Open-Market Macroeconomics: Basic Concepts www.AssignmentPoint.com 1 1 1

Overview Define open economy, closed economy, and exports/imports. Factors that influence open market transactions. Define nominal and real exchange rates. Calculate real exchange rates. Examine the theory of purchasing power parity. Learn that Bangladesh is a small, open economy with perfect capital mobility. www.AssignmentPoint.com 2 2 2

Open or Closed Economies Closed Economy: There are no economic relations with other countries. No exports, no imports, and no capital flows. Open Economy: An economy that interacts freely with other economies around the world. www.AssignmentPoint.com 3 3 3

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. Bangldesh is a small, open economy with perfect capital mobility. www.AssignmentPoint.com 4 4 4

The Flow of Goods Exports: Are domestically produced goods that are sold abroad. Exports include foreign spending on goods that are made domestically, shipped to, and sold in a foreign country. Example: GMG airplanes www.AssignmentPoint.com 5 5 5

The Flow of Goods Imports: Are foreign produced goods and services that are sold to residents of the domestic country. Imports include domestic spending on goods that are made abroad, shipped to, and sold in the domestic economy. Example: Computer monitors made in Korea are imported into Bangladesh. www.AssignmentPoint.com 6 6 6

The Flow of Goods Net Exports (NX) or Trade Balance: Trade Deficit: The value of exports minus the value of imports. Trade Deficit: A situation when net exports (NX) are negative. (i.e. Exports < Imports) Trade Surplus: A situation when net exports (NX) are positive. (i.e. Exports > Imports) www.AssignmentPoint.com 7 7 7

Overview Define open economy, closed economy, and exports\imports. Factors that influence open market transactions. Define nominal and real exchange rates. Calculate real exchange rates. Examine the theory of purchasing power parity. Learn that Bangladesh is a small, open economy with perfect capital mobility. www.AssignmentPoint.com 2 8 8

Factors That Influence a Country’s Exports, Imports, and Net Exports 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. The costs of transporting goods from country to country. The policies of the government toward international trade. www.AssignmentPoint.com 9 9 9

Net Foreign Investment (NFI) Net Foreign Investment: difference between foreign assets purchased by residents and domestic assets purchased by foreigners. Example: Bangladeshi resident buys a car from Toyota. Mexican citizen buys stock in the Royal Bank. www.AssignmentPoint.com 10 10 10

Net Foreign Investment (NFI) When domestic residents purchase more financial assets in foreign economies than foreigners purchase of domestic assets, there is a net capital outflow from the domestic economy. If foreigners purchase more Bangladeshi financial assets than Bangladeshi residents spend on foreign financial assets, then there will be a net capital inflow into Bangladesh. www.AssignmentPoint.com 11 11 11

Net Foreign Investment (NFI) ID > IF => NFID www.AssignmentPoint.com 12 12 12

Net Foreign Investment (NFI) ID > IF => NFID ID < IF => NFID www.AssignmentPoint.com 13 13 13

The Equality of Net Exports and Net Foreign Investment For an economy as a whole, NX and NFI balance each other so that: NX = NFI An increase in exports is accompanied by an increase in foreign exchange. www.AssignmentPoint.com 14 14 14

Quick Quiz! Define net exports and net foreign investment. Explain how they are related. 15 15 15

Overview Define open economy, closed economy, and exports/imports. Factors that influence open market transactions. Define nominal and real exchange rates. Calculate real exchange rates. Examine the theory of purchasing power parity. Learn that Bangladesh is a small, open economy with perfect capital mobility. www.AssignmentPoint.com 2 16 16

Real and Nominal Exchange Rates International transactions are influenced by international prices. The two most important international prices are: Nominal Exchange rate Real Exchange Rate www.AssignmentPoint.com 17 17 17

The Nominal Exchange Rate The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. It is expressed in two ways: 1. In units of foreign currency per one BDT 2. In units of BDT per one unit of the foreign currency www.AssignmentPoint.com 18 18 18

The Nominal Exchange Rate Example: Assume the exchange rate between the $ and BDT is 67 to one. If the exchange rate changes so that a BDT buys more foreign currency, that change is called an appreciation of the BDT. The opposite is called a depreciation of the BDT. www.AssignmentPoint.com 19 19 19

The Real Exchange Rate The real exchange rate is the ratio at which a person can trade the goods and services of one country for the goods and services of another. Compare the prices of the domestic goods and foreign goods in the domestic economy. Example: Case of German TV is twice as expensive as BD TV. Real exchange rate is 1/2. www.AssignmentPoint.com 20 20 20

Overview Define open economy, closed economy, and exports/imports. Factors that influence open market transactions. Define nominal and real exchange rates. Calculate real exchange rates. Examine the theory of purchasing power parity. Learn that Bangladesh is a small, open economy with perfect capital mobility. www.AssignmentPoint.com 2 21 21

Calculating the Real Exchange Rate Real exchange rates are derived from nominal rates. Computing the real exchange rate involves: www.AssignmentPoint.com 22 22 22

Calculating the Real Exchange Rate Real exchange rates are derived from nominal rates. Computing the real exchange rate involves: Real Exchange Rate = www.AssignmentPoint.com 23 23 23

Calculating the Real Exchange Rate Real exchange rates are derived from nominal rates. Computing the real exchange rate involves: Nominal Exchange Rate x Domestic Price Real Exchange Rate = www.AssignmentPoint.com 24 24 24

Calculating the Real Exchange Rate Real exchange rates are derived from nominal rates. Computing the real exchange rate involves: Nominal Exchange Rate x Domestic Price Real Exchange Rate = Foreign Price www.AssignmentPoint.com 25 25 25

The Real Exchange Rate The real exchange rate is a key determinant of how much a country exports and imports. When a country’s real exchange rate is low, its goods are cheap relative to foreign goods, so consumers both at home and abroad tend to buy more of that country’s goods and fewer foreign produced goods. www.AssignmentPoint.com 26 26 26

Quick Quiz! Define the nominal exchange rate and the real exchange rate, and explain how they are related. If the nominal rate goes from 100 to 120 yen per dollar, has the dollar appreciated or depreciated? 27 27 27

Overview Define open economy, closed economy, and exports/imports. Factors that influence open market transactions. Define nominal and real exchange rates. Calculate real exchange rates. Examine the theory of purchasing power parity. Learn that Bangladesh is a small, open economy with perfect capital mobility. www.AssignmentPoint.com 2 28 28

Purchasing-Power Parity The variation of currency exchange rates has different sources. The simplest and most widely accepted theory is called Purchasing-Power Parity Theory. Purchasing-Power Parity Theory states that “a unit of any given currency should be able to buy the same quantity of goods in all countries.” Based upon The Law of One Price www.AssignmentPoint.com 29 29 29

The “Law of One Price” “A good must sell for the same price in all locations.” This law applies in the international market and is a common sense notion. If the law were not true, unexploited profit opportunities would exist, allowing someone to earn riskless profits by purchasing low in one market and selling high in another. Example: Buying coffee in Bangladesh or Japan sell in BD www.AssignmentPoint.com 30 30 30

Purchasing-Power Parity A currency must have the same buying power (i.e. parity) in all countries and it is the exchange rate that assures that this purchasing power is approximately equal across countries. The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries. www.AssignmentPoint.com 31 31 31

Limitations of The Purchasing-Power Parity Two things may keep nominal exchange rates from exactly equalizing purchasing power: 1. Many goods are not easily traded or shipped from one country to another. 2. Traded goods are not always perfect substitutes. www.AssignmentPoint.com 32 32 32

Quick Quiz! Over the past 20 years, Spain has had high inflation and Japan has had low inflation. What do you predict has happened to the number of Spanish pesetas a person can buy with a Japanese yen? 33 33 33

Overview Define open economy, closed economy, and exports/imports. Factors that influence open market transactions. Define nominal and real exchange rates. Calculate real exchange rates. Examine the theory of purchasing power parity. Learn that Bangladesh is a small, open economy with perfect capital mobility. www.AssignmentPoint.com 2 34 34

Perfect Capital Mobility in a Small Open Economy By “small” we mean an economy that is a small part of the world economy. By itself it will have only a negligible effect on the prices of goods and services and interest rates in the rest of the world. www.AssignmentPoint.com 35

Perfect Capital Mobility in a Small Open Economy By “perfect capital mobility” we mean that Bangladeshi have full access to world financial markets and people in the rest of the world have full access to the Bangladeshi financial market. www.AssignmentPoint.com 36

Perfect Captial Mobility in a Small Open Market Implication of perfect capital mobility: The real interest rate in BD should equal the interest rate prevailing in world financial markets. Government policy choices can affect the size of risk and therefore BD interest rates relative to world interest rates. www.AssignmentPoint.com 37

Overview Define open economy, closed economy, and exports/imports. Factors that influence open market transactions. Define nominal and real exchange rates. Calculate real exchange rates. Examine the theory of purchasing power parity. Learn that Bangladesh is a small, open economy with perfect capital mobility. www.AssignmentPoint.com 2 38 38