THE MACROECONOMICS OF OPEN ECONOMIES

Open-Economy
Macroeconomics:
Basic Concepts
 Open-Economy Macroeconomics:
Basic Concepts
• 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.
• An open economy is one that interacts freely with
other economies around the world.
 Open-Economy Macroeconomics:
Basic Concepts
• 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.
 THE INTERNATIONAL FLOW OF
GOODS AND CAPITAL
• An Open Economy
• The United States 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 goods and services that are
produced domestically and sold abroad.
• Imports are goods and services that are
produced abroad and sold domestically.
The Flow of Goods: Exports, Imports, Net
Exports
• Net exports (NX) are the value of a nation’s
exports minus the value of its imports.
• Net exports are also called the trade balance.
The Flow of Goods: Exports, Imports, Net
Exports
• 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.
The Flow of Goods: Exports, Imports, Net
Exports
• 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.
The Flow of Goods: Exports, Imports, Net
Exports
• 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.
 Figure 1 The Internationalization of the U.S.
Economy

Percent
of GDP

15

Imports

10
Exports

0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

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The Flow of Financial Resources: Net Capital
Outflow
• Net capital outflow 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 Financial Resources: Net Capital
Outflow
• When a U.S. resident buys stock in Telmex, the
Mexican phone company, the purchase raises
U.S. net capital outflow.
• When a Japanese residents buys a bond issued
by the U.S. government, the purchase reduces
the U.S. net capital outflow.
The Flow of Financial Resources: Net Capital
Outflow
• Variables that Influence Net Capital Outflow
• 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 Capital
Outflow
• Net exports (NX) and net capital outflow (NCO)
are closely linked.
• For an economy as a whole, NX and NCO must
balance each other so that:
NCO = 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 + Net Capital
Investment Outflow
S = I + NCO
Figure 2 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
1960 1965 1970 1975 1980 1985 1990 1995 2000

Copyright © 2004 South-Western

Figure 2 National Saving, Domestic Investment,
and Net Foreign Investment

(b) Net Capital Outflow (as a percentage of GDP)

Percent
of GDP
4

2
Net capital
1 outflow

–1

–2

–3

–4
1960 1965 1970 1975 1980 1985 1990 1995 2000

Copyright © 2004 South-Western

 THE PRICES FOR INTERNATIONAL
TRANSACTIONS: 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.
Nominal Exchange Rates

• 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.
Nominal Exchange Rates

• Assume the exchange rate between the

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

• Appreciation refers to an increase in the value

of a currency as measured by the amount of
foreign currency it can buy.
• Depreciation refers to a decrease in the value of
a currency as measured by the amount of
foreign currency it can buy.
Nominal Exchange Rates

• 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

• The real exchange rate is a key determinant of

how much a country exports and imports.

N o m in al ex ch an g e rate  D o m estic p rice

R eal ex ch an g e rate =
F o reig n p rice
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.
 A FIRST THEORY OF
EXCHANGE-RATE DETERMINATION:
PURCHASING-POWER PARITY
• The purchasing-power parity theory is the
simplest and most widely accepted theory
explaining the variation of currency exchange
rates.
The Basic Logic of Purchasing-Power Parity

• Purchasing-power parity is a theory of

exchange rates whereby a unit of any given
currency should be able to buy the same
quantity of goods in all countries.
The Basic Logic of Purchasing-Power Parity

• 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 Purchasing-Power Parity

• 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 Purchasing-Power Parity

• 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 Purchasing-Power Parity

• If arbitrage occurs, eventually prices that

differed in two markets would necessarily
converge.
• According to the theory of purchasing-power
parity, a currency must have the same
purchasing power in all countries and exchange
rates move to ensure that.
Implications of Purchasing-Power Parity

• 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 Purchasing-Power Parity

• 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.
 Figure 3 Money, Prices, and the Nominal
Exchange Rate During the German Hyperinflation
Indexes
(Jan. 1921 5 100)

1,000,000,000,000,000

Money supply
10,000,000,000

Price level
100,000

Exchange rate
.00001

.0000000001
1921 1922 1923 1924 1925
Copyright © 2004 South-Western
Limitations of Purchasing-Power Parity

• 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 capital outflow is the acquisition of foreign
assets by domestic residents minus the
acquisition of domestic assets by foreigners.
 Summary
• An economy’s net capital outflow always
equals its net exports.
• An economy’s 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 of purchasing-power
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.