Macroeconomics 1

Topic 11: Open-economy Macroeconomics

Basic Concepts
 Core concepts
• Open vs. closed economy.

• Real vs. Nominal Exchange rates.

• Purchasing Power Parity

2
 Core concepts 2
• Int’l flow of goods and capitals:

o Flow of goods: import, export, net export, trade deficit

vs. trade surplus.

o Flow of financial resources: net foreign investment.

o The equality of the current account and the capital and

financial accounts.

o Saving, investment, and int’l flow.

3
North and South Korea at night:
What do you see?

4
 Open-economy
macroeconomics
• Closed economy: is one that doesn’t interact with other
economies in the world; that is, there are no imports, no
exports and no capital flows.

• Open economy: is one that interacts freely with other

economies around the world..

 Buy & sell goods and services in world’s product markets.

 Buy & sell financial assets in world’s financial markets

5
 The flow of goods: exports,
imports, and net exports
• Exports are goods and services that are produced...and
sold...

• Imports are goods and services that are produce….and

sold….

• Net exports (NX) are the values of a nation’s ….. minus

the values of its……

• Net exports are also called the trade balance

6
 The flow of goods:
exports, imports, and net exports 2

Trade deficit

Trade surplus

Balanced trade

7
 The flow of goods: Exports,
imports, and net exports 3
• Factors that affect net exports:

o The tastes of consumers

o The prices of goods at home and abroad

o The exchange rates

o The income of consumers at home and abroad

o The cost of transporting goods

o The policies of the gov’t towards int’l trade

8
 Is trade beneficial for an
economy? Why?
Let’s work on the concept of Absolute and Comparative
Advantage.

The Global Economy: It’s a small world after all

9
 The concept of Absolute and
Comparative Advantage
Absolute advantage: The ability of an individual, firm or
country to produce more of a good or service than
competitors using the same amount of resources.

Comparative advantage: The ability of an individual, firm or

country to produce a good or service at a lower opportunity
cost than other producers.

10
 The benefits of trade
David Ricardo’s theory of comparative advantage (developed
in 1817) showed how a country could improve the income of its
citizens by allowing them to trade with people in other countries.

Individuals, firms or countries are better off if they specialize in

producing goods and services for which they have a
comparative advantage and obtain other desirable goods and
services by trading.

Trade makes it possible to produce and consume more than

would be possible otherwise.
11
 The flow of financial resources
• Net foreign investment (NFI) refers to the purchase of
foreign assets by domestic residents minus the purchase of
domestic assets by foreigners

• For example:

o An Australia resident buys shares in British Telecom, the

purchase raises Australian net foreign investment

12
The flow of financial resources 2
o A Japanese resident buys a bond issued by the
Australian gov’t, the purchase reduces Australian net
foreign investment

o A Vietnamese student at RMIT Vietnam opens up a

bakery in Sydney?..............................

13
 The flow of financial resources 3
• Variables that influence net foreign investment (NFI)

o The real interest rates being paid on foreign assets

o The real interest rates being paid on domestic assets

o The perceived economic and political risks of holding

assets abroad

o The gov’t policies that affect foreign ownership of

domestic assets

14
 The flow of financial resources 4
How is this trade and financial international exchange
recorded in the National Accounts?

15
 The equality of current and
capital accounts
• The Current Account Balance (CAB) measures:

Net Export (NX) + Net Flow of Income (NY) + Net Flow of

Transfer (NT)
CAB = NX + NY + NT

• On the other hand we have the NFI

• For an economy as a whole, NFI and CAB must balance

each other so that: NFI = CAB
16
 The equality of current and
capital accounts 2

Why? NFI = CAB

As an accounting method, every transaction in one account
will have its counterpart in the other

Example: Vietnam exports footwear to Australia.

Goods transaction: Vietnam’s NX
Getting foreign asset as payment (AU$): Vietnam’s NFI

17
 Saving, Investment and the
relationship to the international flows
Recall GDP = C + I + G + NX

Gross National Disposable Income: GNDY = GDP + NY + NT

Gross National Saving:

S = GNDY – C – G = (C + I + G + NX + NY + NT ) – C – G

S = I + (NX + NY + NT)

S = I + CAB = I + NFI

18
 Saving, Investment and the relationship
to the international flows (2)

S = I + CAB = I + NFI

Saving = Domestic Investment + Net foreign Investment

• Discussion: trade deficit/surplus in different countries and

its implication??

Assignment questions??
19
 Nominal Exchange Rates

• Nominal exchange rate

o Rate at which a person can trade currency of one country for

currency of another

• Appreciation: Increase in the value of a currency

• Buy more foreign currency

• Depreciation: Decrease in the value of a currency

• Buy less foreign currency

20
Nominal exchange rates:
Vietnam

đ
𝐔𝐒 $ 21
 Real exchange rate: our
example

Real exchange rate question: How many bowls of rice do

I need to sell to buy one bowl of rice?
22
 Real exchange rate Equation

Real exchange rate =

23
 Real exchange rate
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.

• The real exchange rate depends on the nominal

exchange rate and the prices of goods in the two countries
measured in local currencies.

• The real exchange rate is a key determinant of how

much a country exports and imports
24
 Real exchange rate: our
example 2

Real exchange rate =

Real exchange rate = = 4

25
 Real exchange rate: our
example 2

Real exchange rate = = 4

26
 Real exchange rate example 3

Shouldn’t the real exchange rate be equal to 1, considering

that trade is possible between Australia and Vietnam? – LAW
OF ONE PRICE
Real exchange rate = = 4
27
 The Law of one price
• According to the law of one price, a good must sell for the
same price in a given currency in all locations

• If the law of one price was not true, unexploited profit

opportunities would exist

• The process of taking advantage of differences in prices in

different markets is called arbitrage

• This process will continue until prices are equal

28
 Purchasing Power Parity (PPP)
• PPP states that a unit of any given currency should be able
to buy the same quantity of goods in all countries.

• The nominal exchange rate should make this possible!

29
 Real exchange rate: our example 3

Under PPP one bowl of rice in Vietnam should be worth a

bowl of rice in Australia

What should be the nominal exchange rate for PPP to hold?

Real exchange rate = = 1

30
 Implication of PPP
• If the purchasing power of the dollar is always the same at
home and abroad, then the exchange rate can’t change

• The nominal exchange rate between the currencies of two

countries must reflect the different price level of those
countries
e: nominal exchange rate
e = P*/P
P*: foreign price level
P: domestic price level

31
 Implication of PPP 2
Notice: The PPP equation that applies for Vietnam has the
foreign price in the numerator. This is because the exchange
rate in Vietnam is commonly expressed as the number of
Dongs per unit of foreign currency.

32
 Does PPP hold in the world?

Watch the video The

price of starbucks latte in different countries

33
 Limitations of PPP
Why PPP does not hold?

• Non-tradable goods or services (examples?)

• Good or services that are not perfect substitutes across

countries

• Trade costs

34
Application: comparison of
standard of living

Vietnam US
GDP per Capita (2015) GDP per Capita
= (2015)=
đ 46,444,200 Nominal exchange rate: US$ 55,836.8
22,000 đ /US$

GDP per Capita (2015)= US$ 2,111.1

35
 Application: comparison of
standard of living 2
(US$ 55,836.8 vs US$ 2,111.1)

Is the purchasing power the US 26 times higher than the Vi-

etnamese? We need to consider PPP (or what those dollars
can really buy in Vietnam)

36