Open Economy Basics

Dr. Katherine Sauer

Principles of Macroeconomics
ECO 2010
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Overview:

I. The Flows of Goods and Services and Capital

II. Nominal and Real Exchange Rates

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I. The Flows of Goods, Services, and Capital
A. The Flow of Goods and Services:
 
Net Exports = value of exports – value of imports
aka “the trade balance”
 
trade surplus: EX > IM
trade deficit: EX < IM
balanced trade: EX = IM

(balanced trade is NOT the same thing as the trade balance!)

When you hear that a country’s trade balance has “worsened”, it

means that there is less of a surplus or more of a deficit.
- imports are increasing or exports are decreasing
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Factors that influence a country’s trade balance:

1) prices of goods manufactured at home

- if home goods are relatively expensive, then a country
will import cheaper goods

2) exchange rates
- if a country’s currency is strong against other currencies,
then it is “cheap” to import while its exports are
“expensive” to other countries

3) trade agreements
- when a country signs a Free Trade Agreement, both
its exports and imports will likely increase

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4) trade barriers
- if a country imposes tariffs on imports, then imports
are reduced
- if a country subsidizes exports, then exports will rise

5) the business cycle at home or abroad

- in an expansion at home, consumer incomes are
increasing, in general this will increase imports

- in an expansion abroad, consumer incomes elsewhere

are increasing so the home country exports more

Most economists don’t believe that trade deficits/surpluses are

inherently good or bad. The economic impact of a surplus or
deficit depends on the specific circumstances surrounding it.

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B. The Flow of Capital:
 
Net
Foreign = purchases of foreign - purchases of domestic
Investment assets by domestics assets by foreigners
aka “Net Capital Outflow”
 
ex:
- US firm buys a factory in Mexico
US NFI rises, Mex. NFI falls

- Canadian exporter is paid in yen for a shipment

Can. NFI rises, Jap. NFI falls

- Political instability causes capital to leave Venezuela in favor of

Brazil
Ven. NFI rises, Braz. NFI falls 6
Factors that influence NFI:

1) real interest rate being paid on foreign assets vs domestic assets

- higher interest rates at home will attract foreign capital
- higher interest rates abroad will direct capital there

2) the perceived economic risks of holding assets in various nations

- the riskier the nation, the less likely you are to keep assets

3) government policies
- taxes, repatriate dividends, restrictions on foreign investment

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C. The link between Net Exports and Net Foreign Investment
 
Each measures a type of imbalance in a world market.
NX: goods/ services flowing in and out
NFI: capital flowing in and out
 
For an economy as a whole,

value of Net Exports = value of Net Foreign Investment

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D. Savings and Investment in the Open Economy
 
recall: Y = C + I + G + NX and S = Y – C – G
Y – C – G = I + NX
S = I + NX
S = I + NFI
 
So,
domestic savings = domestic investment + net foreign investment
 

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E. Three Possible Scenarios for the Open Economy

Trade Deficit Balanced Trade Trade Surplus

EX < IM EX = IM EX > IM

NX < 0 NX = 0 NX > 0

Y< C + I + G Y= C + I + G Y >C + I + G

S<I S= I S >I

NFI < 0 NFI = 0 NFI > 0

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II. Real and Nominal Exchange Rates
 
When making international transactions (like paying for imports
or buying foreign assets), currencies are exchanged as well.

International transactions are influenced by international prices.

The two most important international “prices” are

- nominal exchange rates
- real exchange rates

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1. Nominal Exchange Rate (e)= rate at which you can trade the
currency of one country for the currency of another country
(sometimes called the spot rate)

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Example: Seoul, South Korea
May 2008

1USD = 991won

1yen = 9.54 won

Similarly:
1won = 0.00101USD

1won= 0.10482 yen

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How much is a Subway Club going to cost you?

The price is 4,300won.

The exchange rate is 1USD per 991won.

4300w x 1$ = $4.34
991w

If instead the exchange rate was 1USD per 950won…

4300w x 1$ = $4.50
950w

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Suppose that in 2009, eJPY/USD = 120. In 2010, eJPY/USD = 150.
- initially, one dollar could buy 120 yen
- now, one dollar can buy 150 yen
- the dollar has appreciated against the yen

- initially, it took 120 yen to buy one dollar

- now, it takes 150 yen to buy one dollar
- the yen has depreciated against the dollar

***If eA/B increases, then currency B is appreciating***

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Salzburg, Austria
June 2007

1$ = 0.74270euro
1euro x 1$ = $1.35
0.74270 17
Prague, Czech Republic
June 2007

1$ = 21.3830 koruna 20kc x $1 = $0.94

(CZK) 21.3830 18
Xian, China 1$ = 6.98560yuan 6yuan x 1$ = $0.86
May 2008 (CNY) 6.98560
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Some results of a US dollar depreciation:

-US goods are “cheaper” to foreign consumers … US exports

increase.

-Foreign goods are “more expensive” to US consumers … US

imports less.

-US net exports rise (AD rises)

-more expensive for US travelers abroad

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2. Real Exchange Rate (er)= rate at which goods and services from
one nation could be traded for goods and services of another
 
Relationship between nominal and real exchange rate:
erA/B = eA/B x price in B
price in A

ex: US hotel room costs $100 per night

Japan hotel room costs 16,000yen per night
e = 80yen/$

Calculate the real exchange rate:

erJap/US = 80 ¥ x $100
1$ 16000¥
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e r
Jap/US = 1/2 Japanese hotel room for 1 US hotel room
For the economy as a whole:
erA/B = eA/B x price level in B
price level in A
 
If country B experiences inflation, its real exchange rate
appreciates.

If country A experiences inflation, its real exchange rate

depreciates.

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III. Purchasing Power Parity Theory
 
Purchasing Power Parity (PPP) says that a unit of any given
currency should buy the same quantity of goods in all countries
 
Logic:
- the Law of One Price which says a good should sell for
the same “price” in all locations

- this law should apply to currency as well

 

PPP says in the long run, one unit of a good in one country
should be able to “buy” one unit of that same good in another
country.

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PPP holds true for goods that are easily movable.
 
Limitations:
- long run theory
- many goods aren’t moveable
- goods aren’t always perfect substitutes

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Implications:
- PPP implies that in the long run er = 1. 
1 = eA/B x price level in B
price level in A
 
price level in A = eA/B
price level in B
 
- PPP implies that changes in the nominal exchange rate reflect
changes in the price level (inflation)
 
- PPP implies that if a central bank prints too much money, the
money loses value both in terms of the goods and services it can
buy and ALSO in terms of the foreign currency it can buy.

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ex: Suppose a burrito costs $7 in the US and costs 20SFr in
Switzerland. e = 1.1657SFr / $
 
If PPP holds, what SHOULD the exchange rate be?
PPP
e Swiss/US = eSwiss/US x price level in US
r

price level in Sw.

  PPP

1 = eSwiss/US x $7 .
20SFr
  PPP

$ 7 = eSwiss/US
20SFr
PPP

2.8571 = eSwiss/US
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The implied PPP exchange rate is 2.8571SFr/$.

The actual exchange rate is 1.1657SFr /$.

It takes fewer SFr to get one dollar than it should.

The SFr is overvalued versus the dollar.
The dollar is undervalued versus the SFr.

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PPP tells us that in the long run, two countries’ currencies should
move toward an exchange rate that equalizes the prices of an
identical basket of goods.

The Big Mac is sold in 120 nations.

The Big Mac PPP index is the exchange rate that would make a
Big Mac cost the same amount (in US dollars) in the US and
abroad.

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 Big Mac Prices actual over/under
local price in PPP of exchange rate valued
price US$ US$ per US$ vs US$

US $3.57 $3.57 …. …. ….
Brazil 7.50real $4.73 2.10 1.58 +33
________________________________________________________

To calculate the price in US$:

Multiply the local price by the actual exchange rate.

7.50real x 1$ = $4.74
1.58real

If you bought a Big Mac in Brazil, it would cost you 7.50 real. Which
means it really costs you $4.74.
- It is more expensive to buy a Big Mac in Brazil than the US.
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 Big Mac Prices actual over/under
local price in PPP of exchange rate valued
price US$ US$ per US$ vs US$

US $3.57 $3.57 …. …. ….
Brazil 7.50real $4.73 2.10 1.58 +33
________________________________________________________

To calculate the PPP of the US$:

Divide the local price in the foreign country by the local price in the US

PPP rate = 7.50 / 3.57 = 2.10

Compare the PPP rate to the actual exchange rate to see if the currency
is over or undervalued versus the US$.

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PPP rate = 2.10 real / US$
actual exchange rate = 1.58real/US$

Theory tells us that it should cost 2.10 real to buy one dollar.
But, it currently only costs 1.58 real to buy one dollar.

It takes less real to buy a dollar than it should.

The real is stronger than it should be.

The real is overvalued against the dollar.

We would expect that the real will depreciate in the future.

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 Big Mac Prices actual over/under
local price in PPP of exchange rate valued
price US$ US$ per US$ vs US$

US $3.57 $3.57 …. …. ….
Brazil 7.50real $4.73 2.10 1.58 +33
________________________________________________________

To calculate how much the real is overvalued by:

(PPPrate – actual exchange rate) / actual exchange rate x 100

(2.10 – 1.58) / 1.58 x 100 = 32.9

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 Big Mac Prices actual over/under
local price in PPP of exchange rate valued
price US$ US$ per US$ vs US$

US $3.57 $3.57 …. …. ….
Russia 59.0rubles $2.54 16.5 23.2 -29
________________________________________________________
To calculate the price in US$:
59.0ruble = 1$ = $2.54
23.2ruble

If you were in Russia, your Big Mac would cost you $2.54.
It is cheaper to buy a Big Mac in Russia than the US.

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 Big Mac Prices actual over/under
local price in PPP of exchange rate valued
price US$ US$ per US$ vs US$

US $3.57 $3.57 …. …. ….
Russia 59.0rubles $2.54 16.5 23.2 -29
________________________________________________________
To calculate the PPP rate:
59.0 / 3.57 = 16.5

Theory tells us it should take 16.5 rubles to buy one US dollar.

Actually it takes 23.2 rubles to buy one US dollar.

The ruble is weaker than it should be. It is undervalued versus the US$.
(16.5 – 23.2) / 23.2 x 100 = - 28.8
We would expect the ruble to appreciate in the future.
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