CHAPTER 31

OPEN-ECONOMY
MACROECONOMICS:
BASIC CONCEPTS
 In this chapter

• How are international flows of goods and assets related?

• What is the difference between the real and nominal exchange
rate?
• What is “purchasing power parity” and how does it explain
nominal exchange rates?
 In this chapter

• 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, trade surplus)
• International flows of assets
• Exchange rates
 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 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.
• 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 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 Flow of Financial Resources: Net Capital Outflow

• Net capital outflow (NCO) refers to the purchase of foreign assets

by domestic residents minus the purchase of domestic assets by
foreigners.
• The flow of capital abroad takes two forms
• Foreign direct investment: Domestic residents actively manage the foreign
investment
• Foreign portfolio investment: Domestic residents purchase foreign stocks
or bonds, supplying “loanable funds” to a foreign firm
 The Flow of Financial Resources: Net Capital Outflow

• NCO measures the imbalance in a country’s trade in assets

• NCO > 0, “capital outflow”: Domestic purchases of foreign assets exceed
foreign purchases of domestic assets
When a U.S. resident buys stock in Telmex, the Mexican phone company, the
purchase raises U.S. net capital outflow
• NCO < 0, “capital outflow”: Foreign purchases of foreign assets exceed
domestic purchases of domestic assets
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

Factors that affect 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 NX and NCO

• An accounting identity: NCO = NX

• Arises because every transaction that effects NX also affects NCO by the
same amount (and vice versa)
• When a foreign purchases a good from the US
• US exports and NX increases
• The foreigner pays with currency or assets, so the US acquires some
foreign assets, causing NCO to rise
 The equality of NX and NCO

• An accounting identity: NCO = NX

• Arises because every transaction that effects NX also affects NCO by the
same amount (and vice versa)
• When a US citizen buys foreign good
• US imports rises, NX falls
• The US buyer pays with US dollar or assets, so the other country acquires
US assets, causing US NCO to fall
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 Investment + Net Capital Outflow
S = I + NCO
 Balance of Payments

• The balance of payments is a record of a country's trade in goods,

services, and financial assets with the rest of the world.
• The balance of payments consists of two parts:
(1) The current account records the flow of dollars reflecting the
flow of goods
(2) The capital account reflects the flow of dollars
corresponding to the flow of assets.
 Balance of Payments

Table below describes the general structure of the balance of payments

Balance of Payments
(1) Current Account Credit Debit
Exports (Goods and Services) +
Import (Goods and Services) -
Investment Incom Received +
Investment Income Paid -
Net Unilateral Transfers
 Balance of Payments

Services include transportation, tourism, insurance, education,

and financial services.

Investment income includes interest payments and dividends

people receive from assets owned outside of their own country.

A unilateral transfer occurs when one party gives something

but receives nothing in return,
e.g. foreign aid, remittance…
 Balance of Payments

Balance of Payments (cont.)

(2) Capital Account Credit Debit

Increase in US Holdings of Foreign Assets -
Increase in Foreign Holdings of US Assets +

(3) Official settlements balance - [(1)+(2)]

 Balance of Payments

• Capital Account
• A capital inflow occurs when the home country sells an asset to
another country, e.g. Rockefeller Center is sold to a Japanese
company. A capital outflow occurs when the home country buys
an asset from abroad, e.g. an American obtains a Swiss bank
account.
• The capital account balance = capital inflows - capital outflows
• A country has a capital account surplus when its residents sell
more assets to foreigners than they buy from foreigners.
 Balance of Payments

• Current Account Balance + Capital Account Balance +

official settlements balance = 0
• When a country runs a current account deficit, it means that it received
fewer funds from its exports than the funds paid for imports. To finance
this deficit, it must sell its assets to the foreigners. So, a current account
deficit must be accompanied by a capital account surplus or a fall in
reserve assets.
• The official settlements balance records transactions conducted by
central banks. It measures the net increase in a country's official reserve
assets, assets that can be used in making international payments. The
official settlements balance is called the balance of payments.
 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.
• 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 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.
• 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

• Real exchange rate is a key determinant of how much a country exports

and imports.
• Real exchange rate: the rate at which the goods and services of one
country trade for the good and service of another

Nominal exchange rate ×Domestic price

Real exchange rate =
Foreign price
P
Real exchange rate = E × (E: nominal exchange rate, i.g., foreign
P∗
currency per unit of domestic currency)
 Real Exchange Rates

Example with one good

• A Big Mac costs $5.50 in US, 650 yen in Japan
• E = 125 yen per $
• E × P = price of a Big Mac in Yen
= (125 yen per $) × ($5.50 per Big Mac)
= 687.5 yen per US Big Mac
• Compute the real exchange rate
P 687.5 yen p𝑒𝑟 𝑈𝑆 𝐵𝑖𝑔 𝑀𝑎𝑐
E× =
P∗ 650 yen p𝑒𝑟 𝐽𝑎𝑝𝑎𝑛𝑒𝑠𝑒 𝐵𝑖𝑔 𝑀𝑎𝑐
=1.057 Japanese Big Mac per US Big Mac
 Interpreting the Real exchange rate

• The real exchange rate = 1.057 Japanese Big Mac per US Big Mac
• Correct interpretation: To buy a Big Mac in US, a Japanese citizen
must sacrifice an amount that could purchase 1.075 Big Mac in
Japan
 THE LAW OF ONE PRICE

• Law of one price: the notion that a good should sell for the same
price in all markets
• Suppose a candy bar for 2$ in California, 2.5$ in Chicago and there is no
transportation cost between two regions
• There is an opportunity for arbitrage, making a quick profit by buying
candy bar in California and selling it in Chicago
• Such arbitrage drives up the price in California and drives down the price
in Chicago, until two prices equal
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
(based on the law of one price)
 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.
 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.
 Foreign Exchange Market

Nominal
exchange
rate E
S

𝐸0

𝑄0 Q
 Exchange Rate regime

• The exchange rate regime is the way a country manages its currency in
respect to foreign currencies and the foreign exchange market. It is
closely related to monetary policy.
• The basic types are:
(1)A floating exchange rate, where the market dictates the movements of the
exchange rate;
(2)The fixed (pegged) exchange rate, which ties the currency to another currency,
mostly more widespread currencies such as the US dollar or the euro, and
Governments have to sacrifice the use of an independent domestic monetary
policy to achieve internal stability
(3)A pegged float, where the central bank keeps the rate from deviating too far
from a target band or value.
 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.