Topic 10 - Open Economy Macroeconomics - Basic Concepts

N. Gregory Mankiw & Mohamed H.
Rashwan
Principles of
Economics Arab World Edition
Chapter 32 – Open Economy

Macroeconomics: Basic
Concepts
To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3rd edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
Introduction
 An exchange rate is the rate at which one

currency is converted into another
 The foreign exchange market is a market for
converting the currency of one country into that
of another country
Definitions of Exchange Rates
 Exchange rate is the rate at which a person can trade
the currency of one country for the currency of another.
 The exchange rate is expressed in two ways:

 In units of domestic currency per one unit of the
foreign currency OR in units of foreign currency per
one unit of domestic currency
For a Saudi (3.75 SR = 1$) OR (0.27 $ = 1 SR)

For an American (1.22 $ = 1£) OR (0.82 £ = 1$)
3
To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3 edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
rd
Table :
Exchange
Rate
Quotations
4
rd
Depreciation and Appreciation
 Depreciation is a decrease in the value of a
currency relative to another currency.
 A depreciated currency is less valuable (less
expensive) and therefore can be exchanged for
(can buy) a smaller amount of foreign currency.
 $1/€ → $1.20/€ means that the dollar has
depreciated relative to the euro. It now takes $1.20
to buy one euro, so that the dollar is less valuable.
5
rd
 Appreciation is an increase in the value of a
currency relative to another currency.
 An appreciated currency is more valuable (more
expensive) and therefore can be exchanged for
(can buy) a larger amount of foreign currency.
 $1/€ → $0.90/€ means that the dollar has
appreciated relative to the euro. It now takes
only $0.90 to buy one euro, so that the dollar is
more valuable.
 The euro has depreciated relative to the dollar:
it is now less valuable.
6
rd
 A depreciated currency is less valuable, and therefore it
can buy fewer foreign produced goods that are
denominated in foreign currency.
 A depreciated currency means that imports are more
expensive and exports are less expensive.
(i.e. imports decreases and exports increases; current
account +ive)
7
rd
 An appreciated currency is more valuable, and therefore

it can buy more foreign produced goods that are
denominated in foreign currency.
 An appreciated currency means that imports are less
expensive and exports are more expensive.
(i.e. imports increases and exports decreases; current
account —ive)
8
rd
Open Economy Macroeconomics
 A closed economy does not interact with other
economies in the world.
 An open economy interacts freely with other economies
around the world.
9
rd
National Income Accounting for an Open
Economy
 The national income identity for an open
economy is
Y = C + I + G + EX – IM
= C + I + G + CA
Expenditure by domestic Net expenditure by foreign

individuals and institutions individuals and institutions
10
rd
THE INTERNATIONAL FLOWS OF GOODS AND
CAPITAL
 Exports:
domestically-produced goods and services sold
abroad.
 Imports:
foreign-produced goods and services sold
domestically.
 Net exports (NX), also known as trade balance
= value of exports – value of imports
11
rd
The Flow of Goods: Exports, Imports and Net
Exports
NX measures the imbalance in a country’s trade in
goods and services.
 Trade deficit:
an excess of imports over exports
 Trade surplus:
an excess of exports over imports
 Balanced trade:
when exports = imports
12
rd
ACTIVE LEARNING 1
Variables that affect net exports (NX)
What do you think would happen to

your country’s net exports if:
A. a country you trade with experiences a recession
(falling incomes, rising unemployment)?
B. consumers decide to be patriotic and
buy more domestic made products?
C. prices of goods produced in a country you trade
with rise faster than prices of goods produced at
home?
13
rd
ACTIVE LEARNING 1
Answers
A. A country you trade with experiences a recession

(falling incomes, rising unemployment)
Your country’s net exports would fall
due to a fall in the other country’s consumers’
purchases of your exports.
B. Consumers decide to be patriotic and
buy more domestic made products.
Your country’s net exports would rise
due to a fall in imports.
14
rd
ACTIVE LEARNING 1
Answers
C. Prices of goods produced in a country you trade

with rise faster than prices of goods produced at
home
This makes domestic goods more attractive
relative to the other country’s goods.
Exports to the other country increase,
imports from the other country decrease,
so your country’s net exports increase.
15
rd
The Flow of Goods: Exports, Imports and Net
Exports
 Variables that Influence Net Exports
 Consumers’ preferences for foreign and
domestic goods
 Incomes of consumers at home and abroad
 Prices of goods at home and abroad
 The exchange rates at which foreign currency
trades for domestic currency
 Transportation costs
 Government policies
16
rd
Economy
Y = C + I + G + CA
 when a country exports less than it imports, it earns less
income from exports than it spends on imports
 (net) foreign wealth is decreasing
 when a country exports more than it imports, it earns
more income from exports than it spends on imports
 (net) foreign wealth is increasing
17
rd
National Income Accounting for an Open Economy
 The national income identity for an open economy is

Y = C + I + G + EX – IM
= C + I + G + CA
 Since, S=Y–C–G
S = I + CA
S ‒ I = CA
18
rd
Economy
 Changes in current account are closely linked to the changes in

international borrowing
S – I = CA
S – I = EX – IM
 When a country exports more than it imports, it is selling more to
foreigners than it buys from them. This country finances the current
account deficit of its trading partners by lending to them. Therefore,
a country’s current account balance equals the change in its (net)
foreign wealth.
 When a country imports more than it exports, it is buying more from

foreigners than it sells to them, and must somehow finance this
current account deficit by borrowing from foreigners.
19
rd
Figure: The U.S. Current Account
and Net International Investment Position, 1976–
2012
20
rd
What would a U.S.-China trade war look like? | CNBC
Explains

https://www.youtube.com/watch?v=gZFINBUxf6Y
21
rd
Balance of Payments (BOP) Accounts
 A country’s balance of payments accounts (BOP) records its

payments to and its receipts from foreigners.
 Any transaction resulting in a receipt from foreigners is entered in
the balance of payments accounts as a credit. Any transaction
resulting in a payment to foreigners is entered as a debit.
 Every international transaction automatically enters the balance
of payments twice, once as a credit (+) and once as a debit (–).
This principle of BOP accounting holds true because every
transaction has two sides: if you buy (debit) something from a
foreigner, you must pay him (credit) in some way (i.e. double-
entry bookkeeping).
22
rd
Balance of Payments
 Any transaction that results in a receipt from
foreigners will be recorded as a credit with a
positive sign.
 Any transaction that gives rise to a payment to

foreigners will be recorded as a debit, with a
negative sign.
23
rd
Balance of Payment and Currency Relation
 If the US imports more than exports, the supply

of dollars will exceed demands of dollars.
 US dollar will depreciate against other
currencies.
 Credit entries: Rise to the demand of dollar

 Debit entries: Rise to the supply of dollars
24
rd
Balance of Payments Accounts (cont.)
 The balance of payments accounts are separated into three broad
accounts: current account, financial account and capital account
 Current account: accounts for international flows of goods and
services (imports and exports).
1. merchandise (goods like DVDs)
2. services (payments for legal services, shipping services,
tourist meals, etc.)
3. factor income and net unilateral transfers (interest and
dividend receipts and payments, earnings of firms and
workers (i.e. remittances) operating in foreign countries)
 When a French consumer imports American jeans, the transaction
enters the US balance of payments accounts as a credit on the
current account.
25
rd
Current Account
 Merchandise Trade: Exports and imports of tangible
goods such as oil, wheat, clothes
 Services: Payments and receipts for legal, consulting
and engineering services, shipping fees and tourist
expenditure
 Factor Income: Payments and receipts of interest,
dividends, and other income on foreign investments that
were previously made
 Unilateral Transfers: Remittances; foreign aid, official
and private grants and gifts
26
rd
Financial account records international purchases and sales of
financial assets (financial capital).
 It includes an asset in any one of the forms in which

wealth can be held, such as money, stocks, bonds and
factories (i.e. Portfolio investment and Direct
investment)
 Financial account is the difference between sales of
domestic assets to foreigners and purchases of foreign
assets by domestic citizens.
 When an American company buys a French factory, the
transaction enters the US balance of payments as a
debit in the financial account.
27
rd
Financial Account
 Trades in financial assets affect future payments and receipts of
factor income.
Foreign Direct Investment:
 A foreign direct investment (FDI) is an investment made by a
firm or individual in one country into business interests
located in another country. Generally, FDI takes place when
an investor establishes foreign business operations or
acquires foreign business assets in a foreign company.
 Honda - A Japanese automobile manufacturer, built an assembly
factory in Ohio
 Coca Cola built bottling factories all over the world
28
rd 3-
28
Financial Account
 Trades in financial assets affect future payments and receipts of
factor income.
Foreign Portfolio Investment:
 Sales and purchases of foreign financial assets such as stocks,
and bonds.
 International portfolio investments have boomed in recent years,
partly due to the general relaxation of capital controls and
regulations in many countries and investor’s desire to diversify risk.
29
rd 3-
29
Financial Account
Foreign Portfolio Investment:
Sovereign Wealth Fund (SWF) or sovereign investment fund is a
state-owned investment fund that invests in real and financial assets
such as stocks, bonds, real estate, precious metals. Most SWFs are
funded by revenues from foreign exchange reserves of these
countries swelled by trade surpluses and oil revenues.
 According to the Sovereign Wealth Fund (SWF) Institute, GCC-based
SWFs have a total of $2.6 trillion (Dh9.54 trillion) in assets — about
37 per cent of total SWF assets worldwide in 2015.
 Close to 80 per cent of SWF assets in GCC states are accounted for
by three major players — the Abu Dhabi Investment Authority (ADIA)
with $773 billion, foreign holdings at the Saudi Arabia Monetary
Authority (SAMA) at $757 billion and the Kuwait Investment Authority
with $548 billion. By assets, ADIA and SAMA are the second and
third largest SWFs globally. 30
Financial Account
Other Investments:
 Transactions in currency, bank deposits, trade credits and so
forth.
 These transactions are quite sensitive to the relative interest
rates between countries and anticipated change in the
exchange rate.
31
rd
Capital account includes flows of special categories of assets

(capital): these flows result from nonmarket activities or
represent the acquisition or disposal of nonproduced,
nonfinancial and possibly intangible assets like debt
forgiveness, patents, copyrights and trademarks.
 Patents, trademarks and copyrights are collectively known
as intellectual property. Patent is the granting of a property
right by a sovereign authority to an inventor, such as
processes, methods, and compositions of matter. Copyright is
geared toward literary and artistic works, such as artwork,
books, videos and songs. A trademark protects items that help
define a company brand, such as its brand names, slogans,
and logos.
32
rd
How Do the Balance of Payments Accounts
Balance?
 Due to the double entry of each transaction, the balance

of payments accounts will balance by the following
equation:
current account +
financial account +
capital account = 0
33
rd
 Statistical Discrepancy (Errors and Omissions)

 Data from a transaction may come from different sources that
differ in coverage, accuracy, and timing.
 The balance of payments accounts therefore seldom balance in
practice.
 The statistical discrepancy is the account added to or subtracted
from the financial account to make it balance with the current
account and capital account.
34
rd
Example of Balance of
Payments Accounting
 You import a fax machine from Olivetti (Italian
company).
 Olivetti deposits your check in a U.S. bank.
Fax machine (debit in current account, U.S. good import)

–$80
Bank deposit (credit in financial account, U.S. asset sale)

+$80
Example of Balance of
Payments Accounting (cont.)
 You buy lunch in France and pay by credit card.
 French restaurant receives payment from your credit
card company.
Meal purchase (debit in current account, U.S. service

import)
–$30
Sale of credit card claim (credit in financial account, U.S. asset
sale)
+$30
Example of Balance of Payments Accounting
(cont.)
 You buy a share of BP (British Petroleum company).

 BP deposits the money in a U.S. bank.
Stock purchase (debit in financial account, U.S. asset

purchase)
–$90
Bank deposit (credit in financial account, U.S. asset sale)

+$90
37
rd
U.S. Balance of
Payments
Accounts for
2012 (billions
of dollars)
38
rd

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N. Gregory Mankiw & Mohamed H.

Chapter 32 – Open Economy

 An exchange rate is the rate at which one

 The exchange rate is expressed in two ways:

For a Saudi (3.75 SR = 1$) OR (0.27 $ = 1 SR)

 An appreciated currency is more valuable, and therefore

Expenditure by domestic Net expenditure by foreign

= value of exports – value of imports

What do you think would happen to

A. A country you trade with experiences a recession

C. Prices of goods produced in a country you trade

 The national income identity for an open economy is

 Changes in current account are closely linked to the changes in

 When a country imports more than it exports, it is buying more from

 A country’s balance of payments accounts (BOP) records its

 Any transaction that gives rise to a payment to

 If the US imports more than exports, the supply

 Credit entries: Rise to the demand of dollar

 It includes an asset in any one of the forms in which

Capital account includes flows of special categories of assets

 Due to the double entry of each transaction, the balance

 Statistical Discrepancy (Errors and Omissions)

Fax machine (debit in current account, U.S. good import)

Bank deposit (credit in financial account, U.S. asset sale)

Meal purchase (debit in current account, U.S. service

 You buy a share of BP (British Petroleum company).

Stock purchase (debit in financial account, U.S. asset

Bank deposit (credit in financial account, U.S. asset sale)

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