Open-Economy Macroeconomics: Basic Concepts Chapter 31 Copyright © 2001 by Harcourt, Inc All rights reserved Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Open and Closed Economies An open economy is one that interacts freely with other economies around the world Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Flow of Goods: Exports, Imports, Net Exports Exports are domestically produced goods and services that are sold abroad Imports are foreign produced goods and services that are sold domestically Net Exports are exports minus imports Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Flow of Goods: Exports, Imports, Net Exports 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Internationalization of the U.S Economy Percent of GDP 15 Imports 10 Exports 1950 1955 1960 1965 1970 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 1975 1980 1985 1990 1995 1995 The Flow of Capital: Net Foreign Investment Net foreign investment refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners A U.S resident buys stock in the Toyota corporation and a Mexican buys stock in the Ford Motor corporation Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Flow of Capital: Net Foreign Investment When a U.S resident buys stock in Telmex, the Mexican phone company, the purchase raises U.S net foreign investment When a Japanese residents buys a bond issued by the U.S government, the purchase reduces the U.S net foreign investment Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Variables that Influence Net Foreign Investment 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc The Equality of Net Exports and Net Foreign Investment 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Nominal Exchange Rates 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Nominal Exchange Rates Assume the exchange rate between the Japanese yen and U.S dollar is 80 yen to one dollar One U.S dollar trades for eighty yen One yen trades for 1/80 (=0.0125) of a dollar Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Nominal Exchange Rates If a dollar buys more foreign currency, there is an appreciation of the dollar If it buys less there is a depreciation of the dollar Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc How Do Changes in Exchange Rates Affect People? Businesses Appreciation of the US dollar will hurt US exports and thus US business Depreciation of the US dollar will help US exports and thus US businesses Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Tourists Appreciation of the US dollar will help US tourists by increasing their purchasing power Depreciation of the US dollar will hurt US tourists by decreasing their purchasing power Purchasing-Power Parity The purchasing-power parity theory is the simplest and most widely accepted theory explaining the variation of currency exchange rates Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Money, Prices, and the Nominal Exchange Rate During the German Hyperinflation Indexes (Jan 1921 = 100) 1,000,000,000,000,000 Money supply 10,000,000,000 Price level 100,000 00001 0000000001 Exchange rate 1921 1922 1923 1924 1925 Brief Video on German Hyperinflation This video shows how the DM price of bread increased almost daily during the German hyperinflation of the 1920’s QuickTime™ and a Sorenson Video decompressor are needed to see this picture Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc [...]... items and derived items copyright © 2001 by Harcourt, Inc 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 Harcourt, Inc items and derived items copyright © 2001 by Harcourt, Inc Basic Logic of Purchasing-Power Parity If the law of one