1. Principles of Economics
Session 15

2. Topics To Be Covered Open and Closed Economies
Flow of Goods and Capital
Equality of Net Exports and Net Foreign Investment
Nominal and Real Exchange Rate
Purchasing Power Parity Theory
The Market for Loanable Funds

3. Topics To Be Covered The Market for Foreign-Currency Exchange
Marginal Propensity to Import
Output Determination in Open Economy
Balance of Payments
BP Curve
IS-LM-BP Model
Monetary and Fiscal Policies in Open Economy

4. 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.

5. 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.

6. The Flow of Goods
Exports are domestically produced goods and services that are sold abroad. They mainly depend on exchange rates.
EX = f (e)
Imports are foreign produced goods and services that are sold domestically. They mainly depend on output.
IM = f (Y)

7. The Flow of Goods
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.

8. The Flow of Goods
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.

9. The Internationalization of the Chinese Economy
Percent
of GDP 50 40 30 20 10
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000

10. The Flow of Capital
Net foreign investment refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
A Chinese resident buys stock in the Toyota corporation and an American buys stock in the Sohu corporation.

11. The Flow of Capital
When a Chinese resident buys stock in IBM, the purchase raises Chinese net foreign investment.
When a Japanese resident buys a bond issued by the Chinese government, the purchase reduces the Chinese net foreign investment.

12. The Equality of NX and NFI
Net exports (NX) and net foreign investment (NFI) are closely linked.
For an economy as a whole, NX and NFI must balance each other so that:
NFI = NX
This holds true because every transaction that affects one side must also affect the other side by the same amount.

13. Saving, Investment, and 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

14. Saving, Investment, and the International Flows
National saving (S) equals Y-C-G so:
S = I + NX or
Domestic Investment
Foreign Investment
Saving = +

15. 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.

16. 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 Chinese yuan.
And in units of Chinese yuan per one unit of the foreign currency.

17. Nominal Exchange Rates
Assume the exchange rate between the U.S. dollar and the Chinese yuan is one dollar to 8 yuan.
One U.S. dollar trades for 8 yuan.
One yuan trades for 1/8 (=0.125) of a dollar.

18. Nominal Exchange Rates
If one yuan buys more foreign currency, there is an appreciation of the yuan.
If it buys less there is a depreciation of the yuan.

19. 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.
The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies.

20. Real Exchange Rates
Real Exchange Rate
The real exchange rate is a key determinant of how much a country exports and imports.

21. Real Exchange Rates
A depreciation (fall) in the Chinese real exchange rate means that Chinese goods have become cheaper relative to foreign goods.
This encourages consumers both at home and abroad to buy more Chinese goods and fewer goods from other countries.

22. Real Exchange Rates
As a result, Chinese exports rise, and Chinese imports fall, and both of these changes raise Chinese net exports.
Conversely, an appreciation in the Chinese real exchange rate means that Chinese goods have become more expensive compared to foreign goods, so Chinese net exports fall.

23. Purchasing-Power Parity
The purchasing-power parity theory (PPP theory) is the simplest and most widely accepted theory explaining the variation of currency exchange rates.
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.

24. 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.

25. 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.

26. 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.

27. Implications of Purchasing-Power Parity
If the purchasing power of 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.

28. 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.

29. 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.

30. Fixed vs. Floating Exchange Rates
A country has a fixed exchange rate if it pegs its currency at a given exchange rate and stands ready to defend that rate.
Exchange rates which are determined by market supply and demand are called flexible exchange rates or floating exchange rates.

31. The Market for Loanable Funds
The market for loanable funds (capital market) is one in which those who want to save supply funds and those who want to borrow to invest demand funds.
It is the market in which financial resources (money, bonds, stocks) are traded.

32. The Market for Loanable Funds
S = I + NFI
At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net foreign investment.

33. The Market for Loanable Funds
The supply of loanable funds comes from national saving (S).
The demand for loanable funds comes from domestic investment (I) and net foreign investment (NFI).

34. The Market for Loanable Funds
The supply and demand for loanable funds depend on the real interest rate.
A higher real interest rate encourages people to save and raises the quantity of loanable funds supplied.
The interest rate adjusts to bring the supply and demand for loanable funds into balance.

35. The Market for Loanable Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Demand for loanable funds (for domestic investment and net foreign investment)
Equilibrium
quantity
real interest
rate
Quantity of
Loanable Funds

36. The Market for Loanable Funds
At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment.

37. The Market for Foreign-Currency Exchange
The two sides of the foreign-currency exchange market are represented by NFI and NX.
NFI represents the imbalance between the purchases and sales of capital assets.
NX represents the imbalance between exports and imports of goods and services.

38. The Market for Foreign-Currency Exchange
In the market for foreign-currency exchange, the Chinese yuan is traded for foreign currencies.
For an economy as a whole, NFI and NX must balance each other out, or:
NFI = NX

39. The Market for Foreign-Currency Exchange
The price that balances the supply and demand for foreign-currency is the real exchange rate.

40. The Market for Foreign-Currency Exchange
The demand curve for foreign currency is downward sloping because a higher exchange rate makes domestic goods more expensive.
The supply curve is vertical because the quantity of dollars supplied for net foreign investment is unrelated to the real exchange rate.

41. The Market for Foreign-Currency Exchange
Real
Exchange
Rate
Supply of RMB
(from net foreign investment)
Demand for RMB
(for net exports)
Equilibrium
quantity
Equilibrium real exchange rate
Quantity of RMB Exchanged
into Foreign Currency

42. The Market for Foreign-Currency Exchange
The real exchange rate adjusts to balance the supply and demand for RMB.
At the equilibrium real exchange rate, the demand for RMB to buy net exports exactly balances the supply of RMB to be exchanged into foreign currency to buy assets abroad.

43. Marginal Propensity to Import
The marginal propensity to import (MPm) refers to the increase in the dollar value of imports resulting from each dollar increase in the value of GDP.

44. Output Determination in Open Economy
Expenditure
45°
Output=Expenditure
C = a + bY
Slope(E1 )=b
E1 =C(Y) +I (r )+G
E2 =C(Y) +I(r )+G-IM(Y）
IM = mY Y1
E2 = a +I+G+(b-m)Y Y2
Slope(E2 )=b-m
Output

45. Output Determination in Open Economy
Expenditure
45°
Output=Expenditure
E2 =C(Y) +I(r )+G EX(e) -IM(Y）
E1 =C(Y) +I(r )+G-IM(Y）
1. An increase in export… Y2
2. …leads to an increase in output
Slope=b-m Y1
Output

46. Equilibrium Output in Open Economy
Planned aggregate expenditure in an open economy equals:
In equilibrium:

47. The Open Economy Multiplier
b = MPC
m = MPm
1 – b + m = 1 – MPC + MPm = MPS +MPm
The multiplier is:

48. The Open Economy Multiplier
The multiplier in the closed economy is:
The multiplier in the open economy is:

49. The Balance of Payments
The balance of payment is a statement showing all of a nation’s transactions with the rest of the world for a given period. It includes purchases and sales of goods and services, gifts, government transactions, and capital movements.

50. The Balance of Payments
Suppose the initial international transaction was that a Chinese company exported a plane to the U.S. for $100 million. The Chinese central bank bought $10 million for CNY 80 million.
What was Chinese balance of payments like for that year?

51. The Balance of Payments
Debit
Credit
Current Account
Export
100,000,000
Import
Balance on current account
Capital Account
Private
90,000,000
Official Reserves
10,000,000
Balance on capital account

52. The Balance of Payments
Net Debits (-) or Credits (+)
Current Account
Export
100,000,000
Import
Balance on current account
Capital Account
Private
－90,000,000
Official Reserves
－10,000,000
Balance on capital account
－ 100,000,000
Statistical Discrepancy
Balance of Payments

53. The Balance of Payments
United States Balance of Payments, 1999 (in billion dollars)
CURRENT ACCOUNT
(1) Net export of goods
– 347.2
(2) Net export of services
79.6
(3) Net investment income
– 24.7
(4) Net transfer payments
– 46.6
(5) Balance on current account ( )
– 338.9
CAPITAL ACCOUNT
(6) Change in private U.S. assets abroad (increase is –)
– 381.0
(7) Change in foreign private assets in the United States
706.2
(8) Change in U.S. government assets abroad (increase is –)
8.3
(9) Change in foreign government assets in the U.S.
44.5
(10) Balance on capital account ( )
378.0
STATISTICAL DISCREPENCY
– 39.1
BALANCE OF PAYMENTS ( )

54. The Balance of Payments
A country’s current account is the sum of its:
net exports (exports minus imports),
net income received from investments abroad, and
net transfer payments from abroad.
Exports earn foreign exchange and are a credit (+) item on the current account. Imports use up foreign exchange and are a debit (–) item.

55. The Balance of Payments
The balance of trade is the difference between a country’s exports of goods and services and its imports of goods and services.
A trade deficit occurs when a country’s exports are less than its imports.

56. The Balance of Payments
Investment income consists of holdings of foreign assets that yield dividends, interest, rent, and profits paid to U.S. asset holders (a source of foreign exchange).
Net transfer payments are the difference between payments from the United States to foreigners and payments from foreigners to the United States.

57. The Balance of Payments
The balance on current account consists of net exports of goods, plus net exports of services, plus net investment income, plus net transfer payments. It shows how much a nation has spent relative to how much it has earned.
For each transaction recorded in the current account, there is an offsetting transaction recorded in the capital account.

58. The Balance of Payments
The capital account records the changes in assets and liabilities.
The balance on capital account in the United States is the sum of the following (measured in a given period):
the change in private U.S. assets abroad
the change in foreign private assets in U.S.
the change in U.S. government assets abroad
the change in foreign government assets in U.S.

59. The Balance of Payments
In the absence of errors, the balance on capital account would equal the negative of the balance on current account.
If the capital account is positive, the change in foreign assets in the country is greater than the change in the country’s assets abroad, which is a decrease in the net wealth of the country.

60. The BP Curve
The BP curve is a graph of all combinations of interest (r) and output (Y) that result in foreign exchange market equilibrium.

61. Net Foreign Investment
Deriving the BP Curve
Net Foreign Investment
The BP Curve r r
BP Curve
NFI2 Y2 r2 E2 E2 r1 r1 E1 E1
NFI Y
NFI1 Y1

62. Deriving the BP Equation
n =marginal propensity to import
e =real exchange rate
g＞ 0, n ＞ 0, m ＞ 0
r* =foreign interest rate
r =domestic interest
a ＞ 0

63. Deriving the BP Equation

64. Interest rate increases
Deriving the BP Curve
An increase in income (GDP) increases the import, decreases the net export, in turn decreases NFI.
NFI decrease is responsive to a higher interest.
GDP increases
Import increases
NX decreases
NFI decreases
Interest rate increases

65. The BP Curve r
BP Surplus BP＞0 BP A B C
BP Deficit BP＜0 D F G IS Y

66. The BP Curve
If there exists an BP surplus, the supply of foreign currencies is greater than the demand for them. Foreign currencies are likely to depreciate, while the domestic currency tends to appreciate.
If there exists an BP deficit, the demand for foreign currencies is greater than the supply. Foreign currencies are likely to appreciate, while the domestic currency tends to depreciate.

67. Exchange Rate and BP Curve Changes
BP(e1)
Lower exchange rate moves the BP curve rightward
BP(e2) Y

68. Equilibrium interest rate
The IS-LM-BP Model r LM BP
Equilibrium interest rate E
Equilibrium output IS Y

69. The IS-LM-BP Model r LM
IS2
BP1
BP2 E2 Y2 r2 r1 E1
IS1 Y Y1

70. The IS-LM-BP Model
At E1, both the goods market and money market are in equilibrium, but the foreign exchange market is not, for BP is of deficit. The demand for foreign exchange is greater than the supply. The domestic currency will depreciate. The BP curve tends to move downward
The depreciation of domestic currency will lead to more NX, thus driving the IS curve rightward. Finally the three markets reach an equilibrium at E2.

71. Fiscal Policy and IS-LM-BP in Floating Exchange Rate Context

72. Fiscal Policy and IS-LM-BP in Floating Exchange Rate Context
An expansionary fiscal policy moves the IS curve rightward, and the goods market and money market is in equilibrium at E2.
At E2, there exists BP surplus in the foreign exchange market, the domestic currency tends to appreciate.
The appreciation will decrease the NX, and thus pushing IS curve leftward until E3.

73. Fiscal Policy and IS-LM-BP in Floating Exchange Rate Context
In the open economy, the expansionary fiscal policy has crowding-out effect not only on the domestic investment, but on net export.
Therefore, the multiplier effect of expansionary fiscal policy is not significant. In Japan, for example, the multiplier is estimated to be only 1.2.

74. Monetary Policy and IS-LM-BP in Floating Exchange Rate Context

75. Monetary Policy and IS-LM-BP in Floating Exchange Rate Context
If the central bank effects an expansionary monetary policy, the LM curve moves to the right.
The goods market and money market are of equilibrium at E2, but the foreign exchange market faces a BP deficit—demand for foreign currency is greater than supply.
The domestic currency tends to depreciate, which moves the BP curve downward.

76. Monetary Policy and IS-LM-BP in Floating Exchange Rate Context
The depreciation of domestic currency encourages export, thus moving the IS curve rightward.
The open economy equilibrate at E3.
In the open economy, the monetary policy is very effective.

77. Fiscal Policy and IS-LM-BP in Fixed Exchange Rate Context

78. Fiscal Policy and IS-LM-BP in Fixed Exchange Rate Context
Suppose the government adopts an expansionary policy, the IS curve moves rightward.
At E2, the goods and money markets reach an equilibrium, but the foreign exchange market does not. There exists the BP surplus. As a result, the domestic currency depreciate.

79. Fiscal Policy and IS-LM-BP in Fixed Exchange Rate Context
Since the rates between currencies should remain fixed, the central bank is obliged to buy foreign currencies.
The purchase of foreign currencies increases the supply of domestic currency, shifting the LM curve right.
Fiscal policies in the fixed exchanged foreign rate context are effective.

80. Monetary Policy and IS-LM-BP in Fixed Exchange Rate Context

81. Monetary Policy and IS-LM-BP in Fixed Exchange Rate Context
If the central bank increases its money supply, the LM curve shifts right.
At E2, the goods and money market are of equilibrium, while the foreign exchange market isn’t, for there exists an BP deficit.
The strong demand for foreign currencies will lead to the depreciation of domestic currencies.

82. Monetary Policy and IS-LM-BP in Fixed Exchange Rate Context
To keep the fixed exchange rates constant, the central bank has to sell foreign currencies it holds as reserves.
The selling of foreign currencies means the reduction of money supply, this will bring back the LM curve.
So monetary policies in the open economy is of little or even no effect.

83. Assignment Review Chapter 31 and 34
What are the benefits and harms of keeping the Chinese currency from depreciation during the Asian financial crises? (Group work)

84. Revision for the Final Exam
Review the whole book.
Answer multiple-choice questions in your handouts.
Pay special attention to the following questions:
58—4 58—6
78—1 79—7
130— —2
153— —2
169— —1
187— —9
224— —1

85. Revision for the Final Exam
How is China’s GDP in recent years and its prospect in the future?
Discuss China’s fiscal and monetary policies.
How are China’s price level and employment in recent years? What measures has the government taken to improve them?

86. Thanks