CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 663 Mexican government has imposed, or might impose in the future, on foreign investors in Mexico. THE EQUALITY OF NET EXPORTS AND NET FOREIGN INVESTMENT We have seen that an open economy interacts with the rest of the world in two ways—in world markets for goods and services and in world financial markets. Net exports and net foreign investment each measure a type of imbalance in these markets. Net exports measure an imbalance between a country’s exports and its imports. Net foreign investment measures an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners. An important but subtle fact of accounting states that, for an economy as a whole, these two imbalances must offset each other. That is, net foreign investment (NFI) always equals net exports (NX): NFI ϭ NX. This equation holds because every transaction that affects one side of this equation must also affect the other side by exactly the same amount. This equation is an identity—an equation that must hold because of the way the variables in the equa- tion are defined and measured. To see why this accounting identity is true, consider an example. Suppose that Boeing, the U.S. aircraft maker, sells some planes to a Japanese airline. In this sale, a U.S. company gives planes to a Japanese company, and a Japanese company gives yen to a U.S. company. Notice that two things have occurred simultaneously. The United States has sold to a foreigner some of its output (the planes), and this sale increases U.S. net exports. In addition, the United States has acquired some foreign assets (the yen), and this acquisition increases U.S. net foreign investment. Although Boeing most likely will not hold on to the yen it has acquired in this sale, any subsequent transaction will preserve the equality of net exports and net foreign investment. For example, Boeing may exchange its yen for dollars with a U.S. mutual fund that wants the yen to buy stock in Sony Corporation, the Japan- ese maker of consumer electronics. In this case, Boeing’s net export of planes equals the mutual fund’s net foreign investment in Sony stock. Hence, NX and NFI rise by an equal amount. Alternatively, Boeing may exchange its yen for dollars with another U.S. com- pany that wants to buy computers from Toshiba, the Japanese computer maker. In this case, U.S. imports (of computers) exactly offset U.S. exports (of planes). The sales by Boeing and Toshiba together affect neither U.S. net exports nor U.S. net foreign investment. That is, NX and NFI are the same as they were before these transactions took place. The equality of net exports and net foreign investment follows from the fact that every international transaction is an exchange. When a seller country transfers a good or service to a buyer country, the buyer country gives up some asset to pay for this good or service. The value of that asset equals the value of the good or ser- vice sold. When we add everything up, the net value of goods and services sold by a country (NX) must equal the net value of assets acquired (NFI). The international 664 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES flow of goods and services and the international flow of capital are two sides of the same coin. SAVING, INVESTMENT, AND THEIR RELATIONSHIP TO THE INTERNATIONAL FLOWS A nation’s saving and investment are, as we have seen in Chapters 24 and 25, cru- cial to its long-run economic growth. Let’s therefore consider how these variables are related to the international flows of goods and capital, as measured by net exports and net foreign investment. We can do this most easily with the help of some simple mathematics. As you may recall, the term net exports first appeared earlier in the book when we discussed the components of gross domestic product. The economy’s gross domestic product (Y) is divided among four components: consumption (C), investment (I), government purchases (G), and net exports (NX). We write this as Y ϭ C ϩ I ϩ G ϩ NX. W ILL THE WORLD ’ SDEVELOPING COUN - tries, such as those in Latin America, flood the world’s industrial countries with cheap exports while refusing to import goods from the industrial coun- tries? Will the developing countries use the world’s saving to finance invest- ment and growth, leaving the indus- trial countries with insufficient funds for their own capital accumulation? Some people fear that both of these out- comes might occur. But an accounting identity, and economist Paul Krugman, tell us not to worry. Fantasy Economics B Y P AUL K RUGMAN Reports by international organizations are usually greeted with well deserved yawns. Occasionally, however, such a report is a leading indicator of a sea change in opinion. A few weeks ago, the World Eco- nomic Forum—which every year draws an unmatched assemblage of the world’s political and business elite to its confer- ence in Davos, Switzerland—released its annual report on international compet- itiveness. The report made headlines be- cause it demoted Japan and declared America the world’s most competitive economy. The revealing partof the report, however, is not its more or less mean- ingless competitiveness rankings but its introduction, which offers what seems to be a very clear vision of the global eco- nomic future. That vision, shared by many power- ful people, is compelling and alarming. It is also nonsense. And the fact that this nonsense is being taken seriously by many people who believe themselves to be sophisticated about economics is it- self an ominous portent for the world economy. The report finds that the spread of modern technology to newly in- dustrializing nations is deindustrializing high-wage nations: Capital is flowing to the Third World and low-cost produc- ers in these countries are flooding world markets with cheap manufactured goods. The report predicts that these trends will accelerate, that service jobs will soon begin to follow the lost jobs in manufacturing and that the future of the high-wage nations offers a bleak choice between declining wages and rising un- employment. This vision resonates with many people. Yet as a description of what has IN THE NEWS Flows between the Developing South and the Industrial North CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 665 Total expenditure on the economy’s output of goods and services is the sum of expenditure on consumption, investment, government purchases, and net exports. Because each dollar of expenditure is placed into one of these four components, this equation is an accounting identity: It must be true because of the way the vari- ables are defined and measured. Recall that national saving is the income of the nation that is left after paying for current consumption and government purchases. National saving (S) equals Y Ϫ C Ϫ G. If we rearrange the above equation to reflect this fact, we obtain Y Ϫ C Ϫ G ϭ I ϩ NX S ϭ I ϩ NX. Because net exports (NX) also equal net foreign investment (NFI), we can write this equation as S ϭ I ϩ NFI Saving ϭ Domestic ϩ Net foreign investment investment. actually happened in recent years, it is al- most completely untrue. Rapidly growing Third World econ- omies have indeed increased their ex- ports of manufactured goods. But today these exports absorb only about 1 per- cent of First World income. Moreover, Third World nations have also increased their imports. Overall, the effect of Third World growth on the number of industrial jobs in Western nations has been minimal: Growing exports to the newly industrial- izing countries have created about as many jobs as growing imports have displaced. What about capital flows? The num- bers sound impressive. Last year, $24 billion flowed to Mexico, $11 billion to China. The total movement of capital from advanced to developing nations was about $60 billion. But though this sounds like a lot, it is pocket change in a world economy that invests more than $4 trillion a year. In other words, if the vision of a Western economy battered by low-wage competition is meant to describe today’s world, it is a fantasy with hardly any ba- sis in reality. Even if the vision does not describe the present, might it describe the future? Well, growing exports of manufactured goods from South to North will lead to a net loss of northern industrial jobs only if they are not matched by growth in ex- ports from North to South. The authors of the report evidently envision a future of large-scale Third World trade surpluses. But it is an un- avoidable fact of accounting that a coun- try that runs a trade surplus must also be a net investor in other countries. So large-scale deindustrialization can take place only if low-wage nations are major exporters of capital to high-wage na- tions. This seems unlikely. In any case, it contradicts the rest of the story, which predicts huge capital flows into low-wage nations. Thus, the vision offered by the world competitiveness report conflicts not only with the facts but with itself. Yet it is a vision that a growing number of the world’s most influential men and women seem to share. That is a dangerous trend. Not everyone who worries about low-wage competition is a protectionist. Indeed, the authors of the world compet- itiveness report would surely claim to be champions of free trade. Nonetheless, the fact that such ideas have become re- spectable . . . suggests that the intellec- tual consensus that has kept world trade relatively free, and that has allowed hun- dreds of millions of people in the Third World to get their first taste of prosper- ity, may be unraveling. S OURCE : The New York Times, September 26, 1994, p. A17. 666 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES CASE STUDY ARE U.S. TRADE DEFICITS A NATIONAL PROBLEM? You may have heard the press call the United States “the world’s largest debtor.” The nation earned that description by borrowing heavily in world fi- nancial markets during the 1980s and 1990s to finance large trade deficits. Why did the United States do this, and should this event give Americans reason to worry? To answer these questions, let’s see what these macroeconomic accounting identities tell us about the U.S. economy. Panel (a) of Figure 29-2 shows national saving and domestic investment as a percentage of GDP since 1960. Panel (b) shows net foreign investment as a percentage of GDP. Notice that, as the identi- ties require, net foreign investment always equals national saving minus do- mestic investment. The figure shows a dramatic change beginning in the early 1980s. Before 1980, national saving and domestic investment were very close, and so net for- eign investment was small. Yet after 1980, national saving fell dramatically, in part because of increased government budget deficits and in part because of a fall in private saving. Because this fall in saving did not coincide with a similar fall in domestic investment, net foreign investment became a large negative number, indicating that foreigners were buying more assets in the United States than Americans were buying abroad. Put simply, the United States was going into debt. As we have seen, accounting identities require that net exports must equal net foreign investment. Thus, when net foreign investment became negative, net exports became negative as well. The United States ran a trade deficit: This equation shows that a nation’s saving must equal its domestic investment plus its net foreign investment. In other words, when U.S. citizens save a dollar of their income for the future, that dollar can be used to finance accumulation of do- mestic capital or it can be used to finance the purchase of capital abroad. This equation should look somewhat familiar. Earlier in the book, when we analyzed the role of the financial system, we considered this identity for the spe- cial case of a closed economy. In a closed economy, net foreign investment is zero (NFI ϭ 0), so saving equals investment (S ϭ I). By contrast, an open economy has two uses for its saving: domestic investment and net foreign investment. As before, we can view the financial system as standing between the two sides of this identity. For example, suppose the Smith family decides to save some of its income for retirement. This decision contributes to national saving, the left-hand side of our equation. If the Smiths deposit their saving in a mutual fund, the mu- tual fund may use some of the deposit to buy stock issued by General Motors, which uses the proceeds to build a factory in Ohio. In addition, the mutual fund may use some of the Smiths’ deposit to buy stock issued by Toyota, which uses the proceeds to build a factory in Osaka. These transactions show up on the right- hand side of the equation. From the standpoint of U.S. accounting, the General Motors expenditure on a new factory is domestic investment, and the purchase of Toyota stock by a U.S. resident is net foreign investment. Thus, all saving in the U.S. economy shows up as investment in the U.S. economy or as U.S. net foreign investment. CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 667 Imports of goods and services exceeded exports. In 1998, the trade deficit was $151 billion, or about 1.8 percent of GDP. Are these trade deficits a problem for the U.S. economy? Most economists believe that they are not a problem in themselves, but perhaps are a symptom of a problem—reduced national saving. Reduced national saving is potentially a problem because it means that the nation is putting away less to provide for its future. Once national saving has fallen, however, there is no reason to de- plore the resulting trade deficits. If national saving fell without inducing a trade deficit, investment in the United States would have to fall. This fall in invest- ment, in turn, would adversely affect the growth in the capital stock, labor Percent of GDP 20 18 16 14 12 10 1960 1965 199519901985198019751970 National saving Domestic investment Percent of GDP 4 Ϫ 4 Ϫ 3 Ϫ 2 Ϫ 1 0 1 2 3 Net foreign investment (a) National Saving and Domestic Investment (as a percentage of GDP) (b) Net Foreign Investment (as a percentage of GDP) 2000 1960 1965 199519901985198019751970 2000 Figure 29-2 N ATIONAL S AVIN G , D OMESTIC I NVESTMENT , AND N ET F OREIGN I NVESTMENT . Panel (a) shows national saving and domestic investment as a percentage of GDP. Panel (b) shows net foreign investment as a percentage of GDP. You can see from the figure that national saving has been lower since 1980 than it was before 1980. This fall in national saving has been reflected primarily in reduced net foreign investment rather than in reduced domestic investment. S OURCE : U.S. Department of Commerce. 668 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES productivity, and real wages. In other words, given the fact that U.S. citizens are not saving much, it is better to have foreigners invest in the U.S. economy than no one at all. QUICK QUIZ: Define net exports and net foreign investment. Explain how they are related. THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES So far we have discussed measures of the flow of goods and services and the flow of capital across a nation’s border. In addition to these quantity variables, macro- economists also study variables that measure the prices at which these interna- tional transactions take place. Just as the price in any market serves the important role of coordinating buyers and sellers in that market, international prices help co- ordinate the decisions of consumers and producers as they interact in world mar- kets. Here we discuss the two most important international prices—the nominal and real exchange rates. 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. For example, if you go to a bank, you might see a posted exchange rate of 80 yen per dollar. If you give the bank one U.S. dollar, it will give you 80 Japanese yen; and if you give the bank 80 Japanese yen, it will give you one U.S. dollar. (In actuality, the bank will post slightly different prices for buying and selling yen. The difference gives the bank some profit for of- fering this service. For our purposes here, we can ignore these differences.) An exchange rate can always be expressed in two ways. If the exchange rate is 80 yen per dollar, it is also 1/80 ( ϭ 0.0125) dollar per yen. Throughout this book, we always express the nominal exchange rate as units of foreign currency per U.S. dollar, such as 80 yen per dollar. If the exchange rate changes so that a dollar buys more foreign currency, that change is called an appreciation of the dollar. If the exchange rate changes so that a dollar buys less foreign currency, that change is called a depreciation of the dol- lar. For example, when the exchange rate rises from 80 to 90 yen per dollar, the dol- lar is said to appreciate. At the same time, because a Japanese yen now buys less of the U.S. currency, the yen is said to depreciate. When the exchange rate falls from 80 to 70 yen per dollar, the dollar is said to depreciate, and the yen is said to ap- preciate. At times you may have heard the media report that the dollar is either “strong” or “weak.” These descriptions usually refer to recent changes in the nom- inal exchange rate. When a currency appreciates, it is said to strengthen because it can then buy more foreign currency. Similarly, when a currency depreciates, it is said to weaken. nominal exchange rate the rate at which a person can trade the currency of one country for the currency of another 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 CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 669 For any country, there are many nominal exchange rates. The U.S. dollar can be used to buy Japanese yen, British pounds, French francs, Mexican pesos, and so on. When economists study changes in the exchange rate, they often use indexes that average these many exchange rates. Just as the consumer price index turns the many prices in the economy into a single measure of the price level, an exchange rate index turns these many exchange rates into a single measure of the interna- tional value of the currency. So when economists talk about the dollar appreciating or depreciating, they often are referring to an exchange rate index that takes into account many individual exchange rates. REAL EXCHANGE RATES The real exchange rate is the rate at which a person can trade the goods and ser- vices of one country for the goods and services of another. For example, suppose that you go shopping and find that a case of German beer is twice as expensive as a case of American beer. We would then say that the real exchange rate is 1/2 case of German beer per case of American beer. Notice that, like the nominal exchange rate, we express the real exchange rate as units of the foreign item per unit of the domestic item. But in this instance the item is a good rather than a currency. Real and nominal exchange rates are closely related. To see how, consider an example. Suppose that a bushel of American rice sells for $100, and a bushel of Japanese rice sells for 16,000 yen. What is the real exchange rate between American and Japanese rice? To answer this question, we must first use the nominal ex- change rate to convert the prices into a common currency. If the nominal exchange rate is 80 yen per dollar, then a price for American rice of $100 per bushel is equiv- alent to 8,000 yen per bushel. American rice is half as expensive as Japanese rice. The real exchange rate is 1/2 bushel of Japanese rice per bushel of American rice. We can summarize this calculation for the real exchange rate with the follow- ing formula: Real exchange rate ϭ . Using the numbers in our example, the formula applies as follows: Real exchange rate ϭ ϭ ϭ 1/2 bushel of Japanese rice per bushel of American rice. Thus, the real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in the local currencies. Why does the real exchange rate matter? As you might guess, the real ex- change rate is a key determinant of how much a country exports and imports. When Uncle Ben’s, Inc., is deciding whether to buy U.S. rice or Japanese rice to put into its boxes, for example, it will ask which rice is cheaper. The real exchange rate 8,000 yen per bushel of American rice 16,000 yen per bushel of Japanese rice (80 yen per dollar) ϫ ($100 per bushel of American rice) 16,000 yen per bushel of Japanese rice Nominal exchange rate ϫ Domestic price Foreign price real exchange rate the rate at which a person can trade the goods and services of one country for the goods and services of another 670 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES gives the answer. As another example, imagine that you are deciding whether to take a seaside vacation in Miami, Florida, or in Cancun, Mexico. You might ask your travel agent the price of a hotel room in Miami (measured in dollars), the price of a hotel room in Cancun (measured in pesos), and the exchange rate be- tween pesos and dollars. If you decide where to vacation by comparing costs, you are basing your decision on the real exchange rate. When studying an economy as a whole, macroeconomists focus on overall prices rather than the prices of individual items. That is, to measure the real ex- change rate, they use price indexes, such as the consumer price index, which mea- sure the price of a basket of goods and services. By using a price index for a U.S. basket (P), a price index for a foreign basket (P*), and the nominal exchange rate between the U.S. dollar and foreign currencies (e), we can compute the overall real exchange rate between the United States and other countries as follows: Real exchange rate ϭ (e ϫ P)/P*. This real exchange rate measures the price of a basket of goods and services avail- able domestically relative to a basket of goods and services available abroad. As we examine more fully in the next chapter, a country’s real exchange rate is a key determinant of its net exports of goods and services. A depreciation (fall) in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods. This change 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. Con- versely, an appreciation (rise) 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. QUICK QUIZ: Define nominal exchange rate and real exchange rate, and explain how they are related. ◆ If the nominal exchange rate goes from 100 to 120 yen per dollar, has the dollar appreciated or depreciated? A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING-POWER PARITY Exchange rates vary substantially over time. In 1970, a U.S. dollar could be used to buy 3.65 German marks or 627 Italian lira. In 1998, a U.S. dollar bought 1.76 Ger- man marks or 1,737 Italian lira. In other words, over this period the value of the dollar fell by more than half compared to the mark, while it more than doubled compared to the lira. What explains these large and opposite changes? Economists have developed many models to explain how exchange rates are determined, each emphasizing just some of the many forces at work. Here we develop the simplest theory of ex- change rates, called purchasing-power parity. This theory states that a unit of any given currency should be able to buy the same quantity of goods in all countries. Many economists believe that purchasing-power parity describes the forces that determine exchange rates in the long run. We now consider the logic on which this purchasing-power parity 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 CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 671 long-run theory of exchange rates is based, as well as the theory’s implications and limitations. THE BASIC LOGIC OF PURCHASING-POWER PARITY The theory of purchasing-power parity is based on a principle called the law of one price. This law asserts that a good must sell for the same price in all locations. Oth- erwise, there would be opportunities for profit left unexploited. For example, sup- pose that coffee beans sold for less in Seattle than in Boston. A person could buy coffee in Seattle for, say, $4 a pound and then sell it in Boston for $5 a pound, mak- ing a profit of $1 per pound from the difference in price. The process of taking ad- vantage of differences in prices in different markets is called arbitrage. In our example, as people took advantage of this arbitrage opportunity, they would in- crease the demand for coffee in Seattle and increase the supply in Boston. The price of coffee would rise in Seattle (in response to greater demand) and fall in Boston (in response to greater supply). This process would continue until, eventually, the prices were the same in the two markets. Now consider how the law of one price applies to the international market- place. If a dollar (or any other currency) could buy more coffee in the United States than in Japan, international traders could profit by buying coffee in the United States and selling it in Japan. This export of coffee from the United States to Japan Some of the currencies men- tioned in this chapter, such as the French franc, the German mark, and the Italian lira, are in the process of disappearing. Many European nations have decided to give up their na- tional currencies and start us- ing a new common currency called the euro. A newly formed European Central Bank, with representatives from all of the participating countries, issues the euro and controls the quantity in circulation, much as the Federal Reserve controls the quantity of dollars in the U.S. economy. Why are these countries adopting a common currency? One benefit of a common currency is that it makes trade easier. Imagine that each of the 50 U.S. states had a dif- ferent currency. Ever y time you crossed a state border you would need to change your money and per form the kind of exchange-rate calculations discussed in the text. This would be inconvenient, and it might deter you from buying goods and services outside your own state. The countries of Europe decided that as their economies be- came more inte- grated, it would be better to avoid this incon- venience. There are, however, costs of choosing a common cur- rency. If the na- tions of Europe have only one money, they can have only one monetar y policy. If they disagree about what monetary policy is best, they will have to reach some kind of agreement, rather than each going its own way. Because adopting a single money has both benefits and costs, there is debate among economists about whether Europe’s recent adoption of the euro was a good decision. Only time will tell what effect the decision will have. FYI The Euro 672 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES would drive up the U.S. price of coffee and drive down the Japanese price. Con- versely, if a dollar could buy more coffee in Japan than in the United States, traders could buy coffee in Japan and sell it in the United States. This import of coffee into the United States from Japan would drive down the U.S. price of coffee and drive up the Japanese price. In the end, the law of one price tells us that a dollar must buy the same amount of coffee in all countries. This logic leads us to the theory of purchasing-power parity. According to this theory, a currency must have the same purchasing power in all countries. That is, a U.S. dollar must buy the same quantity of goods in the United States and Japan, and a Japanese yen must buy the same quantity of goods in Japan and the United States. Indeed, the name of this theory describes it well. Parity means equality, and purchasing power refers to the value of money. Purchasing-power parity states that a unit of all currencies must have the same real value in every country. IMPLICATIONS OF PURCHASING-POWER PARITY What does the theory of purchasing-power parity say about exchange rates? It tells us that the nominal exchange rate between the currencies of two countries de- pends on the price levels in those countries. If a dollar buys the same quantity of goods in the United States (where prices are measured in dollars) as in Japan (where prices are measured in yen), then the number of yen per dollar must reflect the prices of goods in the United States and Japan. For example, if a pound of cof- fee costs 500 yen in Japan and $5 in the United States, then the nominal exchange rate must be 100 yen per dollar (500 yen/$5 ϭ 100 yen per dollar). Otherwise, the purchasing power of the dollar would not be the same in the two countries. To see more fully how this works, it is helpful to use just a bit of mathematics. Suppose that P is the price of a basket of goods in the United States (measured in dollars), P* is the price of a basket of goods in Japan (measured in yen), and e is the nominal exchange rate (the number of yen a dollar can buy). Now consider the quantity of goods a dollar can buy at home and abroad. At home, the price level is P, so the purchasing power of $1 at home is 1/P. Abroad, a dollar can be exchanged into e units of foreign currency, which in turn have purchasing power e/P*. For the purchasing power of a dollar to be the same in the two countries, it must be the case that 1/P ϭ e/P*. With rearrangement, this equation becomes 1 ϭ eP/P*. Notice that the left-hand side of this equation is a constant, and the right-hand side is the real exchange rate. Thus, if the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate—the relative price of domestic and foreign goods—cannot change. To see the implication of this analysis for the nominal exchange rate, we can rearrange the last equation to solve for the nominal exchange rate: e ϭ P*/P. . authors of the report evidently envision a future of large-scale Third World trade surpluses. But it is an un- avoidable fact of accounting that a coun- try. profit by buying coffee in the United States and selling it in Japan. This export of coffee from the United States to Japan Some of the currencies men-