Open-Economy Macroeconomics: Basic Concepts • Open and Closed Economies Open-Economy Macroeconomics: Basic Concepts 31 • 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 Copyright © 2004 South-Western Copyright â 2004 South-Western Open-Economy Macroeconomics: Basic Concepts An Open Economy THE INTERNATIONAL FLOW OF GOODS AND CAPITAL • 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 Copyright © 2004 South-Western • 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 Copyright © 2004 South-Western The Flow of Goods: Exports, Imports, Net Exports 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 Copyright © 2004 South-Western Copyright © 2004 South-Western The Flow of Goods: Exports, Imports, Net Exports The Flow of Goods: Exports, Imports, Net Exports • A trade deficit is a situation in which net exports (NX) are negative • Factors That Affect Net Exports • Imports > Exports • A trade surplus is a situation in which net exports (NX) are positive • Exports > Imports • 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 • Balanced trade refers to when net exports are zero—exports and imports are exactly equal Copyright © 2004 South-Western The Flow of Goods: Exports, Imports, Net Exports Copyright © 2004 South-Western Figure The Internationalization of the U.S Economy Percent of GDP • Factors That Affect Net Exports • 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 15 Imports 10 Exports Copyright © 2004 South-Western 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western The Flow of Financial Resources: Net Capital Outflow 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 • A U.S resident buys stock in the Toyota corporation and a Mexican buys stock in the Ford Motor corporation Copyright © 2004 South-Western Copyright © 2004 South-Western The Flow of Financial Resources: Net Capital Outflow The Equality of Net Exports and Net Capital Outflow • Variables that Influence Net Capital Outflow • Net exports (NX) and net capital outflow (NCO) are closely linked • For an economy as a whole, NX and NCO must balance each other so that: NCO = NX • 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 This holds true because every transaction that affects one side must also affect the other side by the same amount Copyright © 2004 South-Western Copyright © 2004 South-Western Saving, Investment, and Their Relationship to the International Flows Saving, Investment, and Their Relationship to 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 • National saving (S) equals Y - C - G so: S = I + NX or Saving = S = Domestic + Net Capital Investment Outflow I NCO + Copyright © 2004 South-Western Figure National Saving, Domestic Investment, and Net Foreign Investment Copyright © 2004 South-Western Figure National Saving, Domestic Investment, and Net Foreign Investment (b) Net Capital Outflow (as a percentage of GDP) (a) National Saving and Domestic Investment (as a percentage of GDP) Percent of GDP Percent of GDP 20 Domestic investment 18 Net capital outflow 16 14 –1 10 1960 –2 National saving 12 –3 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western –4 1960 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western Balance of Payments Balance of Payments • The balance of payments is a record of a country' s trade in goods, services, and financial assets with the rest of the world • The balance of payments consists of two parts: (1) The current account records the flow of dollars reflecting the flow of goods (2) The capital account reflects the flow of dollars corresponding to the flow of assets Table below describes the general structure of the balance of payments Balance of Payments (1) Current Account Exports (Goods and Serrvices) Imports (Goods and Serrvices) Investment Income Received Investment Income Paid Net Unilateral Transfers Credit Debit + + - Copyright © 2004 South-Western Balance of Payments Copyright © 2004 South-Western Balance of Payments Services include transportation, tourism, insurance, education, and financial services Investment income includes interest payments and dividends people receive from assets owned outside of their own country Balance of Payments (cont.) (2) Capital Account Credit Debit Increase in US Holdings of Foreign Assets Increase in Foreign Holdings of US Assets (3) Official settlements balance + - [(1) + (2)] A unilateral transfer occurs when one party gives something but receives nothing in return, e.g foreign aid, remittance… Copyright © 2004 South-Western Balance of Payments Copyright © 2004 South-Western Balance of Payments • Capital Account • A capital inflow occurs when the home country sells an asset to another country, e.g Rockefeller Center is sold to a Japanese company A capital outflow occurs when the home country buys an asset from abroad, e.g an American obtains a Swiss bank account • The capital account balance = capital inflows - capital outflows • A country has a capital account surplus when its residents sell more assets to foreigners than they buy from foreigners Copyright â 2004 South-Western Current Account balance + Capital Account balance + official settlements balance = • When a country runs a current account deficit, it means that it received fewer funds from its exports than the funds paid for imports To finance this deficit, it must sell its assets to the foreigners So, a current account deficit must be accompanied by a capital account surplus or a fall in reserve assets • The official settlements balance records transactions conducted by central banks It measures the net increase in a country' s official reserve assets, assets that can be used in making international payments The official settlements balance is called the balance of payments Copyright © 2004 South-Western 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 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 Copyright © 2004 South-Western Copyright © 2004 South-Western Nominal Exchange Rates Nominal Exchange Rates • The nominal exchange rate is expressed in two ways: • Assume the exchange rate between the Japanese yen and U.S dollar is 80 yen to one dollar • In units of foreign currency per one U.S dollar • And in units of U.S dollars per one unit of the foreign currency • One U.S dollar trades for 80 yen • One yen trades for 1/80 (= 0.0125) of a dollar Copyright © 2004 South-Western Copyright © 2004 South-Western Nominal Exchange Rates Nominal Exchange Rates • Appreciation refers to an increase in the value of a currency as measured by the amount of foreign currency it can buy • Depreciation refers to a decrease 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 • If it buys less there is a depreciation of the dollar Copyright © 2004 South-Western Copyright © 2004 South-Western Real Exchange Rates 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 compares the prices of domestic goods and foreign goods in the domestic economy • If a case of German beer is twice as expensive as American beer, the real exchange rate is 1/2 case of German beer per case of American beer Copyright © 2004 South-Western Copyright © 2004 South-Western Real Exchange Rates 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 • The real exchange rate is a key determinant of how much a country exports and imports Real exchange rate = Nominal exchange rate × Domestic price Foreign price Copyright © 2004 South-Western Copyright © 2004 South-Western Real Exchange Rates Real Exchange Rates • A depreciation (fall) in the U.S real exchange rate means that U.S goods have become cheaper relative to foreign goods • This 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 • Conversely, 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 Copyright © 2004 South-Western Copyright © 2004 South-Western 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 currency exchange rates Copyright © 2004 South-Western The Basic Logic of Purchasing-Power Parity • Purchasing-power parity is a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries Copyright © 2004 South-Western The Basic Logic of Purchasing-Power Parity Basic Logic of Purchasing-Power Parity • 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 • The theory of purchasing-power parity is based on a principle called the law of one price Copyright © 2004 South-Western • According to the law of one price, a good must sell for the same price in all locations Copyright © 2004 South-Western Basic Logic of Purchasing-Power Parity 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 • 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 Copyright © 2004 South-Western Copyright © 2004 South-Western Implications of Purchasing-Power Parity Implications of Purchasing-Power Parity • If the purchasing power of the dollar 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 • 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 Copyright © 2004 South-Western Figure 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 Copyright © 2004 South-Western 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 Exchange rate 00001 0000000001 1921 1922 1923 1924 1925 Copyright © 2004 South-Western Foreign Exchange Market Exchange Rate regime • The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market It is closely related to monetary policy • The basic types are: (1) a floating exchange rate, where the market dictates the movements of the exchange rate; (2) the fixed (pegged) exchange rate, which ties the currency to another currency, mostly more widespread currencies such as the US dollar or the euro, and Nominal exchange rate S E0 D Q0 Copyright © 2004 South-Western Governments have to sacrifice the use of an independent domestic monetary policy to achieve internal stability Q Copyright © 2004 South-Western (3) a pegged float, where the central bank keeps the rate from deviating too far from a target band or value Copyright © 2004 South-Western Summary 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 • 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 Copyright © 2004 South-Western Copyright â 2004 South-Western Summary 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 • 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 Copyright © 2004 South-Western Copyright â 2004 South-Western 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 Copyright © 2004 South-Western ... residents minus the acquisition of domestic assets by foreigners • An economy s net capital outflow always equals its net exports • An economy s saving can be used to either finance investment at home... Net Capital Outflow • Net exports (NX) and net capital outflow (NCO) are closely linked • For an economy as a whole, NX and NCO must balance each other so that: NCO = NX • The real interest rates... The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy • If a case of German beer is twice as expensive as American beer, the real exchange rate