Review (Chap 31)

N.
Gregory Mankiw
Principles of
Economics Sixth Edition
31
Open-Economy Macroeconomics:
Basic Concepts Premium PowerPoint
Slides by
Ron Cronovich
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The Flow of Goods & Services
 Exports:
domestically-produced g&s sold abroad
 Imports:
foreign-produced g&s sold domestically
 Net exports (NX), aka the trade balance
= value of exports – value of imports
NX = Exports – Imports = FP of DG – DP of FG
2
Variables that Influence Net Exports
 Consumers’ preferences for foreign and domestic goods
 Prices of goods at home and abroad
 Incomes of consumers at home and abroad
 The exchange rates at which foreign currency trades for domestic
currency
 Transportation costs
 Govt policies
3
Trade Surpluses & Deficits
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
4
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.
NCO = Capital Outflows – Capital Inflows = DP of FA – FP of DA
5
Variables that Influence NCO
 Real interest rates paid on foreign assets
 Real interest rates paid on domestic assets
 Perceived risks of holding foreign assets
 Govt policies affecting foreign ownership of domestic assets
NCO = Capital Outflows – Capital Inflows = DP of FA – FP of DA
6
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 U.S.,
 U.S. exports and NX increase
 the foreigner pays with currency or assets,
so the U.S. acquires some foreign assets,
causing NCO to rise.
7
Saving, Investment, and International Flows
of Goods & Assets
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.
8
The Nominal and and Real Exchange Rate
 Nominal exchange rate: the rate at which
one country’s currency trades for another
 Real exchange rate: the rate at which the g&s of one
country trade for the g&s of another
exP
 Real exchange rate =
P*
where
P = domestic price
P* = foreign price (in foreign currency)
e = nominal exchange rate, i.e., foreign currency per
unit of domestic currency
9
Starbucks
Eg: Price of a Starbucks latte coffee sold in VN is 100,000 VND
Price of a Starbucks latte coffee sold in the US is $5
+ Exchange rate is 23,500 VND/ USD
Exchange rate is 23,500 VND/ USD => 1/23,500 USD / VND
Þ Real exchange rate ?
Þ Real exchange rate = 5*23,500 / 100,000 = 1.175 Starbucks latte coffee sold in VN for 1 Starbucks latte
coffee sold in the US (0.85 Starbucks latte coffee sold in the US for 1 Starbucks latte coffee sold in VN)
10
PPP and Its Implications
 PPP implies that the nominal P*
exchange rate between two countries e =
P
should equal the ratio of price levels.
 If the two countries have different inflation rates,
then e will change over time:
 If inflation is higher in Mexico than in the U.S.,
then P* rises faster than P, so e rises—
the dollar appreciates against the peso.
 If inflation is higher in the U.S. than in Japan,
then P rises faster than P*, so e falls—
the dollar depreciates against the yen.
11
1. A Guatemalan company exchanges quetzal (Guatemalan currency)
for dollars and then uses the dollars to purchase construction
equipment from a U.S. company. These transactions
a. increase Guatemalan net capital outflow, and increases U.S. net

exports.
b. increase Guatemalan capital outflow, and decreases U.S. net exports.
c. decrease Guatemalan net capital outflow, and increases U.S. net
exports.
d. decrease Guatemalan net capital outflow, and decreases U.S. net
exports.
2. During some year a country had exports of $50 billion, imports of
$70 billion, and domestic investment of $100 billion. What was its
saving during the year?
Export = $50b
Import = $70b
a. $80 billion I = $100
b. $100 billion
Þ S = I + NCO = I + NX = 100 +(50 – 70) = $80 b
c. $120 billion
d. $150 billion
13
3. The nominal exchange rate is 4 Saudi Arabian riyals, 8 Moroccan
dirham, 60 Indian rupees, or 0.8 euros per U.S. dollar. A fast food
breakfast costs $5 in the U.S., 30 riyals in Saudi Arabia, 40
Moroccan dirham in Morocco, 250 Indian rupees in India, and 5
euros in France. According to these numbers, where is the real
exchange rate between American and foreign goods the lowest?
a. France
Saudi Arabia
b. Morocco e = 4 riyas / USD
c. India exP P = $5
Real exchange rate = P* = 30 riyals
d. Saudi Arabia where P*
P = domestic price => Real exchange rate =
P* = foreign price (in foreign (4*5)/30 = 0.67 package of
Saudi fast food per 1
currency) package of US fast food
e = nominal exchange rate, i.e.,
foreign currency per unit of
domestic currency
14

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N.

NCO = Capital Outflows – Capital Inflows = DP of FA – FP of DA

NCO = Capital Outflows – Capital Inflows = DP of FA – FP of DA

Eg: Price of a Starbucks latte coffee sold in VN is 100,000 VND

Price of a Starbucks latte coffee sold in the US is $5

+ Exchange rate is 23,500 VND/ USD

Exchange rate is 23,500 VND/ USD => 1/23,500 USD / VND

Þ Real exchange rate ?

a. increase Guatemalan net capital outflow, and increases U.S. net

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