CHAPTER

31
Open-Economy Macroeconomics:
Basic Concepts

Economics
PRINCIPLES OF

N. Gregory Mankiw

Premium PowerPoint Slides

by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning, all rights reserved
In this chapter,
look for the answers to these questions:
 How are international flows of goods and assets
related?
 What’s the difference between the real and nominal
exchange rate?
 What is “purchasing-power parity,” and how does it
explain nominal exchange rates?

2
 Introduction
 One of the Ten Principles of Economics
from Chapter 1:
Trade can make everyone better off.
 This chapter introduces basic concepts of
international macroeconomics:
 The trade balance (trade deficits, surpluses)
 International flows of assets
 Exchange rates

OPEN-ECONOMY MACROECONOMICS: BASIC 3

 Closed vs. Open Economies
 A closed economy does not interact with other
economies in the world.
 An open economy interacts freely with other
economies around the world.

OPEN-ECONOMY MACROECONOMICS: BASIC 4

 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

OPEN-ECONOMY MACROECONOMICS: BASIC 5

ACTIVE LEARNING 1
Variables that affect NX
What do you think would happen to
U.S. net exports if:
A. Canada experiences a recession
(falling incomes, rising unemployment)
B. U.S. consumers decide to be patriotic and
buy more products “Made in the U.S.A.”
C. Prices of goods produced in Mexico rise faster
than prices of goods produced in the U.S.

6
ACTIVE LEARNING 1
Answers
A. Canada experiences a recession
(falling incomes, rising unemployment)
U.S. net exports would fall
due to a fall in Canadian consumers’
purchases of U.S. exports

B. U.S. consumers decide to be patriotic and

buy more products “Made in the U.S.A.”
U.S. net exports would rise
due to a fall in imports
7
ACTIVE LEARNING 1
Answers
C. Prices of Mexican goods rise faster than prices
of U.S. goods
This makes U.S. goods more attractive
relative to Mexico’s goods.
Exports to Mexico increase,
imports from Mexico decrease,
so U.S. net exports increase.

8
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

OPEN-ECONOMY MACROECONOMICS: BASIC 9

 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

OPEN-ECONOMY MACROECONOMICS: BASIC 10

The U.S. Economy’s Increasing Openness
Trade
Trade deficit
deficit == 5%
5%
of
of GDP
GDP in
in 2007:Q4
2007:Q4
Imports

Exports
 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.

OPEN-ECONOMY MACROECONOMICS: BASIC 12

 The Flow of Capital
The flow of capital abroad takes two forms:
 Foreign direct investment:
Domestic residents actively manage the foreign
investment, e.g., McDonalds opens a fast-food
outlet in Moscow.
 Foreign portfolio investment:
Domestic residents purchase foreign stocks or
bonds, supplying “loanable funds” to a foreign
firm.

OPEN-ECONOMY MACROECONOMICS: BASIC 13

 The Flow of Capital
NCO measures the imbalance in a country’s trade
in assets:
 When NCO > 0, “capital outflow”
Domestic purchases of foreign assets exceed
foreign purchases of domestic assets.
 When NCO < 0, “capital inflow”
Foreign purchases of domestic assets exceed
domestic purchases of foreign assets.

OPEN-ECONOMY MACROECONOMICS: BASIC 14

 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

OPEN-ECONOMY MACROECONOMICS: BASIC 15

 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.
OPEN-ECONOMY MACROECONOMICS: BASIC 16
 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 U.S. citizen buys foreign goods,
 U.S. imports rise, NX falls
 the U.S. buyer pays with U.S. dollars or
assets, so the other country acquires
U.S. assets, causing U.S. NCO to fall.

OPEN-ECONOMY MACROECONOMICS: BASIC 17

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.
OPEN-ECONOMY MACROECONOMICS: BASIC 18
 Case Study: The U.S. Trade Deficit
 The U.S. trade deficit reached record levels in
2006 and remained high in 2007-2008.
 Recall, NX = S – I = NCO.
A trade deficit means I > S,
so the nation borrows the difference
from foreigners.
 In 2007, foreign purchases of U.S. assets
exceeded U.S. purchases of foreign assets by
$775 million.
 Such deficits have been the norm since 1980…
OPEN-ECONOMY MACROECONOMICS: BASIC 19
 U.S. Saving, Investment, and NCO, 1950-2007

Investment
(% of GDP)

Saving

NCO
 Case Study: The U.S. Trade Deficit
Why U.S. saving has been less than investment:
 In the 1980s and early 2000s,
huge budget deficits and low private saving
depressed national saving.
 In the 1990s,
national saving increased as the economy grew,
but domestic investment increased even faster
due to the information technology boom.

OPEN-ECONOMY MACROECONOMICS: BASIC 21

 Case Study: The U.S. Trade Deficit
 Is the U.S. trade deficit a problem?
 The extra capital stock from the ’90s investment
boom may well yield large returns.
 The fall in saving of the ’80s and ’00s,
while not desirable, at least did not depress
domestic investment, as firms could borrow
from abroad.
 A country, like a person, can go into debt
for good reasons or bad ones.
A trade deficit is not necessarily a problem,
but might be a symptom of a problem.
OPEN-ECONOMY MACROECONOMICS: BASIC 22
 Case Study: The U.S. Trade Deficit
as of 12-31-2007
People abroad owned $20.1 trillion in U.S. assets.
U.S. residents owned $17.6 trillion in foreign assets.
U.S.’ net indebtedness to other countries = $2.5 trillion.
Higher than every other country’s net indebtedness.
So, U.S. is “the world’s biggest debtor nation.”
 So far, the U.S. earns higher interest rates on foreign
assets than it pays on its debts to foreigners.
 But if U.S. debt continues to grow, foreigners may
demand higher interest rates, and servicing the debt
would become a drain on U.S. income.
OPEN-ECONOMY MACROECONOMICS: BASIC 23
 The Nominal Exchange Rate
 Nominal exchange rate: the rate at which
one country’s currency trades for another
 We express all exchange rates as foreign
currency per unit of domestic currency.
 Some exchange rates as of 16 July 2008,
all per US$
Canadian dollar: 1.00
Euro: 0.63
Japanese yen: 104.77
Mexican peso: 10.25
OPEN-ECONOMY MACROECONOMICS: BASIC 24
 Appreciation and Depreciation
 Appreciation (or “strengthening”):
an increase in the value of a currency
as measured by the amount of foreign currency
it can buy
 Depreciation (or “weakening”):
a decrease in the value of a currency
as measured by the amount of foreign currency
it can buy
 Examples: During 2007, the U.S. dollar…
 depreciated 9.5% against the Euro
 appreciated 1.5% against the S. Korean Won
OPEN-ECONOMY MACROECONOMICS: BASIC 25
 The Real Exchange Rate
 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

OPEN-ECONOMY MACROECONOMICS: BASIC 26

 Example With One Good
 A Big Mac costs $2.50 in U.S., 400 yen in Japan
 e = 120 yen per $
 e x P = price in yen of a U.S. Big Mac
= (120 yen per $) x ($2.50 per Big Mac)
= 300 yen per U.S. Big Mac
 Compute the real exchange rate:
exP 300 yen per U.S. Big Mac
=
P* 400 yen per Japanese Big Mac
= 0.75 Japanese Big Macs per US Big Mac
OPEN-ECONOMY MACROECONOMICS: BASIC 27
 Interpreting the Real Exchange Rate
“The real exchange rate =
0.75 Japanese Big Macs per U.S. Big Mac”
Correct interpretation:
To buy a Big Mac in the U.S.,
a Japanese citizen must sacrifice
an amount that could purchase
0.75 Big Macs in Japan.

OPEN-ECONOMY MACROECONOMICS: BASIC 28

ACTIVE LEARNING 2
Compute a real exchange rate
e = 10 pesos per $
price of a tall Starbucks Latte
P = $3 in U.S., P* = 24 pesos in Mexico
A. What is the price of a US latte measured in
pesos?
B. Calculate the real exchange rate,
measured as Mexican lattes per US latte.

29
ACTIVE LEARNING 2
Answers
e = 10 pesos per $
price of a tall Starbucks Latte
P = $3 in U.S., P* = 24 pesos in Mexico
A. What is the price of a US latte in pesos?
e x P = (10 pesos per $) x (3 $ per US latte)
= 30 pesos per US latte
B. Calculate the real exchange rate.
exP 30 pesos per U.S. latte
=
P* 24 pesos per Mexican latte
= 1.25 Mexican lattes per US latte
30
The Real Exchange Rate With Many Goods
P = U.S. price level, e.g., Consumer Price Index,
measures the price of a basket of goods
P* = foreign price level
Real exchange rate
= (e x P)/P*
= price of a domestic basket of goods relative to
price of a foreign basket of goods
 If U.S. real exchange rate appreciates,
U.S. goods become more expensive relative to
foreign goods.
OPEN-ECONOMY MACROECONOMICS: BASIC 31
 The Law of One Price
 Law of one price: the notion that a good should
sell for the same price in all markets
 Suppose coffee sells for $4/pound in Seattle
and $5/pound in Boston,
and can be costlessly transported.
 There is an opportunity for arbitrage,
making a quick profit by buying coffee in
Seattle and selling it in Boston.
 Such arbitrage drives up the price in Seattle
and drives down the price in Boston, until the
two prices are equal.
OPEN-ECONOMY MACROECONOMICS: BASIC 32
 Purchasing-Power Parity (PPP)
 Purchasing-power parity:
a theory of exchange rates whereby a unit of
any currency should be able to buy the same
quantity of goods in all countries
 based on the law of one price
 implies that nominal exchange rates adjust
to equalize the price of a basket of goods across
countries

OPEN-ECONOMY MACROECONOMICS: BASIC 33

 Purchasing-Power Parity (PPP)
 Example: The “basket” contains a Big Mac.
P = price of US Big Mac (in dollars)
P* = price of Japanese Big Mac (in yen)
e = exchange rate, yen per dollar
 According to PPP, e x P = P*

price of US price of Japanese

Big Mac, in yen Big Mac, in yen

P*
 Solve for e: e =
P
OPEN-ECONOMY MACROECONOMICS: BASIC 34
 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.
OPEN-ECONOMY MACROECONOMICS: BASIC 35
 Limitations of PPP Theory
Two reasons why exchange rates do not always
adjust to equalize prices across countries:
 Many goods cannot easily be traded
 Examples: haircuts, going to the movies
 Price differences on such goods cannot be
arbitraged away
 Foreign, domestic goods not perfect substitutes
 E.g., some U.S. consumers prefer Toyotas over
Chevys, or vice versa
 Price differences reflect taste differences
OPEN-ECONOMY MACROECONOMICS: BASIC 36
 Limitations of PPP Theory
 Nonetheless, PPP works well in many cases,
especially as an explanation of long-run trends.
 For example, PPP implies:
the greater a country’s inflation rate,
the faster its currency should depreciate
(relative to a low-inflation country like the US).
 The data support this prediction…

OPEN-ECONOMY MACROECONOMICS: BASIC 37

Inflation & Depreciation in a Cross-Section
of 31 Countries
10,000.0
Ukraine
1,000.0
Romania
Avg annual Brazil
100.0
depreciation Argentina
relative to
10.0 Mexico
US dollar
Canada
1993-2003 1.0 Kenya
(log scale)
Japan
0.1
0.1 1.0 10.0 100.0 1,000.0
Avg annual CPI inflation
1993-2003 (log scale)
ACTIVE LEARNING 3
Chapter review questions
1. Which of the following statements about a country
with a trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving
D. Y < C + I + G

2. A Ford Escape SUV sells for $24,000 in the U.S.

and 720,000 rubles in Russia.
If purchasing-power parity holds, what is the
nominal exchange rate (rubles per dollar)?
39
ACTIVE LEARNING 3
Answers
1. Which of the following statements about a country
with a trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving not true!
D. Y < C + I + G

A trade deficit means NX < 0.

Since NX = S – I,
a trade deficit implies I > S.
40
ACTIVE LEARNING 3
Answers
2. A Ford Escape SUV sells for $24,000 in the
U.S. and 720,000 rubles in Russia.
If purchasing-power parity holds, what is the
nominal exchange rate (rubles per dollar)?
P* = 720,000 rubles
P = $24,000
e = P*/P = 720000/24000 = 30 rubles per dollar

41
CHAPTER SUMMARY

 Net exports equal exports minus imports.

Net capital outflow equals domestic residents’
purchases of foreign assets minus foreigners’
purchases of domestic assets.
 Every international transaction involves the
exchange of an asset for a good or service,
so net exports equal net capital outflow.

42
CHAPTER SUMMARY

 Saving can be used to finance domestic

investment or to buy assets abroad. Thus, saving
equals domestic investment plus net capital
outflow.
 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 the two countries.

43
CHAPTER SUMMARY

 According to the theory of purchasing-power parity,

a unit of any country’s currency should be able to
buy the same quantity of goods in all countries.
 This theory implies that the nominal exchange rate
between two countries should equal the ratio of the
price levels in the two countries.
 It also implies that countries with high inflation
should have depreciating currencies.

44