11

THE MACROECONOMICS OF OPEN ECONOMIES

 Open-Economy
6
Macroeconomics

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 The Flow of Goods: Exports, Imports, Net
Exports (revision)

• Exports are goods and services that are

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

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 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.
• 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.
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 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.

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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 incomes of consumers at home and abroad.
• The costs of transporting goods from country to
country.
• The policies of the government toward international
trade. Copyright © 2010 Cengage Learning
Figure 1 The Increasing Openness of the World
Economy

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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 UK resident buys shares in the BMW and a Japanese
resident buys a bond issued by the UK government.
• When a UK resident buys shares in BMW, the German
car company, the purchase raises UK net capital
outflow.
• When a Japanese resident buys a bond issued by the UK
government, the purchase reduces the UK net capital
outflow.
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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.

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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.

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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
• National saving (S) equals Y - C – G, so S = I + NX, or

Saving =
Domestic + Net Capital
Investment Outflow
S = I + NCO
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Figure 2 US 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

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Figure 2 US 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

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 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.
• The nominal exchange rate is the rate at which a
person can trade the currency of one country for the
currency of another.
• 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.
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Nominal Exchange Rates

• The nominal exchange rate is expressed in two ways:

• In units of foreign currency per euro.
• And in euros per unit of the foreign currency.
• Assume the exchange rate between the Japanese yen and
the euro is 80 yen to one euro.
• One euro trades for 80 yen.
• One yen trades for 1/80 (= 0.0125) of a euro.
• 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.
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Real Exchange Rates

• The real exchange rate compares the prices of domestic

goods and foreign goods in the domestic economy.
• If a kilo of Swiss cheese is twice as expensive as a kilo of
English cheese, the real exchange rate is 1/2 a kilo of Swiss
cheese per kilo of English cheese.
• 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.
N om inal exchange rate D om estic price
R eal exchange rate =
Foreign price
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Real Exchange Rates

• A depreciation (fall) in the UK real exchange rate means

that UK goods have become cheaper relative to foreign
goods.
• This encourages consumers both at home and abroad to
buy more UK goods and fewer goods from other
countries.
• As a result, UK exports rise, and UK imports fall, and
both of these changes raise UK net exports.
• Conversely, an appreciation in the UK real exchange
rate means that UK goods have become more expensive
compared to foreign goods, so UK net exports fall.
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 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.
• 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.
• 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.

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The 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.
• 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.
• 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. Copyright © 2010 Cengage Learning
 Implications of Purchasing Power Parity

• If the purchasing power of the euro 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.
• 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.
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 Figure 3 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

Exchange rate
.00001

.0000000001
1921 1922 1923 1924 1925
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 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.

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Key Macroeconomic Variables in an
Open Economy
• An open economy is one that interacts freely
with other economies around the world.
• The important macroeconomic variables of an
open economy include:
• net exports
• net foreign investment
• nominal exchange rates
• real exchange rates

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 Macroeconomic Model of an Open
Economy
• Basic Assumptions:
• The model takes the economy’s GDP as given.
• The model takes the economy’s price level as given.
• The Market for Loanable Funds
S = I + NCO
• At the equilibrium interest rate, the amount that people want
to save exactly balances the desired quantities of investment
and net capital outflows.
• The supply of loanable funds comes from national saving
(S).
• The demand for loanable funds comes from domestic
investment (I) and net capital outflows (NCO).
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The Market for Loanable Funds

• The supply and demand for loanable funds depend on

the real interest rate.
• A higher real interest rate encourages people to save
and raises the quantity of loanable funds supplied.
• The interest rate adjusts to bring the supply and
demand for loanable funds into balance.
• At the equilibrium interest rate, the amount that people
want to save exactly balances the desired quantities of
domestic investment and net foreign investment.

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 Figure 1 The Market for Loanable Funds

Real
Interest
Rate
Supply of loanable funds
(from national saving)

Equilibrium
real interest
rate
Demand for loanable
funds (for domestic
investment and net
capital outflow)

Equilibrium Quantity of
quantity Loanable Funds
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 The Market for Foreign Currency Exchange

• The two sides of the foreign currency exchange market

are represented by NCO and NX.
• NCO represents the imbalance between the purchases
and sales of capital assets.
• NX represents the imbalance between exports and
imports of goods and services.
• In the market for foreign currency exchange, pounds
are traded for foreign currencies.
• For an economy as a whole, NCO and NX must
balance each other out, or:
NCO = NX
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 The Market for Foreign Currency Exchange

• The price that balances the supply and demand for foreign
currency is the real exchange rate.
• The demand curve for foreign currency is downward sloping
because a higher exchange rate makes domestic goods more
expensive.
• The supply curve is vertical because the quantity of pounds
supplied for net capital outflow is unrelated to the real exchange
rate.
• The real exchange rate adjusts to balance the supply and
demand for pounds.
• At the equilibrium real exchange rate, the demand for pounds to
buy net exports exactly balances the supply of pounds to be
exchanged into foreign currency to buy assets abroad.
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 Figure 2 The Market for Foreign Currency
Exchange

Real
Exchange
Rate
Supply of pounds
(from net capital outflow)

Equilibrium
real exchange
rate

Demand for pounds

(for net exports)

Equilibrium Quantity of Pounds Exchanged

quantity into Foreign Currency
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 EQUILIBRIUM IN THE OPEN
ECONOMY
• In the market for loanable funds, supply comes
from national saving and demand comes from
domestic investment and net capital outflow.
• In the market for foreign currency exchange,
supply comes from net capital outflow and demand
comes from net exports.
• Net capital outflow links the loanable funds market
and the foreign currency exchange market.
• The key determinant of net capital outflow is the
real interest rate.
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 Figure 3 How Net Capital Outflow Depends on the
Interest Rate

Real
Interest
Rate

Net capital outflow 0 Net capital outflow Net Capital

is negative. is positive. Outflow
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 EQUILIBRIUM IN THE OPEN
ECONOMY

• Prices in the loanable funds market and the

foreign currency exchange market adjust
simultaneously to balance supply and demand
in these two markets.
• As they do, they determine the macroeconomic
variables of national saving, domestic
investment, net foreign investment, and net
exports.
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Figure 4 The Real Equilibrium in an Open
Economy
(a) The Market for Loanable Funds (b) Net Capital Outflow

Real Real
Interest Supply Interest
Rate Rate

r r

Demand Net capital

outflow, NCO
Quantity of Net Capital
Loanable Funds Outflow

Real
Exchange Supply
Rate

Demand

Quantity of
Pounds

(c) The Market for Foreign Currency Exchange

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 HOW POLICIES AND EVENTS
AFFECT AN OPEN ECONOMY

• The magnitude and variation in important

macroeconomic variables depend on the
following:
• Government budget deficits
• Trade policies
• Political and economic stability

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Government Budget Deficits

• In an open economy, government budget deficits . . .

• reduces national saving, which . . .
• shifts the supply curve for loanable funds to the left,
which . . .
• raises interest rates.
• crowd out domestic investment,
• Higher interest rates reduce investment.
• cause net foreign investment to fall.
• A decrease in net foreign investment reduces the supply
of pounds to be exchanged into foreign currency.
• This causes the real exchange rate to appreciate.
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Figure 5 The Effects of Government Budget Deficit
1. A budget deficit reduces
(a) The Market for Loanable Funds (b) Net Capital Outflow
the supply of loanable funds . . .
Real Real
Interest S S Interest
Rate Rate

B
r2 r2

A
r r
3. . . . which in
2. . . . which
turn reduces
increases
net capital
the real Demand
outflow.
interest NCO
rate . . .
Quantity of Net Capital
Loanable Funds Outflow

Real
Exchange S S
Rate 4. The decrease
in net capital
outflow reduces
the supply of pounds
to be exchanged
E2
into foreign
E1 currency . . .
5. . . . which
causes the
real exchange
rate to Demand
appreciate.

Quantity of
Pounds

(c) The Market for Foreign Currency Exchange

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Trade Policy

• A trade policy is a government policy that directly influences

the quantity of goods and services that a country imports or
exports.
• Tariff: A tax on an imported good.
• Import quota: A limit on the quantity of a good produced
abroad and sold domestically.
• Because they do not change national saving or domestic
investment, trade policies do not affect the trade balance.
• For a given level of national saving and domestic
investment, the real exchange rate adjusts to keep the trade
balance the same.
• Trade policies have a greater effect on microeconomic than on
macroeconomic markets.
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Trade Policy

• Effect of an Import Quota

• Because foreigners need pounds to buy UK net exports,
there is an increased demand for pounds in the market for
foreign currency.
• This leads to an appreciation of the real exchange rate.
• There is no change in the interest rate because nothing
happens in the loanable funds market.
• There is no change in net foreign investment even though an
import quota reduces imports.
• An appreciation of the pound in the foreign exchange market
encourages imports and discourages exports.
• This offsets the initial increase in net exports due to import
quota.
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Figure 6 The Effects of an Import Quota
(a) The Market for Loanable Funds (b) Net Capital Outflow

Real Real
Interest Supply Interest
Rate Rate

r r
3. Net exports,
however, remain
the same.
Demand
NCO
Quantity of Net Capital
Loanable Funds Outflow

Real
Exchange Supply
Rate
1. An import
quota increases
the demand for
E2 pounds . . .
2. . . . and
causes the E
real exchange
rate to D
appreciate.
D

Quantity of
Pounds

(c) The Market for Foreign-Currency Exchange

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Political Instability and Capital Flight

• Capital flight is a large and sudden reduction in the

demand for assets located in a country.
• Capital flight has its largest impact on the
country from which the capital is fleeing, but it
also affects other countries.
• If investors become concerned about the safety
of their investments, capital can quickly leave
an economy.
• Interest rates increase and the domestic
currency depreciates.
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Political Instability and Capital Flight

• When investors around the world observed

political problems in Mexico in 1994, they sold
some of their Mexican assets and used the
proceeds to buy assets of other countries.
• This increased the supply of pesos in the foreign
currency exchange market.
• This increased Mexican net capital outflow.
• The demand for loanable funds in the loanable
funds market increased, which increased the interest
rate.
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 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.
• 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.

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 Summary
• When the nominal exchange rate changes so that each
euro buys more foreign currency, the euro is said to
appreciate or strengthen.
• When the nominal exchange rate changes so that each
euro buys less foreign currency, the euro is said to
depreciate or weaken.
• 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.
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 Summary
• To analyze the macroeconomics of open economies, two
markets are central — the market for loanable funds and the
market for foreign currency exchange.
• In the market for loanable funds, the interest rate adjusts to
balance supply for loanable funds (from national saving) and
demand for loanable funds (from domestic investment and
net capital outflow).
• In the market for foreign currency exchange, the real
exchange rate adjusts to balance the supply of pounds (for
net capital outflow) and the demand for pounds (for net
exports).
• Net capital outflow is the variable that connects the two
markets.
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 Summary
• A policy that reduces national saving, such as a government
budget deficit, reduces the supply of loanable funds and
drives up the interest rate.
• The higher interest rate reduces net capital outflow, reducing
the supply of pounds.
• The pound appreciates, and net exports fall.
• A trade restriction increases net exports and increases the
demand for pounds in the market for foreign currency
exchange.
• As a result, the pound appreciates in value, making domestic
goods more expensive relative to foreign goods. This
appreciation offsets the initial impact of the trade restrictions
on net exports. Copyright © 2010 Cengage Learning
 Summary

• When investors change their attitudes about

holding assets of a country, the effects on the
country’s economy can be profound.
• Political instability in a country can lead to
capital flight.
• Capital flight tends to increase interest rates and
cause the country’s currency to depreciate.

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