1. Open-Economy Macroeconomics: Basic Concepts

2. Closed Vs. Open Economies
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.
An open economy is one that interacts freely with other economies around the world.
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
An Open Economy
The United States is a very large and open economy—it imports and exports huge quantities of goods and services.
Over the past four decades, international trade and finance have become increasingly important.

4. 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.

5. 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.

6. Determinants of 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.
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.

7. Figure 1 The Internationalization of the U.S. Economy
Percent
of GDP 15
Imports 10
Exports 5
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
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8. 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.
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. Determinants of 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. Monetary Economy Revisited Again: Net Exports = Net Capital Flow
For an economy as a whole, net exports (NX) and net capital outflow (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.
Example: If Boeing exports a plane to Japan, NX rises, but, in the simplest case Boeing obtains yen, which increase NCO. In the more complex case, the Japanese company may purchase dollars, but someone with dollars is ending up with yen. If the Japanese buyers get a loan from Boeing, Boeing has acquired a foreign financial asset.

11. Saving, Investment, and Their Relationship to the International Flows
Net exports (NX) is a component of GDP:
Y = C + I + G + NX, or
Y - C - G = I + NX
National saving (S) is the income of the nation that is left after paying for current consumption and government purchases or
S = Y – C - G

12. Therefore,
S = I + NX
Lastly since NX is equal to NCO,
S = I + NCO
National Saving can be saved in two ways, through domestic investment of in foreign assets.
Remember, S underlies the supply of loanable funds and I, and now NCO, underlies the demand for loanable funds.

13. Table 1 International Flows of Goods and Capital: Summary
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14. S, I and Net Capital Outflow
Note in the succeeding panels that S – I = NCO.
Until the 1980s, NCO and hence the trade deficit was small. After 1980, we have had a recurring trade deficit (NCO is negative – the ROW is holding US financial assets.
Is the recurring deficit a problem?
NCO went from -.5% to –3.0% of GDP, 2.1% came from a drop in S (the Reagan budget deficits). Therefore, the trade deficit helped sustain I. If not, I would have fallen affecting future growth.
NCO went from -.3% to –3.7% attributable not to a decline in savings (which increased) but to increases in investment (primarily in the info. Tech sector). The NCO helped fuel the investment boom.
Whether because S fell or I rose, NCO can help to sustain I and therefore future growth, BUT we must grow to help pay off the debt. In many developing countries, this has NOT occurred leading to higher interest payments.

15. Figure 2 National Saving, Domestic Investment, and Net Capital Outflow
(a) National Saving and Domestic Investment (as a percentage of GDP)
Percent
of GDP 20
Domestic investment 18 16 14
National saving 12 10
1960
1965
1970
1975
1980
1985
1990
1995
2000
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16. Figure 2 National Saving, Domestic Investment, and Net Capital Outflow
(b) Net Capital Outflow (as a percentage of GDP)
Percent
of GDP 4 3 2
Net capital
outflow 1 –1 –2 –3 –4
1960
1965
1970
1975
1980
1985
1990
1995
2000
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17. 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.

18. 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.
a internet based currency converter (can’t be used on tests!)

19. Assume the exchange rate between the Japanese yen and U. S
Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one dollar.
One U.S. dollar trades for 113 yen (10/24/2007).
One yen trades for 1/113 (= ) of a dollar.
Appreciation refers to an increase 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. (say 120 yen)
Depreciation refers to a decrease in the value of a currency as measured by the amount of foreign currency it can buy.
If it buys less there is a depreciation of the dollar (say 80 yen).

20. 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.
Trading depends on the physical quantities that can be exchanged at given exchange rates AND the prices of the good in each country
Example, a Honda in Japan costs 4,000,000 yen and $20,000 in the US. Assuming an exchange rate of 100 yen/dollar, the Honda costs Y2,000,000 in the US. Thus, Hondas are ½ as expensive in the US OR two times more expensive in Japan.

21. 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.
Real Exchange Rate = Exchange Rate x PUS
PROW
Example above EP/P*= 100 yen/dollar x $20,000
Y4,000,000
= ½ HondaJAPAN/1 HondaUS
The real exchange rate is a key determinant of how much a country exports and imports.

22. A depreciation (fall) in the U. S. real exchange rate means that U. S
A depreciation (fall) in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods and so net exports rise.
Encourages consumers both at home and abroad to buy more U.S. goods and fewer goods from other countries.As a result, U.S. exports rise, and U.S. imports fall, and both of these changes raise U.S. net exports.
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.
Discourages consumers both at home and abroad to from buying U.S. goods and encourages buying more goods from other countries. As a result, U.S. exports fall, and U.S. imports rise, and both of these changes decrease U.S. net exports.

23. 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 exchange rates and posits that a unit of any given currency should be able to buy the same quantity of goods in all countries
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 countries.

24. If the law of one price were not true, unexploited profit opportunities would exist and arbitrage would occur (arbitrage is a fancy term for trading or buying low and selling high)..
If arbitrage occurs, eventually prices that differed in two markets would necessarily converge, and exchange rates move to ensure that a currency would have the same purchasing power in all countries.

25. Implications of Purchasing-Power Parity
If the purchasing power of the dollar is always the same at home and abroad, then the exchange rate would be constant.
The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries and the real exchange rate would be equal to 1.
Therefore, if a central bank prints large quantities of money, the price level rises (QTofM) and its value in buying goods and services and other currencies falls.

26. Figure 3 Money, Prices, and the Nominal Exchange Rate During the German Hyperinflation
Indexes
(Jan. 1921 5
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
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27. Limitations of Purchasing-Power Parity
The Big Mac Index
New Index Starbucks
Why don’t real exchange rates always equal one?
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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.