BASIC CONCEPT OF

OPEN ECONOMY

prepared by L e d i Tr i a l d i
 BASIC CONCEPT OF
OPEN ECONOMY

 NET EXPORT AND CAPITAL FLOW

 MARKET FOR LOANABLE
FUND
 EXCHANGE RATE AND
PURCHASING POWER PARITY
NET EXPORT & CAPITAL
FLOW

𝑋 − 𝑀=𝑁𝑋
Domestic goods and Foreign goods and
services, sold abroad (export) services, purchased from
abroad (import)
capital outlow
foreign assets
(purchase of )
Flow of funds measured in GDP
To finance investment
capitaldomestic
inflow X
If positive:
(purchase of
assets
−
net capital outflow (NCO) )

If negative:
net capitalinflow
NET EXPORT & CAPITAL
FLOW

NET EXPORT (NX) = NET CAPITAL OUTFLOW (NCO)

Suppose, you sell tens of t-shirts online to US citizens
in USD. Sales of the t-shirt gives you USD400

X by USD400 Keep the dollar CO by USD400

What will you do with USD400? Purchase more foreign currency/asset

Buy Apple’s s tock CO by USD400

Purchase more foreign asset

Buy X- Box M by USD400

Buy imported goods
MARKET FOR LOANABLE
FUND

𝑌 = 𝐶+ 𝐼 + 𝐺 + 𝑁𝑋
National Income equation
Open Economy

𝑌 − 𝐶 − 𝐺 = 𝐼 + 𝑁𝑋
𝑆 = 𝐼 + 𝑁𝑋
NET EXPORT (NX) = NET CAPITAL OUTFLOW (NCO)
𝑁𝑋 >0 → 𝑆 > 𝐼 Saving Gap Net Capital Outflow

𝑁𝑋 <0 → 𝐼 > 𝑆 Investment Gap Net Capital Inflow

𝑆=𝐼 + 𝑁𝐶𝑂Demand for Loanable Fund

Supply of Loanable Fund

𝑆 − 𝑁𝐶𝑂=𝐼 Investment is financed by saving

and (foreign) capital inflow
MARKET FOR LOANABLE
FUND

𝑆=𝐼 + 𝑁𝐶𝑂Demand for Loanable Fund

Supply of Loanable Fund

𝑆 − 𝑁𝐶𝑂=𝐼 Investment is financed by saving

and (foreign) capital inflow

Incentive to Disincentive to
save:
Attract both invest: cost of
Higher
domestic and borrowing

r
foreign savers

 Saving,  Investment,
 Capital inflow
or capital outflow
E X C H A N G E R AT E A N D P U R C H A S I N G P O W E R
PA R I T Y

is the relative price of the currency of two countries

e.g. 0.86 £/US$, Rp16,545/US$, 1.08 US$/€

is the relative price of the Goods & services of two countries

e.g. price of Big Mac in the US is 2.19 times higher than in Indonesia
E X C H A N G E R AT E A N D P U R C H A S I N G P O W E R
PA R I T Y
 E X C H A N G E R AT E A N D P U R C H A S I N G P O W E R
PA R I T Y

Suppose that US$1 = Rp15,000 (or the nominal

exchange rate is Rp15,000/US$). Big Mac price in
the US is US$5, while in Indonesia is Rp45,000.
a. What is the Big Mac price in Indonesia in Big Mac price in Indonesia is cheaper:
terms of US$? Is the price in Indonesia US$3 US$5 (in the US)
higher or lower than in the US?
b. Does the purchasing power parity hold At
at the existing exchange rate (i.e. at US$5 can buy 1 Big Mac in the US, but in Indonesia,
Rp15,000/US$)? Explain. US$5 can buy Big Mac
c. With purchasing power parity of the
currency, what is the (predicted) (or rupiah is undervalued)
exchange rate of Rupiah/US$ supposed
to be?
d. Since the inflation rate in Indonesia . With the US as the domestic economy:
tends to be higher than in the US, will here means price of dollar in terms of rupiah (Rp/US$) (appreciates)
Rupiah depreciate or appreciate to US$
Dollar appreciation means rupiah depreciation (rupiah’s value is lower)
in the long run?
 BASIC CONCEPT OF
OPEN ECONOMY

 NET EXPORT AND CAPITAL FLOW

 MARKET FOR LOANABLE
FUND
 EXCHANGE RATE AND
PURCHASING POWER PARITY