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Open Economy Macroeconomics

Lecture 13

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Open and Closed Economies:

A closed economy is the one that does not

interact with other economies in the world.

An open economy is the one that interactsfreely with other economies around the world.

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International Flow of Goods and Services

An Open Economy interacts with othercountries in two ways:

1. It buys and sells goods and services in worldproduct markets.

2. It buys and sells capital assets in worldfinancial markets.

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International Flow of Goods and ServicesCont

Flow of Goods: Exports, Imports & Net Exports

Exports are domestically produced goodsand services that are sold abroad.

Imports are foreign-produced goods andservices that are sold domestically.

When Boeing (the U.S. aircraft manufacturer)builds a plane and sells it to Air France, the sale is

an export for U.S. and an import for France.

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Flow of Goods: Exports, Imports & Net Exports (Cont.)

Net Exports (NX) of any country are thedifference between the value of its exports and

the value of its imports. Because Net Exports tell us whether a country

is a seller or buyer in world markets, NetExports are also called the trade balance.

Net Exports = Value of Countrys Exports Value of Countrys Imports

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Trade Surplus:

If net exports are positive:

Exports > Imports

This indicates that the country sells moregoods and services abroad than it buys fromother countries.

In this case, the country is said to experiencetrade surplus.

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Trade Deficit:

If net exports are negative:

Exports < Imports

This indicates that the country sells fewergoods and services abroad than it buys fromother countries.

In this case, the country is said to experiencetrade deficit.

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Balanced Trade:

If net exports are zero, countrys exports andimports are exactly equal.

Thus, the country is said to have balancedtrade.

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Factors that Affect Exports, Imports & Net Exports:

Tastes of consumers for domestic and foreign

goods. Prices of goods at home and abroad.

Exchange rates at which people can use domesticcurrency to buy foreign currencies.

The incomes of consumers at home and abroad. The costs of transporting goods from country

to country.

Government policies toward international trade.

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Flow of Financial Resources: Net Capital Outflow:

We have seen how people of an open economyparticipate in world markets for goods and

services. In addition, people of an open economy

participate in world financial markets.

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Flow of Financial Resources: Net Capital Outflow (Cont.):

E.g. a U.S. resident with $20,000 could use that money

to buy a car from Toyota, or could instead use thatmoney to buy stock in the Toyota Corporation.

First transaction represents a flow of goods.

Second transaction represents a flow of capital.

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Net Capital Outflow:

It refers to the difference between the

purchase of foreign assets by domesticresidents and the purchase of domesticassets by foreigners.

Net Capital Outflow = Purchase of Foreign Assets byDomestic Residents Purchase of Domestic Assetsby Foreigners

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Flow of capital abroad takes two forms:1. Foreign Direct Investment:

E.g. if McDonalds opens up food outlet in Russia. In this case, the owner actively manages the

investment.

2. Foreign Portfolio Investment:

E.g. if an American buys stock in a Russian

Company. In this case, the owner has a passive role.

In both cases, both purchases increase U.S.

Net Capital Outflow.

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Net Capital Outflow can be either negative or

positive. When it is positive, domestic residents are

buying more foreign assets than foreigners arebuying domestic assets.

Capital is said to be flowing OUT of the country.

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When it is negative, domestic residents arebuying less foreign assets than foreigners arebuying domestic assets.

Capital is said to be flowing INTO the country.

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Variables that Influence Net Capital Outflow:

Interest rates being paid on foreign assets. Interest rates being paid on domestic assets.

Perceived economic and political risks of holdingassets abroad.

Government policies that affect foreign ownership ofdomestic assets.

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The Prices forInternational Transactions:

Real and Nominal Exchange Rates

Macroeconomists study variables thatmeasure prices at which international

transactions take place. International transactions are influenced

by international prices.

The two most important international

prices are:

1. The Nominal Exchange Rate

2. The Real Exchange Rate

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Real and Nominal Exchange Rates (Cont.)

Nominal Exchange Rates:

The nominal exchange rate is the rate atwhich a person can trade the currency of onecountry for the currency of another.

E.g. if we go to a bank, we might see a postedexchange rate of Rs. 80 per dollar.

This implies that if we give the bank one U.S. dollar,

it will give us 80 rupees.

And if we give the bank 80 rupees, it will give us

one U.S. dollar.

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The Prices forInternational Transactions:Real and Nominal Exchange Rates (Cont.)

Nominal Exchange Rates (Cont.):

If the exchange rate changes so that a dollarbuys more foreign currency, that change iscalled an appreciation of the dollar.

Appreciation refers to an increase in thevalue of a currency as measured by theamount of foreign currency it can buy.

When a currency appreciates, it is said tostrengthen because it can then buy moreforeign currency.

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Real and Nominal Exchange Rates(Cont.)


If the exchange rate changes so that a dollarbuys less foreign currency, that change iscalled a depreciation of the dollar.

Depreciation refers to a decrease in thevalue of a currency as measured by theamount of foreign currency it can buy.

When a currency depreciates, it is said toweaken because it can then buy lessforeign currency.

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E.g. when the exchange rate rises from 80 to 90

rupees per dollar, the dollar is said to appreciate. At the same time, because a rupee now buys less

of the U.S. dollar, the rupee is said to depreciate.

And when the exchange rate falls from 80 to 70rupees per dollar, the rupee is said to appreciateand the dollar is said to depreciate.

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Real Exchange Rates:

The real exchange rate is the rate at which aperson can trade the goods and services of onecountry for the goods and services of another.

E.g. we go for shopping and find that a pound ofSwiss Cheese is twice as expensive as AustralianCheese.

This implies that the real exchange rate is poundof Swiss cheese per pound of Australian cheese.

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Real Exchange Rates:

Real exchange rate depends on thenominal exchange rate and on the prices ofgoods in the two countries.

Thus, it is calculated as:

Real exchange rate=

Nominal exchange rate Domestic price

Foreign price

v

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Real Exchange Rates (Cont.):

Question arises why does real exchange ratematter?

Real exchange rate is a key determinant of howmuch a country imports or exports. E.g. when deciding whether to import (buy)

petroleum from Saudi Arabia or from Iran, Pakistanconsiders which country is giving it at a lesser price.

Thus, when deciding to purchase by comparing

cost, the decision is based on the real exchange

rate.

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A depreciation (fall) in the real exchange

rate of a country means that its goodshave become cheaper relative to foreigngoods.

This encourages consumers of both at

home and abroad to buy more goods fromthis country and fewer goods from othercountries.

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As a result, the exports of the country rise,and imports fall.

Both these changes raise the net exportsof the country.

Conversely, an appreciation (rise) in thereal exchange rate of a country means that

the goods have become more expensivecompared to foreign goods.

Thus, the net exports of this country fall.

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First Theory of Exchange Rate Determination:

Purchasing-Power Parity

The purchasing-power parity theory is thesimplest and most widely accepted theory

explaining the variation of currencyexchange rates.

Purchasing-power parity is a theory ofexchange rates whereby a unit of any given

currency should be able to buy the samequantity of goods in all countries.

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Purchasing-Power Parity (Cont.)

Basic Logic of Purchasing Power Parity:

The theory of purchasing-power parity is

based on a principle called the law of oneprice.

According to the law of one price, agood must sell for the same price in all

locations.

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First Theory of Exchange Rate Determination:Purchasing-Power Parity (Cont.)

Basic Logic of Purchasing Power Parity (Cont.):

The process of taking advantage of differencesin prices for the same item in different markets is

called arbitrage. E.g. suppose that coffee sold for less in city A ($4 a

pound) than in city B ($5 a pound).

A person could buy coffee from city A and sell it incity B.

Thus, making a profit of $1 per pound from thedifference in price.

This difference refers to arbitrage.

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Basic Logic of Purchasing Power Parity (Cont.):

Now consider how the law of one price applies

to international marketplace. If a dollar could buy more coffee in U.S. than in

Japan, international traders could profit by buyingcoffee in U.S. and selling it in Japan.

This export of coffee from U.S. to Japan would driveup the U.S. coffee price and drive down theJapanese price.

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Implications of Purchasing Power Parity:

The theory states that nominal exchange

rate between currencies of two countriesdepends on the price levels in thosecountries. E.g. if a pound of coffee costs 500 yen in Japan

and $5 in U.S., then the nominal exchange rate

must be 100 yen per dollar (500 yen/$5 = 100 yenper dollar).

Otherwise, the purchasing power of the dollarwould not be the same in the two countries.

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Limitations of Purchasing Power Parity:

The theory of purchasing power parity is not

completely accurate. Exchange rates do not always ensure that a

dollar has the same value in all the countriesall the time.

There are two reasons this theory does notalways hold true.

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