Ch. 31-Open Economy Macroeconomics

Open-Economy Macroeconomics: Basic
Concepts
ECO110 MACROECONOMICS
MONSOON SEMESTER 2021
This is an open access resource distributed under the terms and conditions of the Creative Commons Attribution license
Basic Concepts
Closed economy
 Economy that does not interact with other economies in the world
Open economy
 Economy that interacts freely with other economies around the world
International Flow of Goods
Factors that influence a country’s exports, imports,

and net exports:
 Tastes of consumers for domestic & foreign goods
 Prices of goods at home and abroad
 Exchange rates
 People use domestic currency to buy foreign currencies
 Incomes of consumers at home and abroad
 Cost of transporting goods from country to country
 Government policies toward international trade
The increasing openness of the U.S. economy
Increasing importance of international trade and

finance
 1950s, imports and exports: 4-5% of GDP
 Recent years:
 Exports – increased more than twice
 Imports – increased more than three times
The increasing openness of the U.S. economy
Increase in international trade

 Improvements in transportation
 Advances in telecommunications
 Technological progress
 Government’s trade policies
 NAFTA
 GATT
Net Capital Flows and Net Exports for India
https://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/GSNSENYU240C656D860B464E9F41B7C4E53D707B.PDF (Viral
Acharya speech, Dec 2017)
https://www.bis.org/review/r150522e.htm Is India ready for full capital account convertibility?, Padmanabhan, May
2015
https://www.bis.org/publ/bppdf/bispap44m.pdf Capital Flows to India, Mohan, Jan 2009
https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=50436 Developments in India’s BoP (first quarter,
April- June 2020-21), Press Release, RBI, 30 Sep 2020
https://m.rbi.org.in/Scripts/Pr_DataRelease.aspx?SectionID=352&DateFilter=Year RBI Press Releases
https://economictimes.indiatimes.com/topic/Net-capital-outflow
https://tradingeconomics.com/india/capital-flows
https://wits.worldbank.org/CountryProfile/en/Country/IND/Year/LTST/TradeFlow/EXPIMP Exports and Imports

https://dbie.rbi.org.in/DBIE/dbie.rbi?site=home Daily Exchange Rate Regime INR, RBI
https://www.livemint.com/news/india/india-s-virus-woes-hit-imports-more-than-its-exports-11599405788781.html
https://
economictimes.indiatimes.com/news/economy/agriculture/basmati-rice-exporters-from-india-are-renegotiating-with
-importers-from-australia-canada-the-us-and-western-europe/articleshow/78554733.cms
Net Capital Flows and Net Exports for India
https://oec.world/en/profile/country/ind
Govt. of India websites
https://commerce-app.gov.in/eidb/
https://www.indiantradeportal.in/
Papers/Publications
https://link.springer.com/chapter/10.1007/978-81-322-2840-0_10
https://www.sciencedirect.com/science/article/abs/pii/S0939362510000361
https://m.rbi.org.in/Scripts/BS_ViewBulletin.aspx?Id=17994 RBI
Press Release, 10 Jan 2019
The Internationalization of the U.S. Economy
This figure shows exports and imports of the U.S. economy as a percentage of U.S. gross
domestic product since 1950. The substantial increases over time show the increasing
importance of international trade and finance.
The Internationalization of the Indian Economy
Saradhi and Goel (2014), International Journal of Applied Management and Technology
International Flow of Capital
Net capital outflow

 Purchase of foreign assets by domestic residents
 Foreign direct investment
 Foreign portfolio investment
 Minus the purchase of domestic assets by foreigners
Variables that influence net capital outflow

 Real interest rates paid on foreign assets
 Real interest rates paid on domestic assets
 Perceived economic and political risks of holding assets abroad
 Government policies that affect foreign ownership of domestic
assets
Net Exports=Net Capital Outflow
Net exports (NX)

 Imbalance between a country’s exports and its imports
Net capital outflow (NCO)
 Imbalance between
 Amount of foreign assets bought by domestic residents
 And the amount of domestic assets bought by foreigners
Identity: NCO = NX
When NX > 0 (trade surplus)

 Selling more goods and services to foreigners
 Than it is buying from them
 From net sale of goods and services
 Receives foreign currency
 Buy foreign assets
 Capital - flowing out of the country: NCO > 0
When NX < 0 (trade deficit)

 Buying more goods and services from foreigners
 Than it is selling to them
 The net purchase of goods and services
 Needs financed
 Selling assets abroad
 Capital - flowing into the country: NCO < 0
Saving and Investment
Open economy: Y = C + I + G + NX
National saving: S = Y – C – G
• Y – C – G = I + NX
• S = I + NX
NX = NCO
• S = I + NCO
• Saving = Domestic investment + Net capital outflow
International Flows
Trade surplus: Exports > Imports

• Net exports > 0
• Y > Domestic spending (C+I+G)
• S>I
• NCO > 0
Trade deficit: Exports < Imports

• Net exports < 0
• Y < Domestic spending (C+I+G)
• S<I
• NCO < 0
International Flows
Balanced trade : Exports = Imports

• Net exports = 0
• Y = Domestic spending (C+I+G)
• S=I
• NCO = 0
International Flows of Goods and Capital: Summary
This table shows the three possible outcomes for an open economy.
National Saving, Domestic Investment, and Net Capital Outflow
Panel (a) shows national saving and domestic investment as a percentage of GDP. You can see
from the figure that national saving has been lower since 1980 than it was before 1980. This fall in
national saving has been reflected primarily in reduced net capital outflow rather than in reduced
domestic investment.
National Saving, Domestic Investment, and Net Capital Outflow
Panel (b) shows net capital outflow as a percentage of GDP. You can see from the figure that
national saving has been lower since 1980 than it was before 1980. This fall in national saving
has been reflected primarily in reduced net capital outflow rather than in reduced domestic
investment.
Is the U.S. trade deficit a national problem?
Trade deficit induced by a fall in saving

 The nation is putting away less of its income to provide for its
future
 No reason to deplore the resulting trade deficits
 Better to have foreigners invest in the U.S. economy than no one
at all
Is the U.S. trade deficit a national problem?
Trade deficit induced by an investment boom

 Economy is borrowing from abroad to finance the purchase of
new capital goods
 For good return on investment - the economy should be able to
handle the debts that are being accumulated
 For lower return on investment - debts will look less desirable
Real & Nominal Exchange Rates
Nominal exchange rate

 Rate at which a person can trade currency of one country for currency of another
Appreciation (strengthen)
 Increase in the value of a currency
 As measured by the amount of foreign currency it can buy
 Buy more foreign currency
Depreciation (weaken)
 Decrease in the value of a currency
 As measured by the amount of foreign currency it can buy
 Buy less foreign currency
Real exchange rate

 Rate at which a person can trade goods and services of one country
 For goods and services of another
Real exchange rate 

Nominal exchange rate  Domestic price

Foreign price
Real exchange rate = (e ˣ P) / P*

• Using price indexes
• e – nominal exchange rate between the U.S. dollar and foreign currencies (value of 1
unit of the domestic currency)
• P – price index for U.S. basket
• P* – price index for foreign basket
• Ex. Price of a men’s haircut

• USA = $10, India = Rs. 100, e = Rs. 70/US $
• Real exchange rate =
• So one unit of the foreign good is worth 7 units of the domestic good
Real Exchange Rate

• MEX = 50 Pesos, India = Rs. 100, e = Rs. 3.6/MEX Peso
• So one unit of the foreign good is worth 1.8 units of the domestic good or 5 units of the
foreign good is worth 9 units of the domestic good
• KOR = 14,130 Won, India = Rs. 100, e = 16.39 Won/Rupee
• So one unit of the foreign good is worth 8.62 units of the domestic good
• Where is the price of a haircut the cheapest in comparison to India?
Depreciation (fall) in the U.S. real exchange rate

 U.S. goods - cheaper relative to foreign goods
 Consumers at home and abroad - buy more U.S. goods and fewer goods from other
countries
 Higher exports
 Lower imports
 Higher net exports
An appreciation (rise) in the U.S. real exchange rate

 U.S. goods - more expensive compared to foreign goods
 Consumers at home and abroad - buy fewer U.S. goods and more goods from other
countries
 Lower exports
 Higher imports
 Lower net exports
Purchasing-Power Parity
Purchasing-power parity, PPP

 Theory of exchange rates
 A unit of any given currency
 Should be able to buy the same quantity of goods in all countries
Basic logic of purchasing-power parity
 Based on law of one price
 A good must sell for the same price in all locations
Purchasing-Power Parity
Arbitrage
 Take advantage of price differences for the same item in different markets
Parity
 Equality
Purchasing-power
 Value of money in terms of quantity of goods it can buy
 Nominal exchange rate between two currencies depends on the price levels in the two
countries
 So if 1 Rupee buys the same quantity of goods in India and abroad, the nominal exchange
rate must reflect the prices of goods in India and abroad
Implications of PPP
If purchasing power of the dollar

 Is always the same at home and abroad
 Then the real exchange rate cannot change
 1 = (e ˣ P) / P*
 e= P*/P
Theory of purchasing-power parity
 Nominal exchange rate between the currencies of two countries
 Must reflect the price levels in those countries
Limitations of purchasing-power parity
 May not hold for services: cannot be traded, labor costs
 Tradable goods are not perfect substitutes

 Hamburger standard, Indian food served in restaurants in India and restaurants abroad
 Transportation costs
Nominal exchange rate during a hyperinflation
Natural experiment – hyperinflation

 High inflation
 Arises when a government prints money to pay for large
amounts of government spending
German hyperinflation, early 1920s
 Money supply, price level, nominal exchange rate
 Move closely together
German hyperinflation, early 1920s

 Money supply - starts growing quickly
 Price level – starts growing
 Depreciation
 Money supply - stabilizes
 Price level – stabilizes
 Exchange rate – stabilizes
While purchasing power parity cannot clearly be seen, the figure

does prove a fundamental link between money supply, prices
and the nominal exchange rate
Money, Prices, and the Nominal Exchange Rate during the
German Hyperinflation
This figure shows the
money supply, the price
level, and the exchange
rate (measured as U.S.
cents per mark) for the
German hyperinflation
from January 1921 to
December 1924. Notice
how similarly these
three variables move.
When the quantity of
money started growing
quickly, the price level
followed, and the mark
depreciated relative to
the dollar. When the
German central bank
stabilized the money
supply, the price level
and exchange rate
stabilized as well.
Quantity theory of money

 Explains how the money supply affects price level
Purchasing power parity
 Explains how price level affects nominal exchange rate

Ch. 31-Open Economy Macroeconomics

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Ch. 31-Open Economy Macroeconomics

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Open-Economy Macroeconomics: Basic

Factors that influence a country’s exports, imports,

Increasing importance of international trade and

Increase in international trade

https://wits.worldbank.org/CountryProfile/en/Country/IND/Year/LTST/TradeFlow/EXPIMP Exports and Imports

Net capital outflow

Variables that influence net capital outflow

Net exports (NX)

When NX > 0 (trade surplus)

When NX < 0 (trade deficit)

Trade surplus: Exports > Imports

Trade deficit: Exports < Imports

Balanced trade : Exports = Imports

Trade deficit induced by a fall in saving

Trade deficit induced by an investment boom

Nominal exchange rate

Real exchange rate

Real exchange rate 

Real exchange rate = (e ˣ P) / P*

• Ex. Price of a men’s haircut

• Ex. Price of a men’s haircut

• Where is the price of a haircut the cheapest in comparison to India?

Depreciation (fall) in the U.S. real exchange rate

An appreciation (rise) in the U.S. real exchange rate

Purchasing-power parity, PPP

If purchasing power of the dollar

 Tradable goods are not perfect substitutes

Natural experiment – hyperinflation

German hyperinflation, early 1920s

While purchasing power parity cannot clearly be seen, the figure

Quantity theory of money

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