Chapter 31 Open-Economy Macroeconomics: Basic Concepts

Nguyen Thi Thuy VINH

Open-Economy Macroeconomics:
Basic Concepts

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Chapter 31-Open-Economy Macroeconomics: Basic Concepts

In this chapter,
look for the answers to these questions:

• How are international flows of goods and assets

related?
• What’s the difference between the real and nominal
exchange rate?
• What is “purchasing-power parity,” and how does it
explain nominal exchange rates?

Open vs. 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.
 An open economy is one that interacts freely with other
economies around the world.
• It buys and sells goods and services in world product
markets.
• It buys and sells capital assets in world financial
markets
=> Over the past decades, international trade and
finance have become increasingly important.
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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

Why trade?
 Countries that trade (open economies, e.g., most Asian
countries) produce more output and have higher incomes
than countries that do not trade (closed economies , e.g.,
most Arab countries)
 Trade → specialization → growth
• Trade is a win-win.
• World output and global living standards are
higher with open economies

I. The International Flow of Goods and Capital

1. The flow of goods & services
• Exports are goods and services that are produced
domestically and sold abroad.
• Imports are goods and services that are produced
abroad and sold domestically.
• Net exports (NX) = value of exports - value of
imports.
Net exports are also called the trade balance.

-Trade deficit: Imports > Exports

net exports (NX) are negative

-Trade surplus: Exports > Imports

net exports (NX) are positive

- Balanced trade: Exports = Imports

net exports are zero.

Globally, trade deficits in some countries must equal

trade surpluses in other countries

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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

NOW YOU TRY:

Variables that affect NX

What do you think would happen to

Vietnam net exports if:
A. U.S. experiences a recession
(falling incomes, rising unemployment)
B. Vietnamese consumers decide to be patriotic and
buy more products “Made in Vietnam”
C. Prices of goods produced in China rise faster than
prices of goods produced in Vietnam

NOW YOU TRY:

Answers

A. U.S. experiences a recession

(falling incomes, rising unemployment)
Vietnam net exports would fall
due to a fall in U.S. consumers’ purchases of
Vietnam exports

B. Vietnamese consumers decide to be patriotic and

buy more products “Made in Vietnam.”
Vietnam net exports would rise
due to a fall in imports
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NOW YOU TRY:

Answers

C. Prices of goods produced in China rise faster than

prices of goods produced in Vietnam
This makes Vietnam’s goods more attractive relative
to China’s goods.
Exports to China increase,
imports from China decrease,
so Vietnam net exports increase.

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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

Variables that affect Net exports

 The tastes of consumers for domestic and foreign
goods.
 The prices of goods at home and abroad.
 The exchange rates at which foreign currency
trades for domestic currency.
 The incomes of consumers at home and abroad.
 The costs of transporting goods from country to
country.
 The policies of the government toward
international trade.
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I. The International Flow of Goods and Capital

2. The Flow of Capital
• Net capital outflow (NCO):
domestic residents’ purchases of foreign assets
minus
foreigners’ purchases of domestic assets
• NCO is also called net foreign investment.
- U.S. resident buys stock in Hong Kong (SEHK)
=> raises NCO of U.S.
- Japanese residents buys a bond issued by the U.S.
government
=> reduces NCO of U.S.
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2. The Flow of Capital

The flow of capital abroad takes two forms:

– Foreign direct investment:
Domestic residents actively manage the foreign
investment, e.g., KFC opens a fast-food outlet in
Hanoi.
– Foreign portfolio investment:
Domestic residents purchase foreign stocks or bonds,
supplying “loanable funds” to a foreign firm.

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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

2. The Flow of Capital

NCO measures the imbalance in a country’s trade in

assets:
– When NCO > 0, “capital outflow”
Domestic purchases of foreign assets exceed foreign
purchases of domestic assets.
– When NCO < 0, “capital inflow”
Foreign purchases of domestic assets exceed domestic
purchases of foreign assets.

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Variables that Influence NCO

• Real interest rates paid on foreign assets

• Real interest rates paid on domestic assets
• Perceived risks of holding foreign assets
• Government policies affecting foreign ownership of
domestic assets

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3. The Equality of NX and NCO

• An accounting identity: NCO = NX

– arises because every transaction that affects NX also
affects NCO by the same amount
(and vice versa)

• When a foreigner purchases a good from the VN

– VN exports and NX increase
– the foreigner pays with currency or assets,
so the VN acquires some foreign assets,
causing NCO to rise.

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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

 Identity in Open Economy

Y = C + I + G + NX (accounting identity)
Y – C – G = I + NX (rearranging terms)
S = I + NX (since S = Y – C – G)
S = I + NCO (since NX = NCO)
• When S > I, the excess loanable funds flow abroad in
the form of positive net capital outflow.
• When S < I, foreigners are financing some of the
country’s investment, and NCO < 0.

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Case Study: The U.S. Trade Deficit

• Recall, NX = S – I = NCO.
A trade deficit means I > S,
so the nation borrows the difference from foreigners.
• In 2007, foreign purchases of U.S. assets exceeded
U.S. purchases of foreign assets by $775 million.

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Case Study: The U.S. Trade Deficit

Why U.S. saving has been less than investment:

– In the 1980s and early 2000s,
huge budget deficits and low private saving
depressed national saving.
– In the 1990s,
national saving increased as the economy grew, but
domestic investment increased even faster due to the
information technology boom.

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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

Case Study: The U.S. Trade Deficit

• Is the U.S. trade deficit a problem?

– The extra capital stock from the ’90s investment
boom may well yield large returns.
– The fall in saving of the ’80s and ’00s, while not
desirable, at least did not depress domestic
investment, as firms could borrow from abroad.
• A country, like a person, can go into debt for good
reasons or bad ones.
A trade deficit is not necessarily a problem, but might
be a symptom of a problem.
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Case Study: The U.S. Trade Deficit

as of 12-31-2007
People abroad owned $20.1 trillion in U.S. assets.
U.S. residents owned $17.6 trillion in foreign assets.
U.S.’ net indebtedness to other countries = $2.5 trillion.
Higher than every other country’s net indebtedness.
So, U.S. is “the world’s biggest debtor nation.”
• So far, the U.S. earns higher interest rates on foreign
assets than it pays on its debts to foreigners.
• But if U.S. debt continues to grow, foreigners may
demand higher interest rates, and servicing the debt
would become a drain on U.S. income.
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ACTIVE LEARN I N G 3
Review questions
Which of the following statements about a country with a
trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving
D. Y < C + I + G

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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

II. The prices for international transactions:

Real and Nominal exchange rate
• International transactions are influenced by
international prices.
• The two most important international prices are the
nominal exchange rate and the real exchange rate.

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1. Nominal Exchange Rates

• The nominal exchange rate is the rate at which

one country’s currency trades for another
• The nominal exchange rate is expressed in two ways:
- In units of foreign currency per one domestic
currency.
One USD trades for 20,000 VND
- And in units of domestic currency per one unit of
the foreign currency
One VND trades for 1/20,000 USD

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1. Nominal Exchange Rates

• Depreciation (or “weakening”)

refers to a decrease in the value of a currency as measured
by the amount of foreign currency it can buy.

• Appreciation (or “strengthening”)

refers to an increase in the value of a currency as measured
by the amount of foreign currency it can buy.

If one unit of VND buys less foreign currency there is a

depreciation of VND.
If it buys more, there is an appreciation of VND.
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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

1. Nominal Exchange Rates

• Devaluation is the deliberate downward adjustment of

the official exchange rate, normally by official
announcement of the central bank of the respective
country
Depreciation is a fall in the value of a currency due to supply
and demand side factors

• Revaluation is an upward change in the currency's value.

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II. The prices for international transactions

2. 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.
• The real exchange rate compares the prices of
domestic goods and foreign goods in the domestic
economy.

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2. The real exchange rate

ε = real exchange rate,

the relative price of
the lowercase domestic goods
Greek letter in terms of foreign goods
epsilon
(e.g. U.S. Big Mac per VN Big
Mac)

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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

~ McZample ~
 one good: Big Mac
 price in Vietnam:
P = 60 000 VND
 price in USA:
P * = $4.79
 nominal exchange rate
e = 1/22 400 ($ per VND) To buy a VN Big Mac,
someone from U.S.
ε= (e x 60 000)/4.79 would have to pay an
= 0.56 amount that could buy
0.56 U.S. Big Macs.

2. The real exchange rate

exP ($ per VND)*(VND per unit VN goods)

ε = =
P* $ per unit U.S. goods
$ per unit VN goods
=
$ per unit U.S. goods

units U.S. goods

=
per unit Vietnamese goods

The Real Exchange Rate With Many Goods

P = VN price level, e.g., Consumer Price Index,
measures the price of a basket of goods
P* = foreign price level
Real exchange rate
= (e x P)/P*
= price of a domestic basket of goods relative to
price of a foreign basket of goods
• If VN real exchange rate appreciates,
VN goods become more expensive relative to foreign
goods.

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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

2. Real Exchange Rates

• The real exchange rate is a key determinant of how

much a country exports and imports.
• A depreciation (fall) in the VN real exchange rate
means that VN goods have become cheaper relative
to foreign goods.
 This encourages consumers both at home and abroad
to buy more VN goods and fewer goods from other
countries.
 As a result, VN exports rise, and VN imports fall, and
both of these changes raise VN net exports.
• Conversely, …….
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3. A first theory of exchange rate determinant:

Purchasing-power parity (PPP)
 Basic logic
• Purchasing-power parity is 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.
• Implies that nominal exchange rates adjust to equalize
the price of a basket of goods across countries

The theory of purchasing-power parity is based on a

principle called the law of one price.
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• Law of one price: a good must sell for the same price
in all markets.
– Suppose coffee sells for $10/kg in Tay Nguyen and
$12/kg in HCMC, and can be costlessly transported.
– There is an opportunity for arbitrage,
making a quick profit by buying coffee in Tay
Nguyen and selling it in HCMC.
– Such arbitrage drives up the price in Tay Nguyen
and drives down the price in HCMC, until the two
prices are equal.

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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

• Example: The “basket” contains a Big Mac.

P = price of VN Big Mac (in VND)
P* = price of US Big Mac (in $)
e = exchange rate, $ per VND
• According to PPP, e x P = P*

price of VN price of US Big

Big Mac, in $ Mac, in $

P*
 Solve for e: e =
P
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 Implications of PPP
• PPP implies that the nominal
exchange rate between two countries P*
e =
should equal the ratio of price levels. P
• If the two countries have different inflation rates, then
e will change over time:
– If inflation is higher in the VN than in US, then P
rises faster than P*, so e falls –
the VND depreciates against the dollar.
– If inflation is higher in China than in the VN, then
P* rises faster than P, so e rises –
the VND appreciates against the CNY.
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 Implications of PPP

• The nominal exchange rate between the currencies of

two countries must reflect the different price levels in
those countries.
• When the central bank prints large quantities of
money, the money loses value both in terms of the
goods and services it can buy and in terms of the
amount of other currencies it can buy.

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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

Money, Prices, and the Nominal Exchange Rate During

the German Hyperinflation
Indexes
(Jan. 1921 5 100)

1,000,000,000,000,000

Money supply
10,000,000,000

Price level
100,000

Exchange rate
.00001

.0000000001
1921 1922 1923 1924 1925 37
Copyright © 2004 South-Western

 Limitations of PPP Theory

Two reasons why exchange rates do not always adjust to
equalize prices across countries:
• Many goods cannot easily be traded
E.g: haircuts, going to the movies
 Price differences on such goods cannot be
arbitraged away
• Foreign, domestic goods not perfect substitutes
E.g., some U.S. consumers prefer Toyotas over
Fords, or vice versa
 Price differences reflect taste differences
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 Limitations of PPP Theory

• Nonetheless, PPP works well in many cases,

especially as an explanation of long-run trends.
• For example, PPP implies:
the greater a country’s inflation rate,
the faster its currency should depreciate
(relative to a low-inflation country like the US).
• The data support this prediction…

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Chapter 31 Open-Economy Macroeconomics: Basic Concepts

Inflation & Depreciation in a Cross-Section

of 31 Countries
10,000.0
Ukraine
1,000.0
Avg annual Romania
Brazil
depreciation 100.0 Argentina
relative to
10.0 Mexico
US dollar
Canada
1993-2003
1.0 Kenya
(log scale)
Japan
0.1
0.1 1.0 10.0 100.0 1,000.0
Avg annual CPI inflation
1993-2003 (log scale) 40

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