0. Open-Economy Macroeconomics: Basic Concepts
Chapter 6
Open-Economy Macroeconomics: Basic Concepts
© 2007 Thomson South-Western

1. Open-Economy Macroeconomics: Basic Concepts
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 for a closed economy.
An open economy is one that trades goods, services and capital freely with other economies around the world.

2. Open-Economy Macroeconomics: Basic Concepts
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.

3. THE INTERNATIONAL FLOW OF GOODS AND CAPITAL
The Flow of Goods: Exports, Imports, and Net Exports
Turkey is an open economy—it imports and exports large quantities of goods and services.
After 1980s, international trade and finance have become increasingly important.
Trade liberalization: free flow of goods and services across borders.
Financial liberalization: free flow of capital across borders.

4. The Flow of Goods: Exports, Imports, Net Exports
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.
A trade deficit is a situation in which net exports (NX) are negative. Turkey has traditionally had a trade deficit with the rest of the world.
Trade deficit: Imports > Exports

5. The Flow of Goods: Exports, Imports, Net Exports
A trade surplus is a situation in which net exports (NX) are positive. During WW II years, Turkey had a trade surplus.
Trade surplus: Exports > Imports
Balanced trade refers to when net exports are zero—exports and imports are exactly equal.

6. 1000 $

8. Figure 1 The Internationalization of the U.S. Economy
Percent
of GDP 15
Imports
Exports 10 5
195
195 5
1960
1965
1970
1975
1980
198 5
1990
1995
200
2005

9. The Flow of Goods: Exports, Imports, Net Exports
Factors That Affect Net Exports
The prices of goods at home and abroad. If price of Turkish goods relative to other goods go up, what happens to NX?
The exchange rates at which people can use domestic currency to buy foreign currencies. If lira appreciates, what happens to trade balance?
The policies of the government toward international trade: tariffs and quotas on imports. İf tariffs increase, what happens to NX?

10. The Flow of Goods: Exports, Imports, Net Exports
Factors That Affect Net Exports
The incomes of consumers at home and abroad. If per capita GDP increases in Turkey relative to others, what happens to NX?
The costs of transporting goods from country to country. İf transportation costs decrease,....
The tastes of consumers for domestic and foreign goods. İf Turks start liking Italian furniture, what happens?

11. The Flow of Capital: Net Capital Outflow
Net capital outflow (NCO) refers to the purchase of foreign assets (lending) by domestic residents (banks, firms, etc.) minus the purchase of domestic assets (lending) by foreigners.
Two types: Foreign portfolio investment (FPI) and Foreign direct investment (FDI). Difference: FDI takes control of the enterprise, FPI does not. FPI is short term, FDI is long term.
NCO is the opposite of Net Capital İnflows (NCI): NCO = - NCI.

12. Flow of Capital: FPI Examples:
A Turkish firm buys stock in General Motors (+NCO) and a Mexican bank buys stocks of Vestel (-NCO).
Turkish bank buys stocks of Telmex, the Mexican phone company, +NCO, -NCI.
Japanese company buys a Turkish Treasury Bond, -NCO, +NCI.
Turkish bank or firm borrows money from a foreign bank or firm (ex: Deutsche Bank), -NCO, +NCI. Akbank lends money to Albanian bank: +NCO, -NCI.

13. Flow of Capital: FDI Examples:
British company buys Migros: -NCO, +NCI.
Bank of Greece buys Finansbank: -NCO, +NCI.
Koç Holding buys Grundig: +NCO, -NCI.

14. The Flow of Capital: Factors
Variables that Influence NCO
The real interest rates being paid on foreign assets affect FPI. How much (RIR) does the US Treasury Bond pay? (~1%)
The real interest rates (RIR) being paid on domestic assets. How much RIR does Turkish treasury bond pay? (~13%)
Currently, Turkish treasury bonds pay nominal 19%. İf expected inflation is 6%, real interest rate is 13%: probably largest in the world.

15. The Flow of Capital: Factors
Variables that Influence NCO
Risk of default (country risk). The perceived economic and political risks of holding assets abroad. Russian government issued a moratorium (postponement of foreign debt repayments) in Foreign Investors pulled their money out of Russia: Capital Flight.
The government policies that affect foreign ownership of domestic assets. Are there restrictions on foreigners buying Turkish banks, companies, land (FDI) or stocks, bonds (FPI)?

16. The Equality of Net Exports and Net Capital Outflow
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. Ex: When TR buys net imports of $100 worth of goods, must pay with some Turkish assets.

17. The Equality of Net Exports and Net Capital Outflow
NCO = NX
Ex: Turkey’s imports exceed its exports by $ 52 billion in This means Turkey must sell something and receive dollars to pay for extra imports. Turkey sells stocks or bonds, i.e. (Foreign portfolio investment). Turkey borrows, foreigners lend. Or foreigners buy or start a company in Turkey (foreign direct investment). Then, NX = -$52 billion = NCO is negative, NCI is +52 billion.

18. 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

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

20. Table 1 International Flows of Goods and Capital: Summary

21. Figure 2: US National Saving, Domestic Investment, and Net Foreign Investment
(a) National Saving and Domestic Investment (as a percentage of GDP)
Percent
of GDP 20
National saving
Domestic investment 18 16 14 12 10
196
196 5
1970
1975
1980
1985
1990
1995
200
2005

22. Figure 2: US National Saving, Domestic Investment, and Net Foreign Investment
(b) Net Capital Outflow (as a percentage of GDP)
Percent
of GDP 2
Net capital
outflow 1 1 2 3 4 5 6
196
196 5
197
1975
1980
1985
1990
1995
200
2005

23. 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.

24. 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.

25. Nominal Exchange Rates
The nominal exchange rate is expressed in two ways:
İn units of TLs per one unit of the foreign currency (dollars): 1.34 TL/USD
Or in units of foreign currency (dollars) per one YTL: USD/TL
Define ETL/USD as the nominal exchange rate. İt shows how many TLs one can buy with 1 dollar.

26. 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.

27. Nominal Exchange Rates (NER)
Today, EYTL/USD = 1,28 TL/USD. If a crisis occurs and EYTL/USD= 1,38 TL/USD tomorrow, this means lira has appreciated or depreciated?
If one lira buys less (more) dollars then there is a depreciation (appreciation) of the lira.

28. How Are Exchange Rates Determined?
The purchasing-power parity (PPP) theory is the most widely accepted theory of how exchange rates are determined in the long-run.
PPP is based on the law of one price: The same goods must have the same price in all countries.

29. Purchasing-Power Parity Theory
1 ton Turkish steel sold at 134 YTL is the same as 1 ton American steel sold for 100 dollar. So according to the law of one price, the exchange rate must be 1.34 YTL/dollar. (there is only one price of steel in the world).
Assume tariffs and transportation costs are zero.
Assume the goods produced in both countries are the same. Ex: Turkish steel is a perfect substitute for American steel.

30. The Basic Logic of Purchasing-Power Parity
If the law of one price were not true, then traders would buy from the cheap country and sell to the expensive country and make profit. This activity is called arbitrage.
For example, if price of Turkish steel is 100 YTL and the price of American steel is 100 dollars. Then I would buy a lot of steel from Turkey and sell to the US. Everybody would do the same.

31. The Basic Logic of Purchasing-Power Parity
Then through arbitrage, price of steel in Turkey would increase and price of steel in US would increase and they would become equal.
But in reality, many goods are not perfect substitutes. German tractors are not the same as Turkish tractors.

32. Implications of Purchasing-Power Parity
The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries:
This means that if the price level increases 10 % in Turkey and 5 % in the US, lira will depreciate against dollar by 10-5 = 5%.

33. 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.

34. Real Exchange Rates
The real exchange rate (RER) is the ratio of prices of goods produced in Turkey and prices of goods produced in other countries.
İf law of one price and PPP theory is correct, then RER = 1 and constant. But real data tells us a different story.

35. Real Exchange Rates
If one Turkish tractor is 8000 euros and one German tractor is euros, then the real exchange rate is 0,80 German tractor per Turkish tractor.
RERGER/TUR = 0,80 German tractor/ Turkish tractor
According to PPP, Real Exchange Rate must be equal to one because a lot of people would buy Turkish tractors and sell to Germany.

36. 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.
RERUS/TUR = PTUR / (EYTL/USDx PUS)

37. Real Exchange Rates
Ex: Suppose price of one ton of US wheat is 100 dollars in US, and one ton of Turkish wheat is 145 TL in Turkey. Then
RERUS/TUR =
= 145 TL/TRw. / (1,34 TL/USD x 100 USD/USw.)
= 1,08 US wheat / Turkish wheat

38. Real Exchange Rates
RER is a key determinant of how much a country exports and imports.
A depreciation (fall) in Turkey’s real exchange rate means that Turkish goods have become cheaper relative to foreign goods.
This encourages consumers both at home and abroad to buy more Turkish goods and fewer goods from other countries. Turkish net exports increase.

39. Real Exchange Rates
As a result, Turkish exports rise, and Turkish imports fall, and both of these changes raise Turkish net exports.
Conversely, an appreciation in the Turkish real exchange rate means that Turkish goods have become more expensive compared to foreign goods, so Turkish net exports fall. This is the situation these days because TL is appreciating against other currencies: EYTL/USD falling, RERUS/TUR rising.

40. Figure 3: Money, Prices, and the Nominal Exchange Rate During the German Hyperinflation
Indexes
(Jan =
100)
1,000,000,000,000,000
Money supply
10,000,000,000
Price level
100,000 1
Exchange rate
.00001
1921
1922
1923
1924
1925

41. Critique of PPP Theory: Why PPP cannot explain NERs?
Many goods are not easily traded or shipped from one country to another. Ex: Haircuts, houses, etc. are nontradables.
Tradable goods are not always perfect substitutes when they are produced in different countries. İs German cheese the same as Turkish cheese? Tastes are different.
Tariffs and transportation costs are large.