PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University Open-Economy Macroeconomics: Basic Concepts 1 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Basic Concepts Closed economy –An economy that does not interact with other economies in the world Open economy –An economy that interacts freely with other economies around the world 2 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flow of Goods Exports –Goods & services that are produced domestically and sold abroad Imports –Goods and services produced abroad and sold domestically 3 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flow of Goods Net Exports = Exports - Imports –Value of a nation’s exports minus the value of its imports –Also called trade balance Trade balance = Exports - Imports –Value of a nation’s exports minus the value of its imports –Also called net exports 4 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flow of Goods Trade surplus –Excess of exports over imports Means country is exporting more than they are importing Trade deficit –Excess of imports over exports Means country is importing more than they are exporting Balanced trade –Exports equal imports 5 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flow of Goods Factors that influence a country’s exports, imports, and net exports: –Tastes of consumers for domestic & foreign goods –Prices of goods at home and abroad –Exchange rates People use domestic currency to buy foreign currencies –Incomes of consumers at home and abroad –The cost of transporting goods from country to country –Government policies toward international trade 6 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The increasing openness of the U.S. economy Increasing importance of international trade and finance –1950s, imports and exports of goods and services were typically 4-5% of GDP –Recent years: Exports increased more than twice Imports increased more than three times 7 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The increasing openness of the U.S. economy Increase in international trade is due to the following factors –Improvements in transportation –Advances in telecommunications –Technological progress –Government’s trade policies NAFTA (North American Free Trade Agreement) GATT (General Agreement on Tariffs and Trade) 8 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1 9 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Internationalization of the U.S. Economy This figure shows exports and imports of the U.S. economy as a percentage of U.S. gross domestic product since The substantial increases over time show the increasing importance of international trade and finance.

Net Exports=Net Capital Outflow Net exports (NX) –Imbalance between a country’s exports and its imports Net capital outflow (NCO) –Imbalance between Amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners Identity: NCO = NX 10 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flow of Capital Net capital outflow –Measures an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners NCO = NX (net exports) Purchase of foreign assets by domestic residents including foreign direct investment and foreign portfolio investment minus the purchase of domestic assets by foreigners 11 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flow of Capital Net capital outflow example –Suppose you sell a widget for $5000 in Brazil. You take the 4000 reals and invest it in the Brazilian stock market. Since NCO = NX is an identity what happened to one side had to happen to the other: –The widget increase NX by $5000 –The 4000 reals that you invested are worth $5k U.S. so since you invested it in the Brazilian stock market, NCO increase by $5000 (4000 reals) because you acquired a foreign asset 12 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flow of Capital Net capital outflow example continued –Suppose you sell a widget for $5000 in Brazil. You take the 4000 reals and buy a new gadget to bring home. –The widget increase NX by $5000 –The gadget increases imports by $5000 –The net effect is the NX = 0 and NCO is not changed because you did not buy a foreign asset 13 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flow of Capital Net capital outflow –What happens when Walmart imports $50 million worth of goods from China? The $50 million is an import for U.S. so NX = -$50 million The Chinese now have $50 million –If they invest in the U.S, economy, NCO for the U.S. will be -$50 million –If China buys a plane from Boeing then exports will increase $50 million and NX = $0 14 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flow of Capital Variables that influence net capital outflow –Real interest rates paid on foreign assets (Will I get a better return in Germany or Mexico?) (What is expected inflation?) –Real interest rates paid on domestic assets (Am I better off investing in U.S. or abroad?) –Perceived economic and political risks of holding assets abroad (What recourse is there if the borrower defaults?) –Government policies that affect foreign ownership of domestic assets (Imposed restrictions on ownership) 15 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Net Exports=Net Capital Outflow When NX > 0 (trade surplus) –Country selling more goods and services to foreigners than it is buying from them From net sale of goods and services –Receives foreign currency –Buy foreign assets –Capital is flowing out of the country: NCO > 0 16 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Net Exports=Net Capital Outflow When NX < 0 (trade deficit) –Buying more goods and services from foreigners than it is selling to them The net purchase of goods and services –Needs are being financed by foreign $ –Selling assets abroad –Capital is flowing into the country: NCO < 0 17 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Saving and Investment Open economy: Y = C + I + G + NX Recall that national saving: S = Y – C – G Y – C – G = I + NX Substitute S for Y - C – G S = I + NX Recall that NX = NCO Substitute NCO for NX S = I + NCO Saving = Domestic investment + Net capital outflow 18 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Saving and Investment S = I + NCO: Saving = Domestic investment + Net capital outflow Suppose a person puts $10k into a retirement account that is a mutual fund. The $10k contributes to national saving, the left side of the equation. The mutual fund then takes $5k and invests in Google, which used the proceeds to build a new factory. This shows up as domestic investment. Suppose the mutual fund takes the other $5k and purchases Toyota stock. This purchase shows up as NCO $10k = $5 + $5k 19 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flows Trade surplus: Exports > Imports Net exports (NX) > 0 GDP (Y) > Domestic spending (C+I+G) Y = C + I + G + NX so if NX > 0 then GDP has to be less than domestic spending S > I because if S = I + NCO and NX = NCO and NX > 0 therefore NCO > 0 20 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flows Trade deficit: Exports < Imports Net exports < 0 GDP (Y) < Domestic spending (C+I+G) Y = C + I + G + NX and NX < 0 so GDP has to be less than domestic spending S < I because if S = I + NCO and NX = NCO and NX < 0 therefore NCO < 0 21 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Flows Balanced trade : Exports = Imports Net exports = 0 Y = Domestic spending (C+I+G) S = I because NX = 0 therefore NCO = 0 22 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 1 23 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. International Flows of Goods and Capital: Summary This table shows the three possible outcomes for an open economy.

Is the U.S. trade deficit a national problem? Past two decades –National saving fell substantially below investment and NCO < 0 –Borrowed heavily in world financial markets to finance large trade deficits –Capital inflow Before 1980 –National saving & domestic investment were close –Small net capital outflow –S ≈ I 24 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Is the U.S. trade deficit a national problem? After 1980 –National saving fell substantially below investment –Net capital outflow became a large negative number –Capital inflow –U.S. went into debt 25 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Is the U.S. trade deficit a national problem? Changes in capital flows –Arise from changes in saving –Arise from changes in investment 1980 to 1987 –Increase flow of capital into U.S. (from 0.5 to 3.6% of GDP) –Decline in national saving of 2.6 percentage points Explained by decline in public saving which is explained by an increase in the government budget deficit 26 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Is the U.S. trade deficit a national problem? 1991 to 2000 –Increase flow of capital into U.S. (from 0.5 to 3.9% of GDP) –Saving increased over this time as the government had a budget surplus –Investment increased from 13.4 to 17.7% of GDP as firms enjoyed a boom in information technology 27 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Is the U.S. trade deficit a national problem? 2000 to 2006 –Increase in capital flow into the U.S, (to 5.7% o GDP) –Investment boom abated after 2000 –Budget deficits started again –National saving fell to extraordinarily low levels 2007 to 2009, –Trade deficit shrank –Substantial decline in housing prices –Deep recession –Dramatic fall in investment 28 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Is the U.S. trade deficit a national problem? Trade deficit induced by a fall in saving S = I + NCO –If S is decreasing then the nation is putting away less of its income to provide for its future –No reason to deplore the resulting trade deficits (NX < 0 so NCO < 0) as it is better to have foreigners invest in the U.S. economy than no one at all 29 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Is the U.S. trade deficit a national problem? Trade deficit induced by an investment boom –Economy is borrowing from abroad to finance the purchase of new capital goods For good return on investment in the form of higher production of goods and services, the economy should be able to handle the debts that are being accumulated For lower return on investment that fail to yield expected returns, debts will look less desirable 30 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 2 31 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Saving, Domestic Investment, and Net Capital Outflow Panel (a) shows national saving and domestic investment as a percentage of GDP. You can see from the figure that national saving has been lower since 1980 than it was before This fall in national saving has been reflected primarily in reduced net capital outflow rather than in reduced domestic investment.

Figure 2 32 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Saving, Domestic Investment, and Net Capital Outflow Panel (b) shows net capital outflow as a percentage of GDP. You can see from the figure that national saving has been lower since 1980 than it was before This fall in national saving has been reflected primarily in reduced net capital outflow rather than in reduced domestic investment.

Real & Nominal Exchange Rates Nominal exchange rate –Rate at which a person can trade currency of one country for currency of another Appreciation (strengthen) –Increase in the value of a currency as measured by the amount of foreign currency it can buy Buy more foreign currency –Jan 1: $1 = 100 yen –Jan 2: $1 = 110 yen –The $ appreciated against the yen 33 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Real & Nominal Exchange Rates Depreciation (weaken) –Decrease in the value of a currency as measured by the amount of foreign currency it can buy Buy less foreign currency –Jan 1: $1 = 100 yen –Jan 2: $1 = 90 yen –The $ depreciated against the yen 34 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Real & Nominal Exchange Rates Real exchange rate –Rate at which a person can trade goods and services of one country for goods and services of another 35 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Real & Nominal Exchange Rates Real exchange rate = (e ˣ P) / P* Using price indexes e – nominal exchange rate between the U.S. dollar and foreign currencies P – price index for U.S. basket P* – price index for foreign basket 36 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Real & Nominal Exchange Rates Depreciation (fall) in the U.S. real exchange rate –U.S. goods become cheaper relative to foreign goods –Consumers at home and abroad buy more U.S. goods and fewer goods from other countries leading to: Higher exports Lower imports Higher net exports 37 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Real & Nominal Exchange Rates An appreciation (rise) in the U.S. real exchange rate –U.S. goods are more expensive compared to foreign goods –Consumers at home and abroad buy fewer U.S. goods and more goods from other countries Lower exports Higher imports Lower net exports 38 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Purchasing-Power Parity Purchasing-Power Parity, PPP –Theory of exchange rates based on the law of one price –A unit of any given currency should be able to buy the same quantity of goods in all countries Basic logic of Purchasing-Power Parity –Based on law of one price that asserts that a good must sell for the same price in all locations 39 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Purchasing-Power Parity Arbitrage –Take advantage of price differences for the same item in different markets Parity –Equality Purchasing-Power –Value of money in terms of quantity of goods it can buy 40 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Implications of PPP If purchasing power of the dollar –Is always the same at home and abroad then the real exchange rate cannot change other wise there is an arbitrage situation: If a pound of coffee costs $5 in U.S. and 500 Yen in Japan then the exchange rate has to be $1 = 100 yen –If $1 < 100 Yen then buy in U.S. and sell in Japan –If $1 > 100 Yen then buy in Japan and sell in U.S. 41 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Implications of PPP Theory of purchasing-power parity –The nominal exchange rate between the currencies of two countries must reflect the price levels in those countries If coffee prices rise in Japan then the the exchange rate should allow for a $1 to buy more Yen. If it does not then there is an arbitrage situation where we buy in U.S. and sell in Japan 42 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nominal exchange rate during a hyperinflation Natural experiment on hyperinflation –High inflation –Arises when a government prints money to pay for large amounts of government spending German hyperinflation, early 1920s –Money supply, price level, nominal exchange rate all move closely together 43 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nominal exchange rate during a hyperinflation German hyperinflation early 1920s –Money supply starts growing quickly Price level starts growing German Mark depreciates as German goods become expensive, it costs foreigners more to buy German goods –When the money supply stabilizes Price level stabilizes and the exchange rate stabilizes 44 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nominal exchange rate during a hyperinflation The quantity theory of money in the previous chapter explains how the money supply affects price level Purchasing power parity explains how price level affects nominal exchange rate 45 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 3 46 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 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.

Limitations of PPP The theory of purchasing-power parity does not always hold in practice. Exchange rates do not always move to ensure that a dollar has the same real value in all countries all the time. 1.Many goods are not easily traded Services especially 2.Even tradable goods are not always perfect substitutes Heineken (German) vs Budweiser (U.S.) may not be viewed as perfect substitutes to be traded 3.When they are produced in different countries there may be no opportunity for profitable arbitrage 47 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Limitations of PPP Purchasing-power parity –Is not a perfect theory of exchange-rate determination –For these reasons real exchange rates fluctuate over time The basic logic is persuasive; as the real exchange rate drifts from the level predicted by purchasing power parity, people have the incentive to move goods across national borders Large & persistent movements in nominal exchange rates –Typically reflect changes in price levels at home and abroad 48 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Limitations of PPP Because of the incentive to move goods across borders as exchange rates deviate from PPP –Large & persistent movements in nominal exchange rates typically reflect changes in price levels at home and abroad 49 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The hamburger standard Data on - basket of goods consisting of –“Two all-beef patties, special sauce, lettuce, cheese, pickles, onions, on a sesame seed bun” “Big Mac” - sold by McDonald’s around the world July 2009 –Price of a Big Mac = $3.57 in U.S. 50 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The hamburger standard According to purchasing power parity –Cost of “Big Mac” should be same in all countries –Predicted exchange rate = Price in foreign country (in foreign currency) divided by price in U.S. –Keep in mind that “Big Mac” arbitrage is highly unlikely 51 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The hamburger standard Predicted and actual exchange rates –Are not exactly the same –Reasonable first approximation 52 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.