Lec-8B - Chapter 31 - Open-Economy Macroeconomics Basic Concepts

Open-Economy
Macroeconomics:
Basic Concepts
Chapter 31
Open and Closed Economies

A closed economy is one that does not
interact with other economies in the

world.
There
are no exports, no imports, and

no capital flows.
Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Open and Closed Economies

An open economy is one that
interacts freely with other
economies around the world.
An Open Economy
An open economy interacts with other
countries in two ways.

It buys and sells goods and services in world
product markets.
It buys and sells capital assets in world
financial markets.
An Open Economy
The U.S. is a very large and open
economy it imports and exports huge

quantities of goods and services.
Over the past four decades, international
trade and finance have become
increasingly important.
The Flow of Goods: Exports,

Imports, Net Exports
Exports
are domestically produced

goods and services that are sold
abroad.
Imports are foreign produced goods
and services that are sold domestically.

exports (NX) are the value of a
nations exports minus the value of its
imports.
Net exports are also called the trade
balance.
Net

A trade
deficit is a situation in which net

exports (NX) are negative.
Imports > Exports
A trade surplus is a situation in which net
exports (NX) are positive.
Exports > Imports
Balanced trade refers to when net exports are
zero exports and imports are exactly equal.
Factors That Affect

Net Exports
The tastes of consumers for domestic and
foreign goods.
The prices of goods at home and abroad.
The exchange rates at which people can
use domestic currency to buy foreign
currencies.
Factors That Affect Net

Exports
The incomes of consumers at home and
abroad.
The costs of transporting goods from
country to country.
The policies of the government toward
international trade.
The Internationalization of the U.S.

Economy
Percent
of GDP
15
Imports
10
Exports
0
1950 195
1960 1965 1970 1975 1980 1985 1990 199
Harcourt, Inc. items and derived
items copyright 2001 by Harcourt, Inc.
5
5
199
5
The Flow of Capital: Net

Foreign Investment
Net foreign investment refers to the
purchase of foreign assets by domestic

residents minus the purchase of domestic
assets by foreigners.
A U.S. resident buys stock in the Toyota

corporation and a Mexican buys stock in the
Ford Motor corporation.
The Flow of Capital: Net

Foreign Investment
When a U.S. resident buys stock in
Telmex, the Mexican phone company, the
purchase raises U.S. net foreign
investment.
When a Japanese residents buys a bond
issued by the U.S. government, the
purchase reduces the U.S. net foreign
investment.
Variables that Influence Net

Foreign Investment
The real interest rates being paid on
foreign assets.
The real interest rates being paid on
domestic assets.
The perceived economic and political
risks of holding assets abroad.
The government policies that affect
foreign ownership of domestic assets.
The Equality of Net Exports

and Net Foreign Investment
Net
exports (NX) and net foreign

investment (NFI) are closely linked.
For an economy as a whole, NX and NFI
must balance each other so that:
NFI = NX
This holds true because every transaction

that affects one side must also affect the other
side by the same amount.
Saving, Investment, and Their

Relationship to the International
Flows
Net exports is a component of GDP:
Y = C + I + G + NX
National saving is the income of the

nation that is left after paying for current
consumption and government purchases:
Y - C - G = I + NX
Saving, Investment, and Their

Relationship to the International
Flows
National saving (S) equals Y-C-G so:
S = I + NX
or
Saving
=
Domestic + Foreign
Investmen
Investmen
t
t
National Saving, Domestic Investment, and

Net Foreign Investment
(a) National Saving and Domestic Investment
(as a percentage of GDP)
Percent
of GDP
20
Domestic investment
18
16
14
12
National saving
10
1965 1970 1975 1980 1985 1990 1995 200
0

(b) Net Foreign Investment (as a percentage of
GDP)
Percent
of GDP
4
3
2
1
Net foreign
investment
0
-1
-2
-3
4 1965 1970 1975
1980 198
5
1990 1995 200

0
Real and Nominal Exchange

Rates
International transactions are
influenced by international prices.
The two most important international
prices are the nominal exchange rate
and the real exchange rate.
Nominal Exchange Rates

The
nominal exchange rate is the rate

at which a person can trade the
currency of one country for the
currency of another.

The
nominal exchange rate is

expressed in two ways:
In units of foreign currency per one U.S.
dollar.
And in units of U.S. dollars per one unit of
the foreign currency.

Assume
the exchange rate between the

Japanese yen and U.S. dollar is 80 yen to
one dollar.
One U.S. dollar trades for eighty yen.
One yen trades for 1/80 (=0.0125) of a dollar.

If
a dollar buys more foreign currency,

there is an appreciation of the dollar.
If it buys less there is a depreciation of
the dollar.
Real Exchange Rates

The 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.
Real Exchange Rates

The
real exchange rate compares the

prices of domestic goods and foreign
goods in the domestic economy.
If a case of German beer is twice as

expensive as American beer, the real
exchange rate is 1/2 case of German beer per
case of American beer.
Real Exchange Rates

The real exchange rate depends on
the nominal exchange rate and the
prices of goods in the two countries
measured in local currencies.
Real Exchange Rates

Real
Nominalexchangerate x Domesticprice
Exchange
Foreignprice
Rate
The
real exchange rate is a key

determinant of how much a
country exports and imports.
Real Exchange Rates

A depreciation
(fall) in the U.S. real

exchange rate means that U.S. goods
have become cheaper relative to foreign
goods.
This encourages consumers both at home
and abroad to buy more U.S. goods and
fewer goods from other countries.
Real Exchange Rates

As
a result, U.S. exports rise, and U.S.

imports fall, and both of these changes
raise U.S. net exports.
Conversely, an appreciation in the U.S.
real exchange rate means that U.S. goods
have become more expensive compared
to foreign goods, so U.S. net exports fall.
Purchasing-Power Parity
The
purchasing-power parity theory is

the simplest and most widely accepted
theory explaining the variation of
currency exchange rates.
According to the purchasing-power

parity theory, a unit of any given
currency should be able to buy the
same quantity of goods in all
countries.
Basic Logic of
The
theory of purchasing-power parity

is based on a principle called the law of
one price.
According to the law of one price, a
good must sell for the same price in all
locations.
Basic Logic of
If
the law of one price were not true,

unexploited profit opportunities would
exist.
The process of taking advantage of
differences in prices in different
markets is called arbitrage.
Basic Logic of
If
arbitrage occurs, eventually prices that

differed in two markets would necessarily
converge.
According to the theory of purchasingpower parity, a currency must have the
same purchasing power in all countries
and exchange rates move to ensure that.
Implications of
If
the purchasing power of the dollar is

always the same at home and abroad,
then the exchange rate cannot change.
The nominal exchange rate between the
currencies of two countries must reflect the
different price levels in those countries.
Implications of
When
the central bank prints large

quantities of money, the money loses value
both in terms of the goods and services it
can buy and in terms of the amount of
other currencies it can buy.
Money, Prices, and the Nominal Exchange Rate

During the German Hyperinflation
Indexes
(Jan. 1921 =
100)
1,000,000,000,000,000
Money supply
10,000,000,000
Price level
100,000
1
.00001
.0000000001
1921
Exchange rate
1922
1923
1924
1925
Limitations of
Many
goods are not easily traded or

shipped from one country to another.
Tradable goods are not always perfect
substitutes when they are produced in
different countries.
Summary
Net exports are the value of domestic goods
and services sold abroad minus the value of
foreign goods and services sold domestically.
Net foreign investment is the acquisition of
foreign assets by domestic residents minus
the acquisition of domestic assets by
foreigners.
Summary
An
economys net foreign investment

always equals its net exports.
An economys saving can be used to
either finance investment at home or
to buy assets abroad.
Summary
The nominal exchange rate is the relative
price of the currency of two countries.
The real exchange rate is the relative
price of the goods and services of two
countries.
Summary
When the nominal exchange rate changes
so that each dollar buys more foreign
currency, the dollar is said to appreciate
or strengthen.
When the nominal exchange rate changes
so that each dollar buys less foreign
currency, the dollar is said to depreciate
or weaken.
Summary
According to the theory or purchasingpower parity, a unit of currency should
buy the same quantity of goods in all
countries.
The nominal exchange rate between the
currencies of two countries should reflect
the countries price levels in those
countries.
Graphical
Review
The Internationalization of the U.S.

Economy
Percent
of GDP
15
Imports
10
Exports
0
1950 195
1960 1965 1970 1975 1980 1985 1990 199
Harcourt, Inc. items and derived
items copyright 2001 by Harcourt, Inc.
5
5
199
5

(a) National Saving and Domestic Investment
(as a percentage of GDP)
Percent
of GDP
20
Domestic investment
18
16
14
12
National saving
10
1965 1970 1975 1980 1985 1990 1995 200
0

(b) Net Foreign Investment (as a percentage of
GDP)
Percent
of GDP
4
3
2
1
Net foreign
investment
0
-1
-2
-3
4 1965 1970 1975
1980 198
5
1990 1995 200

0
Money, Prices, and the Nominal Exchange Rate

During the German Hyperinflation
Indexes
(Jan. 1921 =
100)
1,000,000,000,000,000
Money supply
10,000,000,000
Price level
100,000
1
.00001
.0000000001
1921
Exchange rate
1922
1923
1924
1925

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Open-Economy

Open and Closed Economies

interact with other economies in the

are no exports, no imports, and

Open and Closed Economies

countries in two ways.

economy it imports and exports huge

The Flow of Goods: Exports,

are domestically produced

The Flow of Goods: Exports,

The Flow of Goods: Exports,

deficit is a situation in which net

Factors That Affect

Factors That Affect Net

The Internationalization of the U.S.

The Flow of Capital: Net

purchase of foreign assets by domestic

A U.S. resident buys stock in the Toyota

The Flow of Capital: Net

Variables that Influence Net

The Equality of Net Exports

exports (NX) and net foreign

This holds true because every transaction

Saving, Investment, and Their

Net exports is a component of GDP:

National saving is the income of the

Saving, Investment, and Their

National saving (S) equals Y-C-G so:

National Saving, Domestic Investment, and

National Saving, Domestic Investment, and

1990 1995 200

Real and Nominal Exchange

Nominal Exchange Rates

nominal exchange rate is the rate

Nominal Exchange Rates

nominal exchange rate is

Nominal Exchange Rates

the exchange rate between the

Nominal Exchange Rates

a dollar buys more foreign currency,

Real Exchange Rates

Real Exchange Rates

real exchange rate compares the

If a case of German beer is twice as

Real Exchange Rates

Real Exchange Rates

real exchange rate is a key

Real Exchange Rates

(fall) in the U.S. real

Real Exchange Rates

a result, U.S. exports rise, and U.S.

purchasing-power parity theory is

According to the purchasing-power

theory of purchasing-power parity

the law of one price were not true,

arbitrage occurs, eventually prices that

the purchasing power of the dollar is

the central bank prints large

Money, Prices, and the Nominal Exchange Rate