Chapter 10: Open Economy Macro

Economics Basic Concepts

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Introduction
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.

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The International Flows Of Goods
And Capital
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
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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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
◦ Consumer tastes 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.

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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.
◦ An Indian resident buys shares in the BMW and a
Japanese resident buys a bond issued by the Indian
government.
◦ When an Indian resident buys shares in BMW, the German
car company, the purchase raises India’s net capital outflow.
◦ When a Japanese resident buys a bond issued by the
Indian government, the purchase reduces the Indian 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

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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

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Table 1 International Flows of Goods and Capital: Summary

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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.

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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 domestic currency.
◦ In domestic currency per unit of the foreign currency.
◦ Assume the exchange rate between the Indian Rupees and
the $ is Rs75 to one $.
◦ One $ trades for Rs.75.
◦ One Rs trades for 1/75 (= 0.0133) of a $.

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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 $ buys:
◦ More foreign currency, there is an appreciation of the $.
◦ Less foreign currency, there is a depreciation of the $.

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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.
The real exchange rate compares the prices of domestic
goods and foreign goods in the domestic economy.
◦ If a kilo of Indian wheat sells for Rs1 and a kilo of American
wheat sells for $3.
◦ If the nominal exchange rate is 2 dollars per Rs, then….
◦ The price of Indian wheat in dollars is $2.
◦ So the real exchange rate is 2/3 kilo of american wheat per
kilo of indian wheat.

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 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.
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

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Real Exchange Rates
A depreciation (fall) in the Indian real exchange rate:
◦ Means that Indian goods have become cheaper relative to
foreign goods.
◦ This encourages consumers both at home and abroad to buy
more Indian goods and fewer goods from other countries.
◦ As a result, Indian exports rise, and Indian imports fall, and
both of these changes raise Indian net exports.
An appreciation in the Indian real exchange rate:
• Means that Indian goods have become more expensive
compared to foreign goods.
• Indian 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.

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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.
◦ It is based on a principle called 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.
◦ Exchange rates move to ensure ppp.

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Implications of Purchasing Power Parity
The nominal exchange rate between the
currencies of two countries must reflect the
different price levels in those countries.
Because the nominal exchange rate depends
on the price levels, it must also depend on the
money supply and money demand in each
country.
◦ If a 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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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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