Open-Economy Macroeconomics

Basic Concepts (Chapter 18)

Purpose of Ch 18

• Develop the basic concepts macroeconomists use to study open economies (i.e., economies with an international sector)– Equivalency of net exports and net capital

outflow– Concepts of real and nominal exchange rates– Purchasing power parity

Closed vs. Open Economy

• Closed economy – an economy that does not interact with other economies in the world– Also called an autarkic economy

• Open economy – an economy that interacts freely with other economies around the world

Flow of Goods

• Exports – goods and services that are produced domestically and sold abroad

• Imports – goods and services that are produced abroad and sold domestically

• Net exports = the value of a nation’s exports minus the value of its imports– Also called trade balance.– Equation: NX = Exports – Imports

Trade Balance

• Trade balance – the value of a nation’s exports minus the value of its imports– Also called net exports– Trade surplus = an excess of exports over

imports (i.e., NX > 0)– Trade deficit = an excess of imports over

exports (i.e., NX < 0)– Balanced trade = exports equal imports (i.e.,

NX = 0)

Are Trade Deficits Bad?

• There are no “good” or “bad” international trade balances, just as there are no good or bad trade balances between states or between a household and a local merchant.

• Trade simply allows individuals to consume more than they would be able to in the absence of trade (i.e., outside their production possibilities frontier)

Factors Affecting Trade Balance

• 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 cost of transporting goods from country to

country• The policies of the government toward

international trade

The Flow of Financial Resources

• Net capital outflow = the purchases of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.

• Net capital outflow abbreviated as NCO

Capital Flows

• The flow of capital abroad takes two forms.– Foreign direct investment (FDI) occurs when a

capital investment is owned and operated by a foreign entity.

– Foreign portfolio investment involves an investment that is financed with foreign money but operated by domestic residents.

Factors Influencing NCO

• 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.

NCO/NX Practice Question

• Would each of the following transactions be included in net exports or net capital outflow? Be sure to say whether it would represent an increase or a decrease in that variable.1. An American buys a Sony TV.

2. An American buys a share of Sony stock.

3. The Sony pension fund buys a bond from the U.S. Treasury.

4. A worker at a Sony plant in Japan buys some Georgia peaches from an American farmer.

NCO Practice Question

• How would the following transactions affect U.S. net capital outflow? Also, state whether each involves direct investment or portfolio investment.1. An American cellular phone company establishes an

office in the Czech Republic.

2. Harrods of London sells stock to the General Electric pension fund.

3. Honda expands its factory in Marysville, Ohio.

4. A Fidelity mutual fund sells its Volkswagen stock to a French investor.

Equality of NCO and NX

• Net capital outflow (NCO) always equals net exports (NX). This is an identity – every transaction that affects one side of the equation affects the other by exactly the same amount.

• NX is also called the current account; NCO is also called the capital account. Another way of stating the above identity is that the current and capital accounts are always equal.

NCO = NX Example• To see why this is an identity, consider the following:

suppose Microsoft sells a copy of Windows 7 to a company in France, receiving 150 Euros in exchange. This is a U.S. export, so U.S. net exports increase.

• Microsoft can do four things with its Euros.– It can keep them. This constitutes an investment in Europe,

since Euros (currency) are an asset.– It can invest in Europe… but this is also purchase of European

assets.– It can buy 150 Euros worth of goods from Europe. In this case

U.S. net exports are now unchanged from their starting value.– Or it can trade the Euros to someone in the U.S. (e.g., a bank)

for dollars. In this case, whoever sold dollars for Euros can now keep them, invest them in Europe, or buy European goods. U.S. NCO is still equal to 150 Euros.

NX and NCO (cont.)

• When a nation is running a trade surplus (NX>0), it is selling more goods and services to foreigners than it is buying from them. In this case NCO>0 as well – capital is flowing out of the nation. This capital can then be used for investment in the foreign country.

• Similarly, if a nation is running a trade deficit (NX<0), NCO<0 and foreigners are providing capital to the deficit nation. This capital can then be used for investment in the deficit nation.

Exchange Rates

• The exchange rate between two countries is the price at which residents of those countries trade with each other.

• Economists distinguish between two exchange rates: the nominal exchange rate and the real exchange rate.

Nominal Exchange Rate

• The nominal exchange rate is the relative price of the currency of two countries. For example, if the exchange rate between the U.S. dollar and the Japanese yen is 120 yen per dollar, then you can exchange one dollar for 120 yen in world markets for foreign currency.

Appreciation and Depreciation

• Appreciation = an increase in the value of a currency as measured by the amount of foreign currency it can buy

• Depreciation = a decrease in the value of a currency as measured by the amount of foreign currency it can buy

• When a currency appreciates, it is said to strengthen; when a currency depreciates, it is said to weaken.

Examples

• In late New York trading late Friday, the euro was at $1.4875 from $1.4872 Thursday. The dollar was at 90.75 yen from 90.67 yen and at 1.1062 Swiss francs from 1.1054 francs. The euro was up versus the yen to 135.00 yen, from 134.92 yen in late New York trading Wednesday, while sterling was largely unchanged at $1.6582, from $1.6581.

Real Exchange Rate

• The real exchange rate is the relative price of the goods of two countries. That is, the real exchange rate tells us the rate at which we can trade the goods of one country for the goods of another.

• The real exchange rate is sometimes called the terms of trade.

Real Exchange Rate Example

• Consider a single good produced in many countries: cars. Suppose an American car costs $10,000 and a similar Japanese car costs 2,400,000 yen.

• To compare the prices of the two cars, we must convert them into a common currency.

Example (cont.)

• If a dollar is worth 120 yen, then the American car costs 1,200,000 yen. Comparing the price of the American car (1,200,000 yen) and the price of the Japanese car (2,400,000 yen), we conclude that the American car costs one-half of what the Japanese car does.

• In other words, at current prices, we can exchange two American cars for one Japanese car.

Example (cont.)• We can summarize our calculation

as follows:

• More generally, we can write this calculation as:

carAmerican

car Japanese0.5

car seyen/Japane 000,400,2

carerican dollars/Am 000,10yen/dollar 120 Rate Exchange Real

GoodForeign of Price

Good Domestic of PriceRate Exchange Nominal Rate Exchange Real

Real Exchange Rate

• We can define the real exchange rate for a basket of goods as follows.

Real Exchange Rate = Nominal Exchange Rate × Ratio of Price Levels

= e × (P/P*)

Where P* is the foreign price level and P is the domestic price level.

Real Exchange Rates

• If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive.

• If the real exchange rate is low, foreign goods are relatively expensive, and domestic goods are relatively cheap.

Purchasing Power Parity

• Purchasing power parity means that the nominal exchange rate between the currencies of two countries will depend on the price level in those countries.

• If a dollar buys the same amount of goods and services in the U.S. as it does in a foreign country, then the nominal exchange rate must reflect the prices of goods and services in the two countries.

PPP and Arbitrage

• If a good sold for less in one location than another, a person could make a profit by buying the good in the location where it is cheaper and selling it in the location where it is more expensive.

• Prices in the cheaper location will rise (because demand is now higher) and prices in the expensive location will fall (because the supply is greater).

• This will continue until the two prices are equal.• The same logic should apply to currencies – a unit of all

currencies must have the same real value in every country.

The PPP Equation

• We can rearrange the equation for real exchange rates, imposing the “law of one price” to get:

e = P* / P

• The nominal exchange rate is determined by the ratio of the foreign price level to the domestic price level.

Exchange Rate and Prices

• Because the nominal exchange rate depends on the price levels, it must also depend on the money supply and money demand in each country.– If the central bank increases the money supply in a

country and raises the price level, it also causes the country’s currency to depreciate relative to other currencies in the world.

– When a central bank prints a large amount of money, that 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.

Change in Nominal Exchange Rates Over Time

• By manipulating the real exchange rate equation, one can show the following:

%e = % + π* - π• If a country has a high rate of inflation relative to

the U.S., a dollar will buy an increasing amount of the foreign currency over time (i.e., will appreciate).

• If a country has a low rate of inflation relative to the U.S., a dollar will buy a decreasing amount of the foreign currency over time (i.e., will depreciate).

Limitations of PPP

• Exchange rates don’t always move to ensure that a dollar has the same real value in all countries all of the time.– Many goods are not easily traded. Thus, arbitrage

would be too limited to eliminate the price differential.– Tradable goods are not always perfect substitutes

when they are produced in different countries. There is no opportunity for arbitrage here, because the price difference reflects the different values the consumer places on the two products.