Open-Economy

Macroeconomics

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Contents

1. The International flows of Goods and Capital

2. Nominal and Real exchange rate
3. Purchasing-Power Parity
4. Supply and Demand for Loanable Funds and for
Foreign-Currency Exchange

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1. The International flows of Goods
and Capital
 International trade can raise living standards
Closed economy
• Not interact with other economies

Open economy
• Interact freely with other economies

 Two ways:

Product markets Financial markets

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 The flows of Goods:
• Exports domestically • Imports foreign-­produced
produced goods and goods and services that
services that are sold are sold domestically
abroad
 Net exports = Value of country’s exports – Value of
country’s imports
 Trade balance:

• Trade surplus: an • Trade deficit: an

excess of exports over excess of imports over
imports exports

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 The flows of Goods:
• Exports domestically • Imports foreign-­produced
produced goods and goods and services that
services that are sold are sold domestically
abroad
 Net exports = Value of country’s exports – Value of
country’s imports
 Trade balance:

• Trade surplus: an • Trade deficit: an

excess of exports over excess of imports over
imports exports

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 The flows of Financial resources:
Net Capital Outflow
=

 The net capital outflow can be either positive or negative

• FDI • Foreign portfolio
investment

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 The flows of Financial resources:
Net Capital Outflow
=

 The net capital outflow can be either positive or negative

• FDI • Foreign portfolio
investment

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 The Equality of Net Exports and Net Capital
Outflow:
 NCO = NX

 Example:

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 The Equality of Net Exports and Net Capital
Outflow:
 NCO = NX

 Example:

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 The Equality of Net Exports and Net Capital
Outflow:
 NCO = NX

 Example:

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 The Equality of Net Exports and Net Capital
Outflow:
 When a nation is running a trade surplus

(NX>0), it is selling more goods and services to

foreigners than it is buying from them. What is
it doing with the foreign currency it receives
from the net sale of goods and services abroad?
It must be using it to buy foreign assets. Capital
is flowing out of the country (NCO>0).

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 The Equality of Net Exports and Net Capital
Outflow:
 When a nation is running a trade deficit

(NX<0), it is buying more goods and services

from foreigners than it is selling to them. How is
it financing the net purchase of these goods and
services in world markets? It must be selling
assets abroad. Capital is flowing into the
country (NCO<0).

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 Saving, Investment and the International flows:
 GDP = C + I + G +NX
S = I + NX
 S = I + NCO
Saving = Domestic investment + Net capital outflow

 saving, investment, and international capital

flows are inextricably linked

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 Saving, Investment and the International flows:
 GDP = C + I + G +NX
S = I + NX
 S = I + NCO
Saving = Domestic investment + Net capital outflow

 saving, investment, and international capital

flows are inextricably linked

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 Saving, Investment and the International flows:
 GDP = C + I + G +NX
S = I + NX
 S = I + NCO
Saving = Domestic investment + Net capital outflow

 saving, investment, and international capital

flows are inextricably linked

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 Trade • EX > IM  NX > 0
surplus • GDP > S  S > I NCO > 0

Trade • EX < IM  NX < 0

deficit • GDP < S  S < I NCO < 0

Balanced • EX = IM  NX = 0
trade • GDP = S  S = I NCO = 0

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 Trade • EX > IM  NX > 0
surplus • GDP > S  S > I NCO > 0

Trade • EX < IM  NX < 0

deficit • GDP < S  S < I NCO < 0

Balanced • EX = IM  NX = 0
trade • GDP = S  S = I NCO = 0

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 Trade • EX > IM  NX > 0
surplus • GDP > S  S > I NCO > 0

Trade • EX < IM  NX < 0

deficit • GDP < S  S < I NCO < 0

Balanced • EX = IM  NX = 0
trade • GDP = S  S = I NCO = 0

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2. Nominal and Real exchange rate

 Nominal Exchange rate - the rate at which a

person can trade the
currency of one country
for the currency of
 Example: another

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 Nominal Exchange rate:
 Appreciation: an increase in the value of a currency as
measured by the amount of foreign currency it can buy
 Depreciation: a decrease in the value of a currency as
measured by the amount of foreign currency it can buy
 “ Strong” / “weak”

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 Real Exchange rate - 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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 Real and nominal exchange rates are closely related
Nominal exchange rate  Domestic price
Real exchange rate 
Foreign price

 Macroeconomists focus on overall prices rather than

the prices of individual items

e P
Real exchange rate  *
P

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 the real exchange rate depends on the nominal exchange
rate and on the prices of goods in the two countries
measured in the local currencies

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3. Purchasing-Power Parity

Exchange rates vary substantially over time.

 Theory of exchange rates: purchasing-power parity
 A unit of any given currency should be able to buy the

same quantity of goods in all countries.

 Determine exchange rates in the long run.

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 The law of one price: a good must sell for the same price in
all locations
 Example: purchasing
Parity power =
= value of
equality money in
term of…

Purchasing-
power
parity

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 The law of one price: a good must sell for the same price in
all locations
 Example: purchasing
Parity power =
= value of
equality money in
term of…

Purchasing-
power
parity

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 The law of one price: a good must sell for the same price in
all locations
 Example: purchasing
Parity power =
= value of
equality money in
term of…

Purchasing-
power
parity

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 Implication:
 The nominal exchange rate depends on the price

levels in those countries

P: price of goods in the U.S

1 e
P*: price of goods in Japan P P*
e: nominal exchange rates
1 e eP
  1 
P P* P*
P
e
P*

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 Implication:
 The nominal exchange rate depends on the price

levels in those countries

P: price of goods in the U.S

1 e
=
P*: price of goods in Japan P P*
e: nominal exchange rates
1 e eP
  1 
P P* P*
P
e
P*
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 Implication:
 According to the theory of purchasing-power parity,

the nominal exchange rate between the currencies

of two countries must reflect the price levels in
those countries.

 When the central bank prints large quantities of

money, that 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: not ensure that a dollar has the same
real value in all countries all the time
 Many goods are not easily traded

 Goods are not always perfect substitutes when

they are produced in different countries

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 Limitations: not ensure that a dollar has the same
real value in all countries all the time
 Many goods are not easily traded

 Goods are not always perfect substitutes when

they are produced in different countries

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 Limitations: not ensure that a dollar has the same
real value in all countries all the time
 Many goods are not easily traded

 Goods are not always perfect substitutes when

they are produced in different countries

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4. Supply and Demand for Loanable Funds and
for Foreign-Currency Exchange

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The Market for Loanable Funds

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The Market for Loanable Funds

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The Market for Foreign-Currency Exchange

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The Market for Foreign-Currency Exchange

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The Market for Foreign-Currency Exchange

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Summary
1. Net capital outflow is the acquisition of foreign assets by
domestic residents (capital outflow) minus the
acquisition of domestic assets by foreigners (capital
inflow).
2. An economy’s net capital outflow always equals its net
exports
3. National saving equals domestic investment plus net
capital outflow
4. The nominal exchange rate is the relative price of the
currency of two countries, and the real exchange rate is
the relative price of the goods and services of two
countries
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