Open-Economy

Macroeconomics:
Basic Concepts
We have discussed the below earlier

• The national income identity:

• The definition of national saving:
• The quantity theory of money: In the long run,
The nominal interest rate, the real interest rate, and the difference between
them
• real interest rate = nominal interest rate – inflation
• real interest rate, ex ante = nominal interest rate – expected inflation
Definitions
• A closed economy is an economy that has no economic interactions
with other economies
• An open economy is an economy whose residents have regular
economic interactions with residents of other economies
• There are cross-border purchases and sales of goods and services
• There are cross-border purchases and sales of financial assets such as stocks
and bonds
• Some degree of migration may also occur
Definitions: Exports, Imports, Net
Exports
• Households, businesses, and government entities in open economies
trade goods and services with foreigners.

• Exports = The market value of goods and services that are produced
domestically and sold abroad
• Imports = The market value of goods and services that are produced
abroad and sold domestically
• Net exports = Exports – Imports
• Net exports is also called the trade balance
• Could be positive, negative, or zero
Definitions: Surplus, Deficit,
Balanced Trade
• Trade surplus
• Net exports > 0
• Exports > Imports
• Trade deficit
• Net exports < 0
• Exports < Imports
• Balanced trade
• Net exports = 0
• Exports = Imports
Definitions: Capital Outflow, Capital
Inflow, Net Capital Outflow
• Households, businesses, and government entities in open economies
trade financial and other assets with foreigners.

• Capital outflow = value of foreign assets purchased by domestic

residents
• Capital inflow = value of domestic assets purchased by foreign
residents
• Net capital outflow = capital outflow – capital inflow
• NCO for short
• Also called net foreign investment
• Could be positive or negative or zero.
An Accounting Identity: NX = NCO
• It turns out that net exports and net capital outflow must always be
equal
• You can’t get something for nothing, right?
• The same is true for countries.
• A country can’t buy more goods, services, and assets from other countries
than it sells to other countries.
• This is the basic reason why NX and NCO must always be equal.
An Accounting Identity: NX = NCO
• For every country,
the value of goods and services purchased from other countries + the
value of assets purchased from other countries =
the value of goods and services sold to other countries + the value of
assets sold to other countries
• Therefore, rearranging the terms, we see that
the value of assets purchased from other countries – the value of
assets sold to other countries =
the value of goods and services sold to other countries – the value of
goods and services purchased from other countries
• Therefore, net capital outflow = net exports!
An Accounting Identity: NX = NCO
• One more time:
• We just saw that,
the value of assets purchased from other countries – the value of
assets sold to other countries =
the value of goods and services sold to other countries – the value of
goods and services purchased from other countries
• Recall that net capital outflow = the value of assets purchased from
other countries – the value of assets sold to other countries,
• and net exports = exports – imports.
• Therefore, net capital outflow = net exports!
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).
• 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).
An Accounting Identity: S = I + NCO
• I assume that you are aware of the following important
macroeconomic ideas:
• The national income identity:
• The definition of national saving:
• The national income identity says this:
• A country’s GDP (denoted Y) is the market value of the total output of final
goods and services, and is therefore also the total expenditure on final goods
and services.
• This total expenditure must be the sum of consumption spending by
households (C), investment spending mainly by businesses (I), government
purchases (G), and net exports (NX).
An Accounting Identity: S = I + NCO
• I assume that you are aware of the following important
macroeconomic ideas:
• The national income identity:
• The definition of national saving:
• The definition of saving says this:
• GDP, being total expenditure—as we just saw—is also total income.
• Income (Y) minus consumption by households (C) and consumption by the
government (G) is the natural way to measure national saving (S).
• Therefore, .
An Accounting Identity: S = I + NCO

• The national income identity:

• The definition of national saving:
• We can rewrite the national income identity as:
• Using the definition of national saving, this becomes:
• And we have seen in only the previous slide that
• Therefore, we can write .
An Accounting Identity: S = I + NCO
•.

• This makes sense:

• A nation’s saving must end up being loaned to domestic borrowers or foreign
borrowers.
• The loans made to domestic borrowers will end up as investment spending
mainly by domestic firms (I).
• And the loans made to foreigners will be net capital outflow (NCO).
• Therefore, .
Definition: Exchange Rates, Nominal
and Real
• We discussed exports, imports, and net exports earlier
• These are influenced by many factors including international prices.
• The two most important international prices are
• the nominal exchange rate and
• the real exchange rate.
Definition: 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.
Definition: Nominal Exchange Rates
• The nominal exchange rate is expressed in two ways:
• In units of foreign currency per one Indian rupee.
• And in units of Indian rupee per one unit of the foreign currency.
Definition: Nominal Exchange Rates
Definition: Nominal Exchange Rates
• Appreciation is an increase in the value of a currency (as measured by
the amount of foreign currency it can buy).
• Depreciation is a decrease in the value of a currency.
Definition: Nominal Exchange Rates
• If the price of a rupee increases (say, from $ 0.0121 to $0.150), it is an
appreciation of the rupee.
• If the price of a rupee decreases (say, from $ 0.0121 to $ 0.001 ), it is a
depreciation of the rupee.
Definition: Real Exchange Rates
• Recall that 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.
Definition: Real Exchange Rates
• The real exchange rate expresses the prices of domestic goods not in
currency units but in units of foreign goods.
Definition: Real Exchange Rates
• Suppose:
• Price of U.S. wheat is P = $4.00 per ton
• Price of French wheat is P* = €6.00 per ton
• Price of a dollar is e = €3.00 per dollar
• Note that:
• Price of a ton of U.S. wheat is $4.00 or, equivalently, €12.00 (because each
dollar is worth 3 euros)
• Therefore, a ton of U.S. wheat costs the same as 2 tons of French wheat
• Therefore, the real exchange rate = 2.
Definition: Real Exchange Rates
• Recap: How did we get 2 as the real exchange rate?
• We multiplied 3 and 4 and divided the result by 6. That is,
• We calculated e × P / P*.
• Therefore, we see that, in general,
• Real Exchange Rate = e × P / P*.
Definition: Real Exchange Rates
• Real Exchange Rate = e × P / P*
• The real exchange rate depends on the nominal exchange rate and
the prices of goods in the two countries, as 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 a n g e rate =
F o reig n p rice
Data on Real Exchange Rates
Theory: Effect of Real Exchange
Rates on Net Exports
• A depreciation (fall) in the India’s 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, India exports rise, and Indian imports fall. Therefore,
Indian net exports increase.
Theory: Effect of Real Exchange
Rates on Net Exports
• Conversely, an
appreciation in the U.S.
Real
real exchange rate Exchange
means that Indian goods Rate
have become more
expensive compared to
foreign goods.
• So Indian net exports Net Exports
Curve
fall.

Net Exports
Theory: Purchasing-Power Parity
• The purchasing-power parity theory is the simplest theory of
exchange rates in the long run.
The Basic Logic of Purchasing-Power
Parity
• According to the purchasing-power parity theory, a unit of any given
currency should buy the same quantity of goods in all countries.
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, once the prices are all expressed in the same currency.
• Consequently, a unit of any given currency should buy the same quantity of
goods in all countries
The Basic Logic of Purchasing-Power
Parity
• If the law of one price were not true, unexploited profit opportunities
would exist.
• If the same good sold at different prices in different countries, you
could make money by simply buying the good where it is cheap and
selling it where it is expensive
• The process of taking advantage of differences in prices in different
markets is called arbitrage.
The Basic Logic of Purchasing-Power
Parity
• Price of a commodity in USA in $ × Rs. per $ exchange rate = Price of
the commodity in USA in Rs.
• If arbitrage occurs, eventually prices in two markets, expressed in the
same currency, must become equal. Therefore:
• Price of a commodity in USA in $ × Rs. per $ exchange rate = Price of
the commodity in Indian in Rs.

• Or,
The Basic Logic of Purchasing-Power
Parity
• We just saw that under purchasing-power parity, .
• But we’ve seen that is the real exchange rate!
• So, the purchasing-power parity theory says the real exchange rate
must be equal to one.
Theory: Purchasing-Power Parity
• The theory of purchasing-
power parity says that the
Real
real exchange rate, which Exchange
is the price of domestic Rate
goods in units of foreign
1 Net Exports
goods, must be equal to Curve (PPP)
one, in the long run.
• The net exports curve
becomes horizontal at the
long-run real exchange
rate. Net Exports
Implications of Purchasing-Power
Parity
• We’ve just seen that in the long run
• This implies

• Therefore, when P↑ we have e↓.

• That is, when prices rise in a country, its currency will be worth less in
terms of other currencies.
Implications of Purchasing-Power
Parity
• I assume you are aware of the quantity theory of money
• It says that in the long run if the quantity of money in an economy increases
faster than the output produced, then prices will rise.
• That is, when the central bank of a country prints large quantities of
money, the country’s money loses value in the sense that it buys
fewer goods and services.
• Moreover, as we saw in the previous slide, the country’s money also
loses value in the sense that it buys smaller amounts of other
currencies.
Figure 3 Money, Prices, and the Nominal Exchange
Rate during the German Hyperinflation
This figure shows the
money supply, the price
level, and the exchange rate
(measured as U.S. cents per
mark) for the German
hyperinflation from January
1921 to December 1924.
Notice how similarly these
three variables move. When
the quantity of money
started growing quickly, the
price level followed, and
the mark depreciated
relative to the dollar. When
the German central bank
stabilized the money supply,
the price level and
exchange rate stabilized as
well.

39
Limitations of Purchasing-Power
Parity
• We will discuss another long-run theory of the real exchange rate
later
• The theory of purchasing-power parity, though intuitive, doesn’t fit
the real world very well
• 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.
The Hamburger Standard
• See the web site for The Economist’s Big Mac
Currency Index:
https://www.economist.com/content/big-mac-ind
ex
 A Macroeconomic
Theory of the Open
Economy
Prerequisites
• Things you need to know before you see the rest of this presentation:

• Net exports are always equal to net capital outflow:

• National saving is always equal to domestic investment plus net capital
outflow:
• The loanable funds theory of the real interest rate, for closed economies
• National saving = private-sector saving + government saving
• Private-sector saving =
• Government saving =
Prerequisites
• Things you need to know before you see the rest of this presentation:

• The real exchange rate is the price of domestic products relative to similar
foreign products
• Calculated as
• Purchasing-power parity theory of the real exchange rate
An Accounting Identity: S = I + NCO
• We have seen before that .

• And we have seen before that it makes sense:

• A nation’s saving must end up being loaned to domestic borrowers or foreign
borrowers.
• The loans made to domestic borrowers will end up as investment spending
mainly by domestic firms (I).
• And the loans made to foreigners will be net capital outflow (NCO).
• Therefore, .
Loanable Funds Theory of the Real
Interest Rate
• The theory of loanable funds says that:
• There’s a market for loanable funds
• The supply of loanable funds = desired national saving (S).
• This supply depends on many factors, including the real interest rate.
• The supply of loanable funds increases when the real interest rate increases.
• The demand for loanable funds = desired domestic investment spending (I) +
desired net capital outflow (NCO).
• This demand depends on many factors, including the real interest rate.
• The demand for loanable funds decreases when the real interest rate increases.
• The real interest rate reaches an equilibrium level at which supply is equal to
demand
• In this way, we get even when the variables are interpreted as the desired
amounts.
The Market for Loanable Funds:
SupplyReal
Interest
Rate
Supply of loanable funds
(National saving, S)

Quantity of Loanable
Funds Supplied
 The Market for Loanable Funds:
Demand
Real Real
Interest Interest
Rate Rate

+
Demand for loanable funds Demand for loanable funds
for domestic investment (I) for net capital outflow (NCO)

Quantity of loanable Quantity of loanable

funds demanded for funds demanded for
domestic investment net capital outflow
The Market for Loanable Funds:
Demand
Real
Interest
Rate

Demand for loanable funds

(domestic investment plus
net capital outflow, I + NCO)

Quantity of Loanable
Funds Demanded
The Market for Loanable Funds:
Equilibrium
Real
Interest
Rate
Supply of loanable funds
(National saving, S)

Equilibrium
Real Interest
Rate

Demand for loanable funds

(domestic investment plus
net capital outflow, I + NCO)

Equilibrium Quantity of
Quantity Loanable Funds
 The Market for Loanable Funds:
Equilibrium

Real Real Real

Interest Interest Interest
Rate Rate Rate Supply (S)

Equilibrium
Equilibrium
real interest
rate

Investment (I) Net Capital

Demand (I + NCO)
Outflow (NCO)

Equilibrium Investment (I) Equilibrium Net Capital Equilibrium Quantity of

investment net capital Outflow (NCO) saving Loanable Funds
outflow
 The Market for Loanable Funds:
Equilibrium
Note that the loanable funds theory predicts that an As an exercise, use the loanable funds theory to predict
increase (meaning a shift to the right) in the national the effects of (i) a shift to the right of the investment
saving curve will reduce the real interest rate, and curve, and (ii) a shift to the right of the net capital
increase the equilibrium amounts of S, I, and NCO. outflow curve.

Real Real Real

Interest Interest Interest
Rate Rate Rate Supply (S)

Equilibrium
Equilibrium
real interest
rate

Investment (I) Net Capital

Demand (I + NCO)
Outflow (NCO)

Equilibrium Investment (I) Equilibrium net Net Capital Equilibrium Quantity of

investment capital outflow Outflow (NCO) saving Loanable Funds
The Market for Foreign-Currency
Exchange
• Just as we may imagine a market in which ice cream is exchanged for
currency, or a market in which Amazon shares are exchanged for
currency, we may imagine a market in which different currencies are
exchanged for each other.
• That’s the market for foreign-currency exchange.
• We assume that in this market there is a supply and a demand for
every currency.
• We assume that this market’s price reaches the equilibrium level at
which supply and demand are equal.
The Market for Foreign-Currency
Exchange
• The supply of the domestic currency = desired net capital outflow
(NCO).
• This supply depends on many factors, but not on the real exchange rate.
• Recall that the determination of desired net capital outflow was determined
in the market for loanable funds before I even mentioned the real exchange
rate.
• The demand for the domestic currency = desired net exports (NX).
• This demand depends on many factors, including the real exchange rate.
• The demand for the domestic currency decreases when the real exchange
rate increases.
The Market for Foreign-Currency
Exchange
• The real exchange rate reaches an equilibrium level at which supply is
equal to demand
• In this way, we get even when the variables are interpreted as the
desired amounts.
Net Exports and the Real Exchange
Rate
Real
Exchange
Rate

Demand for domestic currency

(net exports)

Quantity of domestic currency

exchanged for foreign currency
Net Capital Outflow and the Real
Exchange Rate
Real
Exchange
Rate
Supply of domestic currency
(net capital outflow, determined in the
market for loanable funds)

Equilibrium NCO Quantity of domestic currency

and equilibrium NX exchanged for foreign currency
The Market for Foreign-Currency
Exchange
Real
Exchange
Rate
Supply of domestic currency
(net capital outflow, determined in the
market for loanable funds)

Equilibrium
real exchange
rate

Demand for domestic currency

(net exports)

Equilibrium NCO Quantity of domestic currency

and equilibrium NX exchanged for foreign currency
The Unusual Case of Purchasing-
Power Parity
Real
Exchange
Rate
Supply of domestic currency
(net capital outflow, determined in the
market for loanable funds)

Equilibrium
real exchange = 1
rate Demand for domestic currency
(net exports, PPP)

Equilibrium NCO Quantity of domestic currency

and equilibrium NX exchanged for foreign currency
Simultaneous Equilibrium in Two
Markets
• We need to join together the two markets that we’ve been discussing
—the loanable-funds market and the foreign-currency exchange
market—to get to a coherent understanding of long-run open-
economy macroeconomics
Simultaneous Equilibrium in Two Markets

(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
Domestic Currency

(c) The Market for Foreign-Currency Exchange

Effects of Policy Changes and
Unforeseen Events
• The point of building a macroeconomic theory of an open economy is
to be able to say something that is not totally idiotic about the likely
consequences of some policy change or unforeseen event
• We will now see what our theory says about the effects of:
• A tax cut and/or an increase in government spending
• An import tariff or an import quota
• Political instability and capital flight
A Tax Cut and/or an Increase in
Government Spending
• Recall that:
• The supply of loanable funds = national saving (S)
• National saving = private-sector saving + government saving
• Private-sector saving =
• Government saving =
• Therefore, a tax cut and/or an increase in government spending
implies that T – G decreases (that is, government saving decreases)
• Therefore, national saving (S) decreases
• This shifts the supply of loanable funds to the left
 A Tax Cut and/or an Increase in Government
Spending
1. A tax cut or spending hike 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 domestic currency
to be exchanged
E2
into foreign
E1 currency . . .
5. . . . which
causes the
real exchange
rate to Demand
appreciate.

Quantity of
Domestic Currency

(c) The Market for Foreign-Currency Exchange

An Import Tariff or an Import Quota
• An import tariff is a tax on imported goods
• An import quota puts a limit on the quantity of imports
• Either way, imports will decrease, assuming all other factors that
affect imports (such as the real exchange rate) are unchanged
• Therefore, net exports (NX = exports – imports) will increase.
• As a result, the demand for the domestic currency in the market for
foreign-currency exchange will shift to the right.
• As the curves for S, I, and NCO are unaffected, the market for loanable
funds will be unaffected.
 An Import Tariff or 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 domestic currency . . .
2. . . . and
causes the E
real exchange
rate to D
appreciate.
D

Quantity of
Domestic Currency

(c) The Market for Foreign-Currency Exchange

Political Instability and Capital Flight
• An increase in political instability is likely to cause an increase in net
capital outflow (also called capital flight, when the outflow is large),
assuming all the other factors that affect NCO are unchanged.
• This will shift the NCO curve to the right.
• As the two main sources of the demand for loanable funds are
investment (I) and net capital outflow (NCO), the demand for loanable
funds will shift right.
 Political Instability and Capital Flight

(a) The Market for Loanable Funds (b) Net Capital Outflow

Real Real
Interest Supply Interest 1. An increase
Rate Rate in net capital
outflow. . .

r2 r2

r1 r1

3. . . . which D2
increases
the interest
D1
rate. NCO1 NCO2

2. . . . increases the demand Quantity of Net Capital

for loanable funds . . . Loanable Funds Outflow

Real
Exchange S S2
Rate 4. At the same
time, the increase
in net capital
outflow
E increases the
supply of pesos . . .
5. . . . which
E
causes the
peso to
depreciate. Demand

Quantity of
Domestic currency

(c) The Market for Foreign-Currency Exchange

 Summary of Predictions
National Domestic Net capital Real interest Real exchange
Saving (S) investment (I) outflow (NCO) rate rate
= Net exports
(NX)
Tax cut and/or increase in
↓ ↓ ↓ ↑ ↑
government spending
Import tariff and/or import
No change No change No change No change ↑
quota
Increase in political
↑ ↓ ↑ ↑ ↓
instability
The Unusual Case of Purchasing-
Power Parity
Real
Exchange
Recall that under the unusual case of Rate
Supply of domestic currency
purchasing-power parity, the net (net capital outflow, determined in the
exports (NX) curve is horizontal at the market for loanable funds)

real exchange rate of 1.

Equilibrium
We could repeat the three prediction real exchange = 1
rate Demand for domestic currency
exercises we just did with this (net exports, PPP)
horizontal NX curve instead of the more
common negatively-sloped NX curve.

The predictions would be the same as

Equilibrium NCO Quantity of domestic currency
before, except that the real exchange and equilibrium NX exchanged for foreign currency
rate would remain unchanged (at 1) in
all cases.