0. Open Economy: Basic Concepts

1. Open and Closed Economies
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.

2. Open and Closed Economies
An open economy is one that interacts freely with other economies around the world.

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.

4. The Flow of Goods & Services
Exports: domestically-produced goods & services sold abroad
Imports: foreign-produced goods & services sold domestically
Net exports (NX), aka the trade balance = value of exports – value of imports 4

5. A C T I V E L E A R N I N G 1 Variables that affect NX
What do you think would happen to U.S. net exports if: A. Canada experiences a recession (falling incomes, rising unemployment) B. U.S. consumers decide to be patriotic and buy more products “Made in the U.S.A.” C. Prices of goods produced in Mexico rise faster than prices of goods produced in the U.S.

6. A C T I V E L E A R N I N G 1 Answers
A. Canada experiences a recession (falling incomes, rising unemployment)
U.S. net exports would fall due to a fall in Canadian consumers’ purchases of U.S. exports
B. U.S. consumers decide to be patriotic and buy more products “Made in the U.S.A.”
U.S. net exports would rise due to a fall in imports

7. A C T I V E L E A R N I N G 1 Answers
C. Prices of Mexican goods rise faster than prices of U.S. goods
This makes U.S. goods more attractive relative to Mexico’s goods.
Exports to Mexico increase, imports from Mexico decrease, so U.S. net exports increase.

8. Variables that Influence Net Exports
Consumers’ preferences for foreign and domestic goods
Prices of goods at home and abroad
Incomes of consumers at home and abroad
The exchange rates at which foreign currency trades for domestic currency
Transportation costs
Government policies 8

9. Trade Surpluses & Deficits
NX measures the imbalance in a country’s trade in goods and services.
Trade deficit: an excess of imports over exports
Trade surplus: an excess of exports over imports
Balanced trade: when exports = imports 9

10. The U.S. Economy’s Increasing Openness
Percent of GDP
Trade deficit = 5% of GDP in 2007:Q4
Imports
Exports 10

11. The Flow of Capital
Net capital outflow (NCO): domestic residents’ purchases of foreign assets minus foreigners’ purchases of domestic assets
NCO is also called net foreign investment. 11

12. The Flow of Capital
The flow of capital abroad takes two forms:
Foreign direct investment: Domestic residents actively manage the foreign investment, e.g., McDonalds opens a fast-food outlet in Moscow.
Foreign portfolio investment: Domestic residents purchase foreign stocks or bonds, supplying “loanable funds” to a foreign firm. 12

13. The Flow of Capital
NCO measures the imbalance in a country’s trade in assets:
When NCO > 0, “capital outflow” Domestic purchases of foreign assets exceed foreign purchases of domestic assets.
When NCO < 0, “capital inflow” Foreign purchases of domestic assets exceed domestic purchases of foreign assets. 13

14. Variables that Influence NCO
Real interest rates paid on foreign assets
Real interest rates paid on domestic assets
Perceived risks of holding foreign assets
Govt policies affecting foreign ownership of domestic assets 14

15. The Equality of NX and NCO
An accounting identity: NCO = NX
arises because every transaction that affects NX also affects NCO by the same amount (and vice versa)
When a foreigner purchases a good from the U.S.,
U.S. exports and NX increase
the foreigner pays with currency or assets, so the U.S. acquires some foreign assets, causing NCO to rise. 15

16. The Equality of NX and NCO
An accounting identity: NCO = NX
arises because every transaction that affects NX also affects NCO by the same amount (and vice versa)
When a U.S. citizen buys foreign goods,
U.S. imports rise, NX falls
the U.S. buyer pays with U.S. dollars or assets, so the other country acquires U.S. assets, causing U.S. NCO to fall. 16

17. Saving, Investment, and International Flows of Goods & Assets
Saving, Investment, and International Flows of Goods & Assets
Y = C + I + G + NX accounting identity
Y – C – G = I + NX rearranging terms
S = I + NX since S = Y – C – G
S = I + NCO since NX = NCO
When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow.
When S < I, foreigners are financing some of the country’s investment, and NCO < 0. 17

18. The Nominal Exchange Rate
Nominal exchange rate: the rate at which one country’s currency trades for another
We express all exchange rates as foreign currency per unit of domestic currency.
Some exchange rates as of 16 July 2008, all per US$
Canadian dollar:
Euro:
Japanese yen:
Mexican peso:
Turkish Lira: 1.22 18

19. Appreciation and Depreciation
Appreciation (or “strengthening”): an increase in the value of a currency as measured by the amount of foreign currency it can buy
Depreciation (or “weakening”): a decrease in the value of a currency as measured by the amount of foreign currency it can buy
Examples: During 2007, the U.S. dollar…
depreciated 9.5% against the Euro
appreciated 1.5% against the S. Korean Won 19

20. The Real Exchange Rate e x P P = domestic price
Real exchange rate: the rate at which the g&s of one country trade for the g&s of another
Real exchange rate =
where
P = domestic price
P* = foreign price (in foreign currency)
e = nominal exchange rate, i.e., foreign currency per unit of domestic currency
e x P P* 20

21. 400 yen per Japanese Big Mac
Example With One Good
A Big Mac costs $2.50 in U.S., 400 yen in Japan
e = 120 yen per $
e x P = price in yen of a U.S. Big Mac
= (120 yen per $) x ($2.50 per Big Mac)
= 300 yen per U.S. Big Mac
Compute the real exchange rate:
300 yen per U.S. Big Mac
400 yen per Japanese Big Mac =
e x P P*
= Japanese Big Macs per US Big Mac 21

22. Interpreting the Real Exchange Rate
“The real exchange rate = Japanese Big Macs per U.S. Big Mac”
Correct interpretation: To buy a Big Mac in the U.S., a Japanese citizen must sacrifice an amount that could purchase 0.75 Big Macs in Japan. 22

23. A C T I V E L E A R N I N G 2 Compute a real exchange rate
e = 10 pesos per $ price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico A. What is the price of a US latte measured in pesos? B. Calculate the real exchange rate, measured as Mexican lattes per US latte.

24. A C T I V E L E A R N I N G 2 Answers
A C T I V E L E A R N I N G Answers
e = 10 pesos per $
price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico
A. What is the price of a US latte in pesos?
e x P = (10 pesos per $) x (3 $ per US latte)
= 30 pesos per US latte
B. Calculate the real exchange rate.
30 pesos per U.S. latte
24 pesos per Mexican latte =
e x P P*
= Mexican lattes per US latte

25. The Real Exchange Rate With Many Goods
P = U.S. price level, e.g., Consumer Price Index, measures the price of a basket of goods
P* = foreign price level
Real exchange rate = (e x P)/P* = price of a domestic basket of goods relative to price of a foreign basket of goods
If U.S. real exchange rate appreciates, U.S. goods become more expensive relative to foreign goods. 25

26. The Law of One Price
Law of one price: the notion that a good should sell for the same price in all markets
Suppose coffee sells for $4/pound in Seattle and $5/pound in Boston, and can be costlessly transported.
There is an opportunity for arbitrage, making a quick profit by buying coffee in Seattle and selling it in Boston.
Such arbitrage drives up the price in Seattle and drives down the price in Boston, until the two prices are equal. 26

27. Purchasing-Power Parity (PPP)
Purchasing-power parity: a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries
based on the law of one price
implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries 27

28. Purchasing-Power Parity (PPP)
Example: The “basket” contains a Big Mac.
P = price of US Big Mac (in dollars)
P* = price of Japanese Big Mac (in yen)
e = exchange rate, yen per dollar
According to PPP,
e x P = P*
price of US Big Mac, in yen
price of Japanese Big Mac, in yen P* P
e =
Solve for e: 28

29. PPP and Its Implications
PPP implies that the nominal exchange rate between two countries should equal the ratio of price levels.
If the two countries have different inflation rates, then e will change over time:
If inflation is higher in Mexico than in the U.S., then P* rises faster than P, so e rises – the dollar appreciates against the peso.
If inflation is higher in the U.S. than in Japan, then P rises faster than P*, so e falls – the dollar depreciates against the yen. P* P
e = 29

30. Limitations of PPP Theory
Two reasons why exchange rates do not always adjust to equalize prices across countries:
Many goods cannot easily be traded
Examples: haircuts, going to the movies
Price differences on such goods cannot be arbitraged away
Foreign, domestic goods not perfect substitutes
E.g., some U.S. consumers prefer Toyotas over Chevys, or vice versa
Price differences reflect taste differences 30

31. Limitations of PPP Theory
Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends.
For example, PPP implies: the greater a country’s inflation rate, the faster its currency should depreciate (relative to a low-inflation country like the US).
The data support this prediction… 31

32. Inflation & Depreciation in a Cross-Section of 31 Countries
Ukraine
Brazil
Romania
Avg annual depreciation relative to US dollar (log scale)
Argentina
Mexico
Canada
Kenya
Japan
Avg annual CPI inflation (log scale) 32

33. A C T I V E L E A R N I N G 3 Chapter review questions
1. Which of the following statements about a country with a trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving
D. Y < C + I + G
2. A Ford Escape SUV sells for $24,000 in the U.S. and 720,000 rubles in Russia.
If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)?

34. A C T I V E L E A R N I N G 3 Answers
1. Which of the following statements about a country with a trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving
D. Y < C + I + G
not true!
A trade deficit means NX < 0. Since NX = S – I, a trade deficit implies I > S.

35. A C T I V E L E A R N I N G 3 Answers
2. A Ford Escape SUV sells for $24,000 in the U.S. and 720,000 rubles in Russia. If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)? P* = 720,000 rubles P = $24,000 e = P*/P = /24000 = 30 rubles per dollar

36. Turkish Economy Turkey is a small open economy.
Turkey must take the real‑world interest rate as their own (ignore risk).
If rTurkey < r* where r* is the world real interest rate, then Turkey would have no capital.
All the capital would leave the country for the higher returns abroad (this assumes there are no restrictions on the export of capital, called capital controls).
There is no reason to offer rTurkey > r* since the country can get all the capital it needs from the ROW by offering r*.

37. Turkish Economy
Turkey faces an infinitely elastic (horizontal) supply of capital at r*.
Investment spending is still a negative function of the real interest rate.
For Turkey, r = r*, so the real interest rate cannot adjust to changes domestically, therefore NCF must adjust to maintain equilibrium of leakages = injections.

38. Turkish Economy Supply of savings in a small open economy.
B0 = original international borrowing
B1 = new international borrowing

39. Suppose Government Spending Increases
Suppose G ↑ in a small open economy at full employment.
As before, national savings S ↓ because government savings Sg ↓.
The saving curve shifts left.
Since r = r*, a gap opens between national savings and investment.
This gap is NCF; foreign capital flows into the economy to make up the difference between national savings and total investment.
In a small open economy there is no crowding out of investment!
Downside: Increased foreign borrowing must be repaid in the future
These payments to foreigners may lower future living standards.

40. Turkish Economy
Before 1980, Turkey was following import-substituting industrialization strategy.
Therefore, imports and exports were quite low.
After 1980, Turkey opened up its markets to imports and subsidized exports.
In 1989, Turkey removed capital controls.
Before 1989, if Turkish savings fell by $1 billion, Turkish investment fell by about $1 billion as in a closed economy.
After 1989 and especially since 2001, if Turkish savings fell by $1 billion, investment would only fall by much less than $1 billion.
This implies that today foreigners are more able and willing to invest in Turkey.

41. Twin Deficits in Turkey?
In 1970s and 1980s current account (trade ) deficit and government budget deficit moved together, but since the second half of 1990s the relationship changed.
After the 2001 crisis budget deficits declined while current account (trade) deficit increased

42. Saving, Investment and Capital Flow

43. National Saving, Investment and Net Capital Flows
After the 2001 economic crisis, national saving was steady while investment rose so Turkey had a large capital inflow.
After 2001 we observed a downward trend in Sp and upward trend in government savings.
Investment, on the other hand, rose.
NCF rose during this period, so borrowing from foreigners increased to pay for private sector investments.

44. Savings, Investment and the Current Account

45. Exchange Rate in Turkey (1/e=TL/[$+€] basket)
Before 2001 crisis, TL was not freely floating, it was managed by the central bank (that is why, smooth graph before 2001).
TL’s value depreciated (an upward jump in the exchange rate) sharply during the crisis.
Since then it is fluctuating between 1.5 and 2.0.
Jumps in June 2006 (capital outflows from the emerging markets) and October 2008 (after the collapse of the Lehman Brothers in the U.S.)

46. Exchange Rate (TL/[$+€] basket)

47. The United States Economy
The United States is a large open economy.
Changes in the United States have effects on the world real interest rate r*.
U.S. savings account for 20% of world savings.
A decrease in U.S. savings would raise world interest rates.
This chokes off some U.S. investment as in the closed economy case, but the magnitude of crowding out would be lower due to foreign capital inflows.

48. The United States Economy
In the decades after World War II, if U.S. savings fell by $1 billion, U.S. investment fell by about $1 billion as in a closed economy.
Today if U.S. savings fell by $1 billion, investment would only fall by between $350 and $500 million.
This implies that today foreigners are more able and willing to invest in the United States.

49. Twin Deficits in the U.S.
The trade deficit and government budget deficit often move together but not always
In the 1980s increases in the budget deficit were accompanied by increases in foreign borrowing and a trade deficit. During the late 1990s the fiscal deficit fell but the trade deficit increased.

50. The Supply of U.S. Dollars
U.S. citizens’ supply of dollars to buy foreign goods and investments
The supply curve is upward sloping.
If e ↑, foreign currency and foreign goods are cheaper, so U.S. residents supply a greater quantity of dollars.
The supply curve of dollars shifts when U.S. residents wish to:
Buy more imported goods
Invest more in foreign countries
Take more trips abroad

51. The Demand for U.S. Dollars
The demand curve for dollars represents the demand by foreigners for U.S. currency.
The demand curve is downward sloping.
If e ↑, the dollar is more expensive to foreigners so they buy fewer dollars.
The demand curve for dollars shifts right when foreigners want to:
Buy more U.S. exports
Invest more in the United States
Take more trips to the United States

52. Equilibrium

53. The Effects of Increased Foreign Borrowing
Suppose the United States borrows more from foreigners, say, from Japan.
To attract Japanese investors, the U.S. interest rate must rise.
The increased demand for dollars by Japanese investors shifts the demand curve for dollars to the right since high U.S. interest rates make U.S. investments attractive to Japanese investors.
The supply of dollars shifts to the left because Japanese investments are less attractive to U.S. investors.
In equilibrium, there is a higher exchange rate; the dollar appreciates against the yen.
Fluctuations in the exchange rate ensure that the trade balance and foreign borrowing move together; that is,
NX + NCF = 0.

54. The Effects of Increased Foreign Borrowing (continued)

55. The U.S. Trade Deficit
The U.S. trade deficit reached record levels in 2006 and remained high in
Recall, NX = S – I = NCO.
A trade deficit means I > S, so the nation borrows the difference from foreigners.
In 2007, foreign purchases of U.S. assets exceeded U.S. purchases of foreign assets by $775 million.
Such deficits have been the norm since 1980. 55

56. U.S. Saving, Investment, and NCO, 1950-2007
(% of GDP)
NCO 56

57. The U.S. Trade Deficit
Why U.S. saving has been less than investment:
In the 1980s and early 2000s, huge budget deficits and low private saving depressed national saving.
In the 1990s, national saving increased as the economy grew, but domestic investment increased even faster due to the information technology boom. 57

58. The U.S. Trade Deficit Is the U.S. trade deficit a problem?
Is the U.S. trade deficit a problem?
The extra capital stock from the ’90s investment boom may well yield large returns.
The fall in saving of the ’80s and ’00s, while not desirable, at least did not depress domestic investment, as firms could borrow from abroad.
A country, like a person, can go into debt for good reasons or bad ones. A trade deficit is not necessarily a problem, but might be a symptom of a problem. 58

59. The U.S. Trade Deficit
as of People abroad owned $20.1 trillion in U.S. assets.
U.S. residents owned $17.6 trillion in foreign assets.
U.S.’ net indebtedness to other countries = $2.5 trillion.
Higher than every other country’s net indebtedness.
So, U.S. is “the world’s biggest debtor nation.”
So far, the U.S. earns higher interest rates on foreign assets than it pays on its debts to foreigners.
But if U.S. debt continues to grow, foreigners may demand higher interest rates, and servicing the debt would become a drain on U.S. income. 59

60. CHAPTER SUMMARY
Net exports equal exports minus imports. Net capital outflow equals domestic residents’ purchases of foreign assets minus foreigners’ purchases of domestic assets.
Every international transaction involves the exchange of an asset for a good or service, so net exports equal net capital outflow.

61. CHAPTER SUMMARY
Saving can be used to finance domestic investment or to buy assets abroad. Thus, saving equals domestic investment plus net capital outflow.
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 the two countries.

62. CHAPTER SUMMARY
According to the theory of purchasing-power parity, a unit of any country’s currency should be able to buy the same quantity of goods in all countries.
This theory implies that the nominal exchange rate between two countries should equal the ratio of the price levels in the two countries.
It also implies that countries with high inflation should have depreciating currencies.