in a foreign good P? will be reflected in a change in local prices P or the

exchange rate E will adjust
• fluctuations in nominal exchange rates through speculation will be reflected in local
prices (pass-through)

9
Purchasing Power Parity

Definition (purchasing power parity)

a theory of exchange rates whereby a unit of any given currency should be able to buy the same
quantity of goods in all countries

• example: one local shoe against one foreign shoe

• implication:
P.E
Real Exchange Rate = 1 =
P?

• an increase in a foreign good P? will be reflected in a change in local prices P or the

exchange rate E will adjust
• fluctuations in nominal exchange rates through speculation will be reflected in local
prices (pass-through)
• within a common currency area zone, E = 1, prices must adjust

9
Basic Logic and Limitations

• Why would PPP be true?

10
Basic Logic and Limitations

• Why would PPP be true?

• if goods are cheaper in a foreign country, an importer will import them and sell
domestically

10
Basic Logic and Limitations

• Why would PPP be true?

• if goods are cheaper in a foreign country, an importer will import them and sell
domestically (tends to depreciate the exhange rate)

10
Basic Logic and Limitations

• Why would PPP be true?

• if goods are cheaper in a foreign country, an importer will import them and sell
domestically (tends to depreciate the exhange rate)
• until prices converge

10
Basic Logic and Limitations

• Why would PPP be true?

• if goods are cheaper in a foreign country, an importer will import them and sell
domestically (tends to depreciate the exhange rate)
• until prices converge
• Does it happen?
• cf Big Mac index:
Country Price Predicted x.r Actual x.r.
United States 3 dollars
Euro area 2.85 euros 0.95 euros / $ 0.76 euros / $
United Kingdom 1.88 pounds 0.63 euros / pds 0.75 euros / pds

10
Basic Logic and Limitations

• Why would PPP be true?

• if goods are cheaper in a foreign country, an importer will import them and sell
domestically (tends to depreciate the exhange rate)
• until prices converge
• Does it happen?
• cf Big Mac index:
Country Price Predicted x.r Actual x.r.
United States 3 dollars
Euro area 2.85 euros 0.95 euros / $ 0.76 euros / $
United Kingdom 1.88 pounds 0.63 euros / pds 0.75 euros / pds
• not really. . . and very bad for short term fluctuations

10
Basic Logic and Limitations

• Why would PPP be true?

• if goods are cheaper in a foreign country, an importer will import them and sell
domestically (tends to depreciate the exhange rate)
• until prices converge
• Does it happen?
• cf Big Mac index:
Country Price Predicted x.r Actual x.r.
United States 3 dollars
Euro area 2.85 euros 0.95 euros / $ 0.76 euros / $
United Kingdom 1.88 pounds 0.63 euros / pds 0.75 euros / pds
• not really. . . and very bad for short term fluctuations
• Why not?

10
Basic Logic and Limitations

• Why would PPP be true?

• if goods are cheaper in a foreign country, an importer will import them and sell
domestically (tends to depreciate the exhange rate)
• until prices converge
• Does it happen?
• cf Big Mac index:
Country Price Predicted x.r Actual x.r.
United States 3 dollars
Euro area 2.85 euros 0.95 euros / $ 0.76 euros / $
United Kingdom 1.88 pounds 0.63 euros / pds 0.75 euros / pds
• not really. . . and very bad for short term fluctuations
• Why not?
• non tradable goods

10
Basic Logic and Limitations

• Why would PPP be true?

• if goods are cheaper in a foreign country, an importer will import them and sell
domestically (tends to depreciate the exhange rate)
• until prices converge
• Does it happen?
• cf Big Mac index:
Country Price Predicted x.r Actual x.r.
United States 3 dollars
Euro area 2.85 euros 0.95 euros / $ 0.76 euros / $
United Kingdom 1.88 pounds 0.63 euros / pds 0.75 euros / pds
• not really. . . and very bad for short term fluctuations
• Why not?
• non tradable goods
• goods not perfect substitutes, differences in tastes

10
Basic Logic and Limitations

• Why would PPP be true?

• if goods are cheaper in a foreign country, an importer will import them and sell
domestically (tends to depreciate the exhange rate)
• until prices converge
• Does it happen?
• cf Big Mac index:
Country Price Predicted x.r Actual x.r.
United States 3 dollars
Euro area 2.85 euros 0.95 euros / $ 0.76 euros / $
United Kingdom 1.88 pounds 0.63 euros / pds 0.75 euros / pds
• not really. . . and very bad for short term fluctuations
• Why not?
• non tradable goods
• goods not perfect substitutes, differences in tastes
• distance, tariffs, quota
10
Takeaways

• Loanable Funds and Currency Exchange Markets

• Familiarize yourself with the justifications about why each line behaves in a
certain way
• Simple predictions of the model
• governement debt: increases interest rate, and appreciates exchange rate
• tariffs on imports: appreciates exchange rate but no effect on trade Balance
• capital flights: increase interest rates, but not enough to prevent capital
outflows

11