Presentation on Open Market Economies Basic Concepts

1. OPEN-ECONOMY
MACROECONOMICS: BASIC
CONCEPTS

2. Closed Vs. Open Economies
 Open and Closed Economies
 A clo se d e co no m y is one that does not interact with
other economies in the world.
 There are no exports, no imports, and no capital flows.
 An o pe n e co no m y is one that interacts freely
with other economies around the world.
 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.

3. THE INTERNATIONAL FLOW OF
GOODS AND CAPITAL
 An Open Economy
 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.

4. The Flow of Goods: Exports, Imports, Net
Exports
 Expo rts are goods and services that are
produced domestically and sold abroad.
 Im po rts are goods and services that are
produced abroad and sold domestically.
 Ne t e xpo rts (NX) are the value of a nation’s
exports minus the value of its imports.
 Net exports are also called the trade balance .

5.  A trade de ficit 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
 Balance d trade refers to when net exports are
zero—exports and imports are exactly equal.

6. Determinants of Net Exports
 Factors That Affect Net Exports
 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.
 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.

7. Figure 1 The Internationalization of the U.S.
Economy
Percent
of GDP
0
5
10
15
1950 1955 1960 1965 1970 1975 1980 19901985 20001995
Exports
Imports
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8. The Flow of Financial Resources: Net
Capital Outflow
 Ne t capitalo utflo w 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 raise s U.S.
net capital outflow.
 When a Japanese residents buys a bond issued by
the U.S. government, the purchase re duce s the U.S.
net capital outflow.

9. Determinants of Net Capital Outflow
 Variables that Influence Ne t CapitalO utflo w
 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.

10. Monetary Economy Revisited Again: Net
Exports = Net Capital Flow
 For an economy as a whole, net exports (NX) and net
capital outflow (NCO ) must balance each other so that:
NCO = NX
 This holds true because every transaction that affects one side
must also affect the other side by the same amount.
 Example: If Boeing exports a plane to Japan, NX rises, but, in
the simplest case Boeing obtains yen, which increase NCO. In
the more complex case, the Japanese company may purchase
dollars, but someone with dollars is ending up with yen. If the
Japanese buyers get a loan from Boeing, Boeing has acquired a
foreign financial asset.

11. Saving, Investment, and Their Relationship
to the International Flows
 Net exports (NX) is a component of GDP:
Y = C + I + G + NX, or
Y - C - G = I + NX
 National saving (S) is the income of the nation
that is left after paying for current consumption
and government purchases or
S = Y – C - G

12.  Therefore,
S = I + NX
 Lastly since NX is equal to NCO,
S = I + NCO
 National Saving can be saved in two ways,
through domestic investment of in foreign
assets.
 Remember, S underlies the supply of loanable
funds and I, and now NCO, underlies the
demand for loanable funds.

13. Table 1 International Flows of
Goods and Capital: Summary
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14. S, I and Net Capital Outflow
 Note in the succeeding panels that S – I = NCO.
 Until the 1980s, NCO and hence the trade deficit was
small. After 1980, we have had a recurring trade deficit
(NCO is negative – the ROW is holding US financial
assets.
 Is the recurring deficit a problem?
 1980-1987 NCO went from -.5% to –3.0% of GDP, 2.1% came
from a drop in S (the Reagan budget deficits). Therefore, the
trade deficit helped sustain I. If not, I would have fallen affecting
future growth.
 1991-2000 NCO went from -.3% to –3.7% attributable not to a
decline in savings (which increased) but to increases in
investment (primarily in the info. Tech sector). The NCO helped
fuel the investment boom.
 Whether because S fell or I rose, NCO can help to sustain I and
therefore future growth, BUT we must grow to help pay off the
debt. In many developing countries, this has NOT occurred
leading to higher interest payments.

15. Figure 2 National Saving, Domestic Investment,
and Net Capital Outflow
Percent
of GDP
20
18
16
14
12
10
1960 1965 199519901985198019751970
(a) National Saving and Domestic Investment (as a percentage of GDP)
2000
Domestic investment
National saving
Copyright © 2004 South-Western

16. Figure 2 National Saving, Domestic Investment,
and Net Capital Outflow
Percent
of GDP
4
–4
–3
–2
–1
0
1
2
3
Net capital
outflow
(b) Net Capital Outflow (as a percentage of GDP)
1960 1965 199519901985198019751970 2000
Copyright © 2004 South-Western

17. 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.

18. Nominal Exchange Rates
 The no m inale xchang e 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 U.S. dollar.
 And in units of U.S. dollars per one unit of the foreign
currency.
 http://www.xe.com/ucc/ a internet based
currency converter (can’t be used on tests!)

19.  Assume the exchange rate between the
Japanese yen and U.S. dollar is 80 yen to one
dollar.
 One U.S. dollar trades for 113 yen (10/24/2007).
 One yen trades for 1/113 (= 0.00885) of a dollar.
 Appre ciatio n refers to an increase 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. (say 120 yen)
 De pre ciatio n refers to a decrease in the value
of a currency as measured by the amount of
foreign currency it can buy.
 If it buys less there is a depreciation of the dollar (say
80 yen).

20. Real Exchange Rates
 The re ale xchang e rate is the rate at which a person can
trade the goods and services of one country for the
goods and services of another.
 Trading depends on the physical quantities that can be
exchanged at given exchange rates AND the prices of
the good in each country
 Example, a Honda in Japan costs 4,000,000 yen and
$20,000 in the US. Assuming an exchange rate of 100
yen/dollar, the Honda costs Y2,000,000 in the US. Thus,
Hondas are ½ as expensive in the US OR two times
more expensive in Japan.

21. 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.
 Real Exchange Rate = Exchange Rate x PUS
PROW
 Example above EP/P*
= 100 yen/dollar x $20,000
Y4,000,000
= ½ HondaJAPAN/1 HondaUS
 The real exchange rate is a key determinant of
how much a country exports and imports.
 Real Exchange Rate = Exchange Rate x PUS
PROW

22.  A depreciation (fall) in the U.S. real exchange rate means
that U.S. goods have become cheaper relative to foreign
goods and so net exports rise.
 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.
 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.
 Discourages consumers both at home and abroad to from buying
U.S. goods and encourages buying more goods from other
countries. As a result, U.S. exports fall, and U.S. imports rise,
and both of these changes decrease U.S. net exports.

23. A FIRST THEORY OF
EXCHANGE-RATE DETERMINATION: PURCHASING-
POWER PARITY
 The purchasing -po we r parity the o ry is the
simplest and most widely accepted theory
explaining the variation of exchange rates and
posits that 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 o f o ne price .
 According to the law of one price, a good must sell for
the same price in all countries.

24.  If the law of one price were not true, unexploited
profit opportunities would exist and arbitrage
would occur (arbitrag e is a fancy term for trading
or buying low and selling high)..
 If arbitrage occurs, eventually prices that
differed in two markets would necessarily
converge, and exchange rates move to ensure
that a currency would have the same
purchasing power in all countries.

25. Implications of Purchasing-Power Parity
 If the purchasing power of the dollar is always
the same at home and abroad, then the
exchange rate would be constant.
 The nominal exchange rate between the
currencies of two countries must reflect the
different price levels in those countries and the
real exchange rate would be equal to 1.
 Therefore, if a central bank prints large
quantities of money, the price level rises
(QTofM) and its value in buying goods and
services and other currencies falls.

26. Figure 3 Money, Prices, and the Nominal Exchange Rate
During the German Hyperinflation
10,000,000,000
1,000,000,000,000,000
100,000
1
.00001
.0000000001
1921 1922 1923 1924
Exchange rate
Money supply
Price level
1925
Indexes
(Jan. 19215 100)
Copyright © 2004 South-Western

27. Limitations of Purchasing-Power Parity
 The Big Mac Index
 http://www.economist.com/displaystory.cfm?story_id=1730909
 New Index Starbucks
 http://www.economist.com/displaystory.cfm?story_id=2361072
 Why don’t real exchange rates always equal
one?
 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.

28. 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.

29. Summary
 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.

30. 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.

31. Summary
 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.

32. 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.