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Open-Economy Macroeconomics: Basic Concepts

Closed Vs. Open Economies


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.

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

THE INTERNATIONAL FLOW OF GOODS AND CAPITAL


An Open Economy
The United States is a very large and open economyit imports and exports huge quantities of goods and services. Over the past four decades, international trade and finance have become increasingly important.

The Flow of Goods: Exports, Imports, Net Exports


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) are the value of a nations exports minus the value of its imports. Net exports are also called the trade balance.

A trade deficit is a situation in which net exports (NX) are negative.


Imports > Exports

A trade surplus is a situation in which net exports (NX) are positive.


Exports > Imports

Balanced trade refers to when net exports are zeroexports and imports are exactly equal.

Determinants of Net Exports


Factors 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 people can use domestic currency to buy foreign currencies. 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.

Figure 1 The Internationalization of the U.S. Economy


Percent of GDP

15

Imports 10 Exports

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Copyright 2004 South-Western

The Flow of Financial Resources: Net Capital Outflow


Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
When a U.S. resident buys stock in Telmex, the Mexican phone company, the purchase raises U.S. net capital outflow. When a Japanese residents buys a bond issued by the U.S. government, the purchase reduces the U.S. net capital outflow.

Determinants of Net Capital Outflow


Variables that Influence Net Capital Outflow
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.

Monetary Economy Revisited Again: Net Exports = Net Capital Flow


For an economy as a whole, net exports (NX) and net capital outflow (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. Example: If Boeing exports a plane to Japan, NX rises, but, in the simplest case Boeing obtains yen, which increase NCO. In the more complex case, the Japanese company may purchase dollars, but someone with dollars is ending up with yen. If the Japanese buyers get a loan from Boeing, Boeing has acquired a foreign financial asset.

Saving, Investment, and Their Relationship to the International Flows


Net exports (NX) is a component of GDP: Y = C + I + G + NX, or Y - C - G = I + NX National saving (S) is the income of the nation that is left after paying for current consumption and government purchases or S=YC-G

Therefore,
S = I + NX Lastly since NX is equal to NCO, S = I + NCO National Saving can be saved in two ways, through domestic investment of in foreign assets. Remember, S underlies the supply of loanable funds and I, and now NCO, underlies the demand for loanable funds.

Table 1 International Flows of Goods and Capital: Summary

Copyright2004 South-Western

S, I and Net Capital Outflow


Note in the succeeding panels that S I = NCO. Until the 1980s, NCO and hence the trade deficit was small. After 1980, we have had a recurring trade deficit (NCO is negative the ROW is holding US financial assets. Is the recurring deficit a problem?
1980-1987 NCO went from -.5% to 3.0% of GDP, 2.1% came from a drop in S (the Reagan budget deficits). Therefore, the trade deficit helped sustain I. If not, I would have fallen affecting future growth. 1991-2000 NCO went from -.3% to 3.7% attributable not to a decline in savings (which increased) but to increases in investment (primarily in the info. Tech sector). The NCO helped fuel the investment boom. Whether because S fell or I rose, NCO can help to sustain I and therefore future growth, BUT we must grow to help pay off the debt. In many developing countries, this has NOT occurred leading to higher interest payments.

Figure 2 National Saving, Domestic Investment, and Net Capital Outflow


(a) National Saving and Domestic Investment (as a percentage of GDP) Percent of GDP 20 Domestic investment 18

16

14

12

National saving

10 1960

1965

1970

1975

1980

1985

1990

1995

2000

Copyright 2004 South-Western

Figure 2 National Saving, Domestic Investment, and Net Capital Outflow


(b) Net Capital Outflow (as a percentage of GDP) Percent of GDP 4

3 2
1 Net capital outflow

0 1 2 3
4 1960

1965

1970

1975

1980

1985

1990

1995

2000

Copyright 2004 South-Western

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES International transactions are influenced by international prices. The two most important international prices are the nominal exchange rate and the real exchange rate.

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. 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.

http://www.xe.com/ucc/ a internet based currency converter (cant be used on tests!)

Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one dollar.
One U.S. dollar trades for 113 yen (10/24/2007). One yen trades for 1/113 (= 0.00885) of a dollar.

Appreciation refers to an increase in the value of a currency as measured by the amount of foreign currency it can buy.
If a dollar buys more foreign currency, there is an appreciation of the dollar. (say 120 yen)

Depreciation refers to a decrease in the value of a currency as measured by the amount of foreign currency it can buy.
If it buys less there is a depreciation of the dollar (say 80 yen).

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. Trading depends on the physical quantities that can be exchanged at given exchange rates AND the prices of the good in each country Example, a Honda in Japan costs 4,000,000 yen and $20,000 in the US. Assuming an exchange rate of 100 yen/dollar, the Honda costs Y2,000,000 in the US. Thus, Hondas are as expensive in the US OR two times more expensive in Japan.

Real Exchange Rates


The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies.
Real Exchange Rate = Exchange Rate x PUS PROW Example above EP/P*= 100 yen/dollar x $20,000 Y4,000,000 = HondaJAPAN/1 HondaUS

The real exchange rate is a key determinant of how much a country exports and imports. Real Exchange Rate = Exchange Rate x PUS
PROW

A depreciation (fall) in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods and so net exports rise.
Encourages consumers both at home and abroad to buy more U.S. goods and fewer goods from other countries.As a result, U.S. exports rise, and U.S. imports fall, and both of these changes raise U.S. net exports.

An appreciation in the U.S. real exchange rate means that U.S. goods have become more expensive compared to foreign goods, so U.S. net exports fall.
Discourages consumers both at home and abroad to from buying U.S. goods and encourages buying more goods from other countries. As a result, U.S. exports fall, and U.S. imports rise, and both of these changes decrease U.S. net exports.

A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING-POWER PARITY The purchasing-power parity theory is the simplest and most widely accepted theory explaining the variation of exchange rates and posits that a unit of any given currency should be able to buy the same quantity of goods in all countries 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 countries.

If the law of one price were not true, unexploited profit opportunities would exist and arbitrage would occur (arbitrage is a fancy term for trading or buying low and selling high).. If arbitrage occurs, eventually prices that differed in two markets would necessarily converge, and exchange rates move to ensure that a currency would have the same purchasing power in all countries.

Implications of Purchasing-Power Parity


If the purchasing power of the dollar is always the same at home and abroad, then the exchange rate would be constant. The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries and the real exchange rate would be equal to 1. Therefore, if a central bank prints large quantities of money, the price level rises (QTofM) and its value in buying goods and services and other currencies falls.

Figure 3 Money, Prices, and the Nominal Exchange Rate During the German Hyperinflation
Indexes (Jan. 1921 5 100)

1,000,000,000,000,000

10,000,000,000 Price level 100,000

Money supply

.00001

Exchange rate

.0000000001 1921 1922 1923 1924 1925


Copyright 2004 South-Western

Limitations of Purchasing-Power Parity


The Big Mac Index
http://www.economist.com/displaystory.cfm?story_id=1730909 New Index Starbucks http://www.economist.com/displaystory.cfm?story_id=2361072

Why dont real exchange rates always equal one?


Many goods are not easily traded or shipped from one country to another. Tradable goods are not always perfect substitutes when they are produced in different countries.

Summary
Net exports are the value of domestic goods and services sold abroad minus the value of foreign goods and services sold domestically. Net capital outflow is the acquisition of foreign assets by domestic residents minus the acquisition of domestic assets by foreigners.

Summary
An economys net capital outflow always equals its net exports. An economys saving can be used to either finance investment at home or to buy assets abroad.

Summary
The nominal exchange rate is the relative price of the currency of two countries. The real exchange rate is the relative price of the goods and services of two countries.

Summary
When the nominal exchange rate changes so that each dollar buys more foreign currency, the dollar is said to appreciate or strengthen. When the nominal exchange rate changes so that each dollar buys less foreign currency, the dollar is said to depreciate or weaken.

Summary
According to the theory of purchasingpower parity, a unit of currency should buy the same quantity of goods in all countries. The nominal exchange rate between the currencies of two countries should reflect the countries price levels in those countries.