N.

GREGORY MANKIW NINTH EDITION

PRINCIPLES OF
ECONOMICS

Lecture 12
Open-Economy Macroeconomics: Basic Concepts
adapted by Guangyu Nie

Interactive PowerPoint Slides by:

V. Andreea Chiritescu
Eastern Illinois University
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 IN THIS CHAPTER
• 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?

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 Introduction
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

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 Milton Friedman’s Famous Example
Trade can make everyone better off.
• https://www.bilibili.com/video/BV1wtdnYrE
Ap/

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 International Flows of Goods and Capital
• Closed economy
– Economy that does not interact with other
economies in the world
• Open economy
– Economy that interacts (freely or with
restrictions) with other economies around the
world
– Buys and sells goods and services in world
product markets
– Buys and sells capital assets such as stocks
and bonds in world financial markets
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 The Flow of Goods
• Exports
– Goods and services that are produced
domestically and sold abroad
• Imports
– Goods and services that are produced
abroad and sold domestically
• Net exports, NX (Trade balance)
= Value of exports – value of imports

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Average of Exports and Imports in 2020

7
 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.

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 Factors that Influence NX
• Factors that might influence a country’s
exports, imports, and net exports:
– Consumers’ tastes for foreign and domestic
goods
– Prices of goods at home and abroad
– Exchange rates at which foreign currency
trades for domestic currency
– Incomes of consumers at home and abroad
– Transportation costs
– Government policies
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 Trade Surpluses & Deficits
• Trade surplus, NX > 0
– Exports are greater than imports
• The country sells more goods and services
abroad than it buys from other countries
• Trade deficit, NX < 0
– Imports are greater than exports
• The country sells fewer goods and services
abroad than it buys from other countries
• Balanced trade: Exports = Imports
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The Chinese economy’s increasing openness

11
The U.S. economy’s increasing openness

12
 Global Imbalance of Capital Flows

Cumulative External Balances Around the World: 1980-2012,

billions of U.S. dollars

13
Global Imbalance of Capital Flows

14
 The Flow of Financial Resources
• Net capital outflow, NCO (net foreign
investment)
– Purchase of foreign assets by domestic
residents (capital outflow)
• Foreign direct investment
• Foreign portfolio investment
– Minus the purchase of domestic assets by
foreigners (capital inflow)

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 Net Capital Outflow, NCO
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

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 Variables that Influence NCO
– Real interest rates paid on foreign assets
– Real interest rates paid on domestic
assets
– Perceived economic and political risks of
holding foreign assets
– Government policies affecting foreign
ownership of domestic assets

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 The Equality of NX and NCO – 1
• An accounting identity: NCO = NX
– 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.

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 The Equality of NX and NCO – 2
• 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.

19
 EXAMPLE 1: Exporting to Germany
Kiara is a web designer living in Illinois. She creates
and sells a website to Gabrielle who is living in
Germany. Gabrielle pays Kiara 5,000 euros for the
website.
• What is the effect on the U.S. net exports and net
capital outflows if:
A. Kiara keeps the 5,000 euros at home
B. Kiara buys 5,000 euros worth of stocks in a German
company
C. Kiara spends the 5,000 euros on shoes made in
Germany
D. Kiara exchanges the 5,000 euros into U.S. dollars
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 EXAMPLE 2: Importing from China
Amazon in U.S. purchases $10,000,000 worth of goods
from China (to sell to the American customers).
• What is the effect on the U.S. net exports and net
capital outflows if:
A. China buys $10 million worth of U.S. government
bonds
B. China buys $10 million worth of goods from the U.S.
C. China buys $10 million worth of stocks in U.S.
companies

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 Trade Surplus and NCO
• A country running a trade surplus, NX > 0
– Selling more goods and services to
foreigners than it is buying from them.
– Use the foreign currency it receives from
the net sale of goods and services abroad
to buy foreign assets.
– Capital is flowing out of the country,
NCO > 0

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 Trade Deficit and NCO
• A country is running a trade deficit, NX < 0
– Buying more goods and services from
foreigners than it is selling to them.
– Financing the net purchase of these
goods and services in world markets by
selling assets abroad.
– Capital is flowing into the country,
NCO < 0

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 Saving and Investment
• Open economy: Y = C + I + G + NX
• National saving: S = Y – C – G
• Y – C – G = I + NX
• S = I + NX
• NX = NCO
• S = I + NCO
• Saving = Domestic investment + Net
capital outflow

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 International flows of goods and capital
• Trade surplus:
• Exports > Imports and Net exports > 0
• Y > Domestic spending (C+I+G)
• S > I and NCO > 0
• Trade deficit:
• Exports < Imports and Net exports < 0
• Y < Domestic spending (C+I+G)
• S < I and NCO < 0

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 ASK THE EXPERTS
Trade Balances and Trade Negotiations
“A typical country can increase its citizens’
welfare by enacting policies that would
increase its trade surplus (or decrease its
trade deficit).”

Source: IGM Economic Experts Panel, December 9, 2014 and March 22, 2016.

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 Is the U.S. trade deficit a national problem?
• Before 1980
– S and I were close: small net capital outflow
(between – 1 and 1 % of GDP)
• After 1980
– S often falling below I; sizable trade deficits,
substantial inflows of capital
– NCO is often a large negative number
• Unbalanced fiscal policy: 1980 to 1987
– Flow of capital into the U.S. declines due to a
fall in national saving

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 Is the U.S. trade deficit a national problem?
• An investment boom: 1991 to 2000
– Increase flow of capital; S and I increased
– Government budget surplus
• Economic downturn and recovery: 2000 to 2018
– 2000-2009, S and I fell
• Investment: tough economic times made
capital accumulation less profitable
• Saving: government began running
extraordinarily large budget deficits
– 2009-2018, as the economy recovered, S and I
increased by about 3 percentage points
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 Is the U.S. trade deficit a national problem?
• Trade deficit: by a fall in saving (1980s)
– The nation is putting away less of its income to
provide for its future
• Better to have foreigners invest in the U.S.
economy than no one at all
• Trade deficit: by an investment boom
(1990s)
– Economy is borrowing from abroad to finance
the purchase of new capital goods
• For lower return on investment - debts will
look less desirable
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 U.S. saving, investment, and NCO, 1950–2019
25.00

20.00
Investment

15.00

10.00
Saving
(% of GDP)

5.00

0.00

-5.00
NCO
-10.00
1959-09-01

1979-01-01

1986-04-01

2005-08-01
1950-01-01
1952-06-01
1954-11-01
1957-04-01

1962-02-01
1964-07-01
1966-12-01
1969-05-01
1971-10-01
1974-03-01
1976-08-01

1981-06-01
1983-11-01

1988-09-01
1991-02-01
1993-07-01
1995-12-01
1998-05-01
2000-10-01
2003-03-01

2008-01-01
2010-06-01
2012-11-01
2015-04-01
2017-09-01
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 Is the U.S. trade deficit a national problem?
• 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, since 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.

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 The Nominal Exchange Rate
• Nominal exchange rate:
– 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,1 October 2019, per US$
• Canadian dollar: 1.32
• Euro: 0.91
• Japanese yen: 107.70
• Mexican peso: 19.82

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 Prices for International Transactions
• Appreciation (or “strengthening”)
– Increase in the value of a currency as
measured by the amount of foreign
currency it can buy
• Depreciation (or “weakening”)
– Decrease in the value of a currency
– As measured by the amount of foreign
currency it can buy

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 EXAMPLE 3: Appreciation or depreciation?
What is the exchange rate? Did the US dollar
appreciated or depreciated?
A. Last year, Khalid exchanged $1 for 100
Japanese yen, but this year he exchanged
$1 for 105 Japanese yen.
B. Last year, Amira exchanged $1 for 25
Mexican pesos, but this year she
exchanged $1 for 20 Mexican pesos.

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 The Real Exchange Rate
• Real exchange rate:
– Rate at which the goods and services of
one country trade for the goods and
services of another
• Real exchange rate = e x P / P*
– Where
• P = domestic price
• P* = foreign price (in foreign currency)
• e = nominal exchange rate (foreign currency
per unit of domestic currency)
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 EXAMPLE 4: Calculating real exchange rate
A Big Mac costs $4 in U.S., 380 yen in Japan.
The exchange rate is 110 yen per dollar.
• Compute the real exchange rate.
e x P = price in yen of a U.S. Big Mac
= (110 yen per $) x ($4 per Big Mac)
= 440 yen per U.S. Big Mac
Real exchange rate = e x P / P*
= 440 yen per U.S. Big Mac / 380 yen per Japanese
Big Mac
= 1.16 Japanese Big Macs per U.S. Big Mac

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 Active Learning 2: Compute a real exchange rate

The exchange rate is e = 20 pesos per $

The price of a tall Starbucks Latte is:
P = $3 in U.S. and P* = 40 pesos in Mexico
A. What is the price of a U.S. latte measured
in pesos?
B. Calculate the real exchange rate,
measured as Mexican lattes per U.S. latte.

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 For the Economy as a Whole
• Real exchange rate = (e x P)/P*
= price of a domestic basket of goods relative
to price of a foreign basket of goods
• P = U.S. price level, e.g., Consumer Price
Index, measures the price of a basket of
goods
• P* = foreign price level
– If U.S. real exchange rate appreciates, U.S.
goods become more expensive relative to
foreign goods.
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 Purchasing-Power Parity – 1
• Purchasing-power parity
– 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
• Based on the law of one price:
– A good should sell for the same price in all
locations
• Arbitrage
– Take advantage of price differences for the same
item in different markets

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 EXAMPLE 5: The law of one price
If coffee beans sell for $4/pound in Seattle
and $5/pound in Boston; and coffee beans
can be costlessly transported, how will the two
markets reach equilibrium?
• Opportunity for arbitrage: making a quick profit
by buying coffee in Seattle and selling it in
Boston.
• Seattle: increase demand drives up the price
• Boston: increase supply drives the price down
• Until the two prices are equal.
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 EXAMPLE 5: The law of one price
If coffee beans sell for $4/pound in Seattle
and CA$5/pound in Vancouver; and coffee
beans can be costlessly transported, how do
you determine the exchange rate e between
U.S. dollar and CA dollar?

• Pus = e Pca
• e = Pus/ Pca

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 Purchasing-Power Parity – 2
• PPP: a currency must have the same
purchasing power in all countries
– A U.S. dollar must buy the same quantity
of goods in the United States and Japan
– And a Japanese yen must buy the same
quantity of goods in Japan and the United
States
– A unit of a currency must have the same
real value in every country.

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 EXAMPLE 6: Applying PPP
Using the theory of purchasing-power parity, find
the exchange rate if a bushel of apples sells for
$30 in the U.S. and 300 krona in Sweden.
• PPP: a dollar buys the same quantity of goods
in the United States (prices in $) as in Sweden
(prices in krona)
• The number of krona per dollar must reflect the
prices of goods in the U.S. and Sweden.
• Nominal exchange rate = 300 krona / 30 dollars
= 10 krona per dollar

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 Implications of PPP – 1
• If purchasing power of the dollar is always the
same at home and abroad
– Then the real exchange rate cannot change
• Theory of purchasing-power parity, e = P*/P
– Nominal exchange rate between the currencies of
two countries must reflect the price levels in those
countries
• P = domestic price level
• P* = foreign price level
• And e = exchange rate (foreign currency per $)
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 Implications of PPP – 2
• Implications:
– Nominal exchange rates change when
price levels change
– When a central bank in any country
increases the money supply
• And causes the price level to rise
• It also causes that country’s currency to
depreciate relative to other currencies in the
world

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 Limitations of PPP – 1
• Theory of purchasing-power parity does
not always hold in practice
1. Many goods are not easily traded
• Price differences on such goods cannot be
arbitraged away
2. Even tradable goods are not always perfect
substitutes when they are produced in different
countries
• Price differences reflect taste differences
3. Different weights of goods in the baskets

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Testing PPP: The Big-Mac

January 2015

47
Testing PPP: International Comparison Program
• It represents the most extensive and thorough effort to measure
absolute PPP rates across countries.
• The ICP was established in the late 1960s on the recommendation
of the United Nations Statistical Commission (UNSC). It began as a
research project carried out jointly by the United Nations Statistical
Office and the University of Pennsylvania. The first comparison,
conducted in 1970, covered 10 economies. Now, 40 years later, the
ICP is a worldwide statistical operation whose latest comparison—
ICP 2011—involved 199 economies. The program is led and
coordinated by the ICP Global Office hosted by the World Bank.
• The 2011 ICP round collected over 7 million prices from 199
economies in eight regions, with the help of 15 regional and
international partners. It is the most extensive effort to measure
PPPs ever undertaken.
48
Testing PPP: International Comparison Program

49
Higher Prices in Rich Countries

50
 Limitations of PPP – 2
• Purchasing-power parity
– Not a perfect theory of exchange-rate
determination
– Real exchange rates fluctuate over time
• Large and persistent movements in
nominal exchange rates
– Typically reflect changes in price levels at
home and abroad

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 Hyperinflation in Germany, 1921-1924

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 Hyperinflation in Germany, 1921-1924

Brief 4-year timeline of the marks per one U.S. dollar

exchange rate:
➢ April 1919: 12 marks
➢ November 1921: 263 marks
➢ January 1923: 17,000 marks
➢ August 1923: 4.621 million marks
➢ October 1923: 25.26 billion marks
➢ December 1923: 4.2 trillion marks

53
 Active Learning 3: Chapter review questions
A. 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
B. 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)?
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 THINK-PAIR-SHARE
You are watching a national news broadcast
with your parents. The news anchor explains that
the exchange rate for the dollar just hit its lowest
value in a decade. The on-the-spot report shifts to a
spokesman for Caterpillar, a heavy equipment
manufacturer. The spokesman reports that sales of
its earthmoving equipment have hit an all-time high
and so has the value of its stock. Your parents are
shocked by the report’s positive view of the low
value of the dollar. They just cancelled their
European vacation because of the dollar’s low
value.

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55
license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
 THINK-PAIR-SHARE
A. Why do Caterpillar and your parents have
different opinions about the value of the dollar?
B. Caterpillar imports many parts and raw materials
for their manufacturing processes, and they sell
many finished products abroad. Since they are
happy about a low dollar, what must be true about
the proportions of their imports and exports?
C. If someone argues that a strong dollar is “good for
America” because Americans are able to
exchange some of their GDP for a greater amount
of foreign GDP, is it true that a strong dollar is
good for every American? Why or why not?
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license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
 CHAPTER IN A NUTSHELL
• Net exports are exports minus imports.
• 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 either to finance
investment at home or to buy assets abroad. Thus,
national saving equals domestic investment plus
net capital outflow.

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license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
 CHAPTER IN A NUTSHELL
• 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.
• 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.

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58
license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
 CHAPTER IN A NUTSHELL
• According to the theory of purchasing-power parity,
a dollar (or a unit of any other currency) should be
able to buy the same quantity of goods in all
countries.
• This theory implies that the nominal exchange rate
between the currencies of two countries should
reflect the price levels in those countries. As a
result, countries with relatively high inflation should
have depreciating currencies, and countries with
relatively low inflation should have appreciating
currencies.

© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a
59
license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.