31 open economy macroeconomics

Open-Economy Macroeconomics:
Basic Concepts
• Open and Closed Economies

Open-Economy
Macroeconomics:
Basic Concepts

31

• 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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Open-Economy Macroeconomics:
Basic Concepts
• An Open Economy

THE INTERNATIONAL FLOW OF
GOODS AND CAPITAL
• An Open Economy

• 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 United States is a very large and open
economy—it imports and exports huge quantities of
goods and services.
• Over the past four decades, international trade and
finance have become increasingly important.

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The Flow of Goods: Exports, Imports, Net
Exports

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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1


The Flow of Goods: Exports, Imports, Net
Exports

The Flow of Goods: Exports, Imports, Net
Exports

• A trade deficit is a situation in which net
exports (NX) are negative.

• Factors That Affect Net Exports

• Imports > Exports

• A trade surplus is a situation in which net
exports (NX) are positive.
• Exports > Imports

• The tastes of consumers 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.

• 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

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Figure 1 The Internationalization of the U.S.
Economy
Percent
of GDP

• Factors That Affect Net Exports
• 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.

15
Imports
10
Exports

5

0

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1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
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The Flow of Financial Resources: Net Capital
Outflow

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.

• When a U.S. resident buys stock in Telmex, the
Mexican phone company, the purchase raises
U.S. net capital outflow.
• When a Japanese residents buys a bond issued
by the U.S. government, the purchase reduces
the U.S. net capital outflow.

• A U.S. resident buys stock in the Toyota
corporation and a Mexican buys stock in the Ford
Motor corporation.

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2


The Flow of Financial Resources: Net Capital
Outflow

The Equality of Net Exports and Net Capital
Outflow

• Variables that Influence 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

• 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.

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

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

• National saving (S) equals Y - C - G so:
S = I + NX
or
Saving

=

S

=

Domestic + Net Capital
Investment
Outflow

I

NCO

+

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Figure 2 National Saving, Domestic Investment,
and Net Foreign Investment

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Figure 2 National Saving, Domestic Investment,
and Net Foreign Investment
(b) Net Capital Outflow (as a percentage of GDP)

(a) National Saving and Domestic Investment (as a percentage of GDP)
Percent
of GDP
4

Percent
of GDP
20

3

Domestic investment
18

2

Net capital
outflow

1

16

0
14

–1

10
1960

–2

National saving

12

–3

1965

1970

1975

1980

1985

1990

1995

2000

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–4
1960

1965

1970

1975

1980

1985

1990

1995

2000

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Balance of Payments

Balance of Payments

• The balance of payments is a record of a
country'
s trade in goods, services, and financial
assets with the rest of the world.
• The balance of payments consists of two parts:
(1) The current account records the flow of
dollars reflecting the flow of goods
(2) The capital account reflects the flow of
dollars corresponding to the flow of assets.

Table below describes the general structure of the balance of payments

Balance of Payments

(1) Current Account
Exports (Goods and Serrvices)
Imports (Goods and Serrvices)
Investment Income Received

Investment Income Paid
Net Unilateral Transfers

Credit Debit
+
+
-

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Balance of Payments

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Balance of Payments

Services include transportation, tourism,
insurance, education, and financial services.
Investment income includes interest payments
and dividends people receive from assets owned
outside of their own country.

Balance of Payments (cont.)

(2) Capital Account

Credit Debit

Increase in US Holdings of Foreign Assets
Increase in Foreign Holdings of US Assets

(3) Official settlements balance

+
- [(1) + (2)]

A unilateral transfer occurs when one party
gives something but receives nothing in return,
e.g. foreign aid, remittance…
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Balance of Payments

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Balance of Payments

• Capital Account
• A capital inflow occurs when the home country sells
an asset to another country, e.g. Rockefeller Center is
sold to a Japanese company. A capital outflow occurs
when the home country buys an asset from abroad, e.g.
an American obtains a Swiss bank account.
• The capital account balance = capital inflows - capital
outflows
• A country has a capital account surplus when its
residents sell more assets to foreigners than they buy
from foreigners.
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• Current Account balance + Capital Account balance +
official settlements balance = 0
• When a country runs a current account deficit, it means that
it received fewer funds from its exports than the funds paid
for imports. To finance this deficit, it must sell its assets to
the foreigners. So, a current account deficit must be
accompanied by a capital account surplus or a fall in reserve
assets.
• The official settlements balance records transactions
conducted by central banks. It measures the net increase in a
country'
s official reserve assets, assets that can be used in
making international payments. The official settlements
balance is called the balance of payments.
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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.

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.

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Nominal Exchange Rates

Nominal Exchange Rates

• The nominal exchange rate is expressed in two
ways:

• Assume the exchange rate between the
Japanese yen and U.S. dollar is 80 yen to one
dollar.

• In units of foreign currency per one U.S. dollar.
• And in units of U.S. dollars per one unit of the
foreign currency.

• One U.S. dollar trades for 80 yen.
• One yen trades for 1/80 (= 0.0125) of a dollar.

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Nominal Exchange Rates

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 dollar buys more foreign currency, there is
an appreciation of the dollar.
• If it buys less there is a depreciation of the
dollar.

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Real Exchange Rates

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 case of German beer is twice as expensive as
American beer, the real exchange rate is 1/2 case of
German beer per case of American beer.

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Real Exchange Rates

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.
Real exchange rate =

Nominal exchange rate × Domestic price
Foreign price

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Real Exchange Rates

Real Exchange Rates

• A depreciation (fall) in the U.S. real exchange
rate means that U.S. goods have become
cheaper relative to foreign goods.
• This encourages consumers both at home and
abroad to buy more U.S. goods and fewer
goods from other countries.

• As a result, U.S. exports rise, and U.S. imports
fall, and both of these changes raise U.S. net
exports.
• Conversely, an appreciation in the U.S. real
exchange rate means that U.S. goods have
become more expensive compared to foreign
goods, so U.S. 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.

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The Basic Logic of Purchasing-Power Parity

Basic Logic of Purchasing-Power Parity

• According to the purchasing-power parity
theory, a unit of any given currency should be
able to buy the same quantity of goods in all
countries.

• The theory of purchasing-power parity is based
on a principle called the law of one price.

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• According to the law of one price, a good must sell
for the same price in all locations.

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Basic Logic of Purchasing-Power Parity

Basic Logic of Purchasing-Power Parity

• 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.

• If arbitrage occurs, eventually prices that
differed in two markets would necessarily
converge.
• According to the theory of purchasing-power
parity, a currency must have the same
purchasing power in all countries and exchange
rates move to ensure that.

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Implications of Purchasing-Power Parity

Implications of Purchasing-Power Parity

• If the purchasing power of the dollar is always
the same at home and abroad, then the
exchange rate cannot change.
• The nominal exchange rate between the
currencies of two countries must reflect the
different price levels in those countries.

• When the 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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Figure 3 Money, Prices, and the Nominal
Exchange Rate During the German Hyperinflation
Indexes
(Jan. 1921 5 100)
1,000,000,000,000,000

Money supply

10,000,000,000
Price level

100,000

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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.

1

Exchange rate

.00001

.0000000001

1921

1922

1923

1924

1925
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Foreign Exchange Market

Exchange Rate regime

• The exchange rate regime is the way a country manages
its currency in respect to foreign currencies and the foreign
exchange market. It is closely related to monetary policy.
• The basic types are:
(1) a floating exchange rate, where the market dictates the
movements of the exchange rate;
(2) the fixed (pegged) exchange rate, which ties the
currency to another currency, mostly more widespread
currencies such as the US dollar or the euro, and

Nominal exchange rate
S

E0
D
Q0

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Governments have to sacrifice the use of an independent
domestic monetary policy to achieve internal stability
Q
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(3) a pegged float, where the central bank keeps the rate
from deviating too far from a target band or value.
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Summary

Summary

• Net exports are the value of domestic goods and
services sold abroad minus the value of foreign
goods and services sold domestically.
• 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 to either
finance investment at home or to buy assets
abroad.

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Summary

Summary

• 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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Summary
• According to the theory of purchasing-power
parity, a unit of currency should buy the same
quantity of goods in all countries.
• The nominal exchange rate between the
currencies of two countries should reflect the
countries’ price levels in those countries.

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