1. Principles of Economics
Open-Economy Macroeconomics
Tomislav Herceg

2. Flow of goods and services
Exports (EX) are domestically produced goods & services sold abroad
Imports (IM) are foreign-produced goods & services sold domestically
Net exports (NX, trade balance) = exports – imports
Trade surplus: when EX > IM
Trade deficit: when IM > EX
Balanced trade: when IM = EX

3. Flow of financial resources
Net capital outflow (NCO, net foreign investment) = purchase of foreign assets by domestic residents – purchase of domestic assets by foreigners
Net capital outflow is equal to net exports
In an open trade: Y = C + I + G + NX
Since S = Y – C – G then S = I + NX.
Since NX = NCO then S = I + NCO
(savings can be used to purchase capital domestically or abroad)

4. Summary Trade deficit Trade surplus Balanced trade NX < 0 NX > 0
EX < IM
EX > IM
EX = IM
Y < C + I + G
Y > C + I + G
Y = C + I + G
S < I
S > I
S = I
NCO < 0
NCO > 0
NCO = 0

5. Exchange rates
Nominal exchange rate (e) is a rate at which one currency is traded for another
Appreciation is an increase in the value of a currency as measured by the amount of the foreign currency it can buy
Depreciation is a decrease in the value of a currency as measured by the amount of the foreign currency it can buy
Real exchange rate (er)is the rate at which goods of one country can be traded for the goods of another: er = e∙pd/pf

6. Purchasing power parity (PPP)
First theory of exchange rate determination
PPP is a theory which states that a unit of a currency should be able to buy the same amount of goods in all countries, hence:
e = pf/pd
Under PPP nominal and real exchange rate are equal
Common currency area is a geographical area covering several countries that use common currency
Purchasing power standard (PPS) is a fictional currency that expresses a purchasing power in EU.

7. Limitations of PPP
Not all goods can be traded (e.g. haircuts, these goods are called non-tradeables)
Goods are not always perfect substitutes when produced in different countries (e.g. economic nationalism)

8. Market for loanable funds
Supply of loanable funds: savings (S)
Demand for loanable funds: domestic investment (I) + net capital outflow (NCO)
Real interest rate
S = supply
S = I + NCO
I+NCO = demand
Quantity of loanable funds

9. Market for foreign currency exchange
Supply of currency comes from net capital outflow, while demand for currency comes from net exports
Note: NCO defines supply of foreign exchange and demand for loanable funds
Real exchange rate
NCO = supply
NX = NCO
NX = demand
Quantity of currency exchanged

10. Simultaneous equilibrium
Real interest rate
S = supply
Real interest rate
S = I + NCO
NCO
I+NCO = demand
Quantity of loanable funds
Net capital outflow
Real exchange rate
NCO = supply
NX = NCO
NX = demand
Quantity of currency exchanged

11. The Effects of Budget Deficit
Real interest rate S2
S = S1
Real interest rate
S = I + NCO
NCO
I+NCO = demand
Quantity of loanable funds
Net capital outflow
Budget deficit reduces supply of loanable funds which causes interest rates to rise, hence net capital outflow falls reducing supply of domestic currency on exchange market
Real exchange rate s2
NCO = S1
NX = NCO
NX = demand
Quantity of currency exchanged

12. The Effects of Import Quota
Real interest rate
S = S1
Real interest rate
S = I + NCO
NCO
I+NCO = demand
Quantity of loanable funds
Net capital outflow
Trade policy is a government policy whose prime goal is to affect the quantity of goods and services that a country imports or exports
It affects only exchange rate, not the trade balance since NX = NCO = S – I and S and I are not affected by trade policy
Real exchange rate
NCO = S1
NX = NCO D2
Quantity of currency exchanged
NX = D1

13. The Effects of Capital Flight
Real interest rate D2 S
Real interest rate
S = I + NCO
NCO2
I+NCO = D1
Quantity of loanable funds
NCO1
Net capital outflow
Increase in net capital outflow causes demand for loanable funds to increase which causes interest rates to increase. Also supply of domestic currency on the exchange market increases thus depreciating domestic currency.
Real exchange rate s2
NX = NCO
NX = demand
NCO = S1
Quantity of currency exchanged

14. Problem 1
Japanese car costs yen and similar German car costs €. Yen/€ exchange rate is 100.
What are the nominal and the real exchange rates?
ey/€ = 100, e€/y = 0.01
er, y/€ = 10000×100/ = 2
b) How would we call a situation in which 1€ would now buy 80 yen instead of 100?
It would mean € depreciated against yen and yen appreciated against €

15. Problem 2
Explain effects of the following actions on exports, imports and capital flows:
Agrokor (Cro) buys Mercator (Slo)
Croatian net capital outflow rised (NCO)
b) Croatian export rises and import drops due to recession
Net exports rise

16. Problem 3
A Big Mac costs 3₤ in London and 15 HRK in Zagreb. Exchange rate HRK/ ₤ = 10 HRK.
Does PPP hold?
ePPP = 15/3 = 5 – no, it does not hold
b) Find real exchange rate HRK/ ₤
er = 3×10/15 = 2 (if er = e then PPP holds)
With the same amount of money consumer can buy 1 Big Mac in Croatia and 2 Big Macs in UK

17. Problem 4
Exchange rates on 11 January 2014 published by Croatian National Bank are:
1 € = HRK
1 USD = HRK
100 JPY = HRK
1 CHF = HRK
If exchange rate parity holds, find exchange rates for € against all other currencies

18. Problem 5 Market for Euro is given with the following table:
What is the equilibrium exchange rate?
What defines supply & demand for Euro?
What should ECB do if it wants to reach exchange rate 1.5 USD/EUR?
USD/EUR
Supply of Euro (100 Bill.)
Demand for Euro (100 Bill.)
1.1
200
260
1.3
220
1.5
240
180
1.7
140

19. Solution
1.3 where S = D
Supply is net capital outflow (NCO) and demand is net exports (NX)
Increase demand for € by 6000 Bill.

20. Problem 6
Price of a Big Mac is 3.57$ in the USA and 18 HRK in Croatia. Exchange rate is HRK for 1$.
Does PPP hold?
If not, find undevaluation/overvaluation of HRK

21. Solution
PPP = Pd/Pf = 18/3.57 = However e = , hence PPP does not hold
%over/underval. = (PPP-e)×100%/e =
( )×100%/6.493 = %