1. PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University A Macroeconomic Theory of the Open Economy 1 © 2012 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.

2. 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.

3. The Flow of Goods: Exports, Imports, Net Exports A trade deficit is a situation in which net exports (NX) are negative. (Imports > Exports) A trade surplus is a situation in which net exports (NX) are positive. (Exports > Imports) Balanced trade refers to when net exports are zero—exports and imports are exactly equal.

4. The Flow of Goods: Exports, Imports, Net Exports Factors That Affect 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.

5. The Flow of Goods: Exports, Imports, Net Exports 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.

6. Figure 1 The Internationalization of the U.S. Economy Percent of GDP 0 5 10 15 19501955196019651970197519801990198520001995 Exports Imports Copyright © 2004 South-Western

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

8. The Flow of Financial Resources: Net Capital Outflow 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.

9. The Flow of Financial Resources: Net Capital Outflow Variables that Influence Net Capital Outflow  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.

10. The Equality of Net Exports and 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  This holds true because every transaction that affects one side must also affect the other side by the same amount. (double-entry bookkeeping, 複式簿記 )

11. 複式簿記舉例 : 電腦廠出口電腦賺得美金 100 萬  出口 +100  外國資產 ( 美金 ) +100 => NCO +100

12. Balance of Payments A country’s balance of payments accounts are a summary of the country’s transactions with other countries. A country’s balance of payments on current account, or current account, is its balance of payments on goods and services plus net international transfer payments and factor income.

13. The merchandise trade balance, or trade balance, is the difference between a country’s exports and imports of goods. A country’s balance of payments on financial account, or simply its financial account, is the difference between its sales of assets to foreigners and its purchases of assets from foreigners during a given period.

14. A fundamental rule of balance of payments accounting for any country is: current account (CA) + financial account (FA) = 0 Or, CA = –FA

15. 15 of 39 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Table 29-1 The Balance of Payments, 2010 (billions of dollars) CURRENT ACCOUNT Exports of goods$1,289 Imports of goods−1,935 Balance of trade−646 Exports of services549 Imports of services−403 Balance of services146 Income received on investments663 Income payments on investments−498 Net income on investments165 Net transfers−136 Balance on current account−471 FINANCIAL ACCOUNT Increase in foreign holdings of assets in the United States1,259 Increase in U.S. holdings of assets in foreign countries−1,005 Balance on financial account254 BALANCE ON CAPITAL ACCOUNT 0 Statistical discrepancy217 Balance of payments0 The sum of the balance of trade and the balance of services equals net exports.

16. 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

17. Saving, Investment, and Their Relationship to the International Flows National saving (S) equals Y - C - G so: S = I + NX or Saving Domestic Investment Net Capital Outflow =+ SI NCO =+

18. Figure 2 National Saving, Domestic Investment, and Net Foreign Investment Percent of GDP 20 18 16 14 12 10 19601965199519901985198019751970 (a) National Saving and Domestic Investment (as a percentage of GDP) 2000 Domestic investment National saving Copyright © 2004 South-Western

19. Figure 2 National Saving, Domestic Investment, and Net Foreign Investment Percent of GDP 4 –4 –3 –2 –1 0 1 2 3 Net capital outflow (b) Net Capital Outflow (as a percentage of GDP) 196019651995199019851980197519702000 Copyright © 2004 South-Western

20. 20 of 39 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The recession of 2007-2009 was a period of prosperity for McDonald’s. Its success continued into 2010, but with limited growth in the U.S. market, McDonald’s has been expanding in foreign markets. Since McDonald’s revenue comes from many different currencies, its revenue and profits are affected by fluctuations in the value of the dollar in foreign exchange markets. For McDonald’s, the revenue measured in local currencies is less than the revenue in terms of dollars. Since the value of the dollar has increased, converting foreign currencies to dollars has yielded fewer dollars. A Strong Dollar Hurts McDonald’s Profits

21. 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.

22. 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. The nominal exchange rate is expressed in two ways: – In units of foreign currency per one U.S. dollar. – And in units of U.S. dollars per one unit of the foreign currency.

23. Nominal Exchange Rates Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one dollar. – One U.S. dollar trades for 80 yen. – One yen trades for 1/80 (= 0.0125) of a dollar.

24. 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

25. 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.

26. Real Exchange Rates 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.

27. Real Exchange Rates

28. 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.

29. 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.

30. Real Exchange Rates 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.

31. 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.

32. 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.

33. The 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.

34. 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. Suppose a hamburger is $1 USD in US. If the law of one price is true, the same hamburger should be $1 x Exchange rate NTD in Taiwan.

35. 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.

36. Basic Logic of Purchasing-Power Parity 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.

37. Law of one price: Purchasing Power Parity (PPP):

38. PPP implies:

39. 39 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Is the price of a Big Mac in Buenos Aires the same as the price of a Big Mac in New York? COUNTRYBIG MAC PRICE IMPLIED EXCHANGE RATEACTUAL EXCHANGE RATE Mexico32.0 pesos7.86 pesos per dollar11.70 pesos per dollar Japan320 yen78.62 yen per dollar78.40 yen per dollar United Kingdom2.39 pounds0.59 pound per dollar0.61 pound per dollar Switzerland6.50 Swiss francs1.60 Swiss francs per dollar0.81 Swiss francs per dollar Indonesia22,534 rupiahs5,537 rupiahs per dollar8,523 rupiahs per dollar Canada4.73 Canadian dollars1.16 Canadian dollars per U.S. dollar 0.95 Canadian dollars per U.S. dollar China14.7 yuan3.61 yuan per dollar6.45 yuan per dollar The Big Mac Theory of Exchange Rates Making the Connection The Economist magazine regularly compares the prices of Big Macs in different countries. If purchasing power parity holds, you should be able to take the dollars required to buy a Big Mac in the United States and exchange them for the amount of foreign currency needed to buy a Big Mac in any other country. Your Turn: Test your understanding by doing related problem 2.11 at the end of this chapter. MyEconLab

40. 40 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Calculating Purchasing Power Parity Exchange Rates Using Big Macs Solved Problem 30.2 Fill in the missing values in the following table. Remember that the implied exchange rate shows what the exchange rate would be if purchasing power parity held for Big Macs. Assume that the Big Mac is selling for $4.07 in the United States. Explain whether the U.S. dollar is overvalued or undervalued relative to each currency and predict what will happen in the future to each exchange rate. Finally, calculate the implied exchange rate between the Polish zloty and the Brazilian real (plural: reais) and explain which currency is undervalued in terms of Big Mac purchasing power parity. COUNTRYBIG MAC PRICE IMPLIED EXCHANGE RATE ACTUAL EXCHANGE RATE Brazil9.50 reals1.54 reals per dollar Poland8.63 zlotys2.80 zlotys per dollar South Korea3,700 won1,056 won per dollar Malaysia7.20 ringgits2.97 ringgits per dollar Solving the Problem Step 1: Review the chapter material.

41. 41 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Calculating Purchasing Power Parity Exchange Rates Using Big Macs Solved Problem 30.2 Step 2: Fill in the table. To calculate the purchasing power parity exchange rate, divide the foreign currency price of a Big Mac by the U.S. price. COUNTRYBIG MAC PRICE IMPLIED EXCHANGE RATE ACTUAL EXCHANGE RATE Brazil9.50 reais2.33 reais per dollar1.54 reais per dollar Poland8.63 zlotys2.12 zlotys per dollar2.80 zlotys per dollar South Korea3,700 won909 won per dollar1,056 won per dollar Malaysia7.20 ringgits1.77 ringgits per dollar2.97 ringgits per dollar Step 3: Explain whether the U.S. dollar is overvalued or undervalued against the other currencies. The dollar is overvalued if the actual exchange rate is greater than the implied exchange rate, and it is undervalued if the actual exchange rate is less than the implied exchange rate. Step 4: Calculate the implied exchange rate between the zloty and the real. The implied exchange rate between the zloty and the real is 8.63 zlotys/9.50 reais, or 0.91 zlotys per real. We can calculate the actual exchange rate by taking the ratio of zlotys per dollar to reais per dollar: 2.80 zlotys/1.54 reais, or 1.82 zlotys per real. Therefore, the zloty is undervalued relative to the real because our Big Mac purchasing power parity calculation tells us that it should take fewer zlotys to buy a real than it actually does. Your Turn: Test your understanding by doing related problem 2.12 at the end of this chapter. MyEconLab

42. 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.

43. Implications of Purchasing-Power Parity 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.

44. Figure 3 Money, Prices, and the Nominal Exchange Rate During the German Hyperinflation 10,000,000,000 1,000,000,000,000,000 100,000 1.00001.0000000001 1921192219231924 Exchange rate Money supply Price level 1925 Indexes (Jan. 1921 5 100) Copyright © 2004 South-Western

45. 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.

46. 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.

47. Summary 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.

48. 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.

49. Summary 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.

50. 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.