ECO121-Macroeconomics Chapter

31

Open-Economy
Macroeconomic:
Basic Concepts
Lecturer : Mr. Nguyễn Quốc Quân
Email : quannq6@fe.edu.vn;
FPT Education- FPT University Danang Campus
In this chapter,
look for the answers to these questions:
 How are international flows of
goods and assets related?
 What’s the difference between the real
and nominal exchange rate?
 What is “purchasing-power parity”
(PPP), and how does it explain
nominal exchange rates?
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 Introduction
One of the Ten Principles of Economics:
Trade can make everyone better off.
This chapter introduces basic concepts of
international macroeconomics:
The trade balance, trade deficits, trade
surpluses
International flows of assets
Exchange rates

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 3

Closed Economies vs. Open Economies
A closed economy does
not interact with other
economies in the world.
An open economy interacts
freely with other economies
around the world.
OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 4
 I. The Flow of Goods & Services
 Exports:
domestically-produced g&s sold abroad

 Imports:
foreign-produced g&s sold domestically
 Net exports (NX) (or trade balance)
= value of exports – value of imports

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 5

 Trade Surpluses & Deficits
Net Export (NX) measures the imbalance in a
country’s trade in goods and services.
 Trade deficit: import > export, NX<0
an excess of imports over exports
 Trade surplus: import < export, NX>0
an excess of exports over imports
 Balanced trade: exports = imports, NX=0

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 6

ACTIVE LEARNING 1
Variables that affect NX
What do you think would happen to
U.S. net exports if:
A. Canada experiences a recession
(falling incomes, rising unemployment)
B. U.S. consumers decide to be patriotic and
buy more products “Made in the U.S.A.”
C. Prices of goods produced in Mexico rise faster
than prices of goods produced in the U.S.

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ACTIVE LEARNING 1
Answers
A. Canada experiences a recession
(falling incomes, rising unemployment)
U.S. net exports would fall
due to a fall in Canadian consumers’
purchases of U.S. exports
B. U.S. consumers decide to be patriotic and
buy more products “Made in the U.S.A.”
U.S. net exports would rise
due to a fall in imports

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ACTIVE LEARNING 1
Answers
C. Prices of Mexican goods rise faster than prices
of U.S. goods
This makes U.S. goods more attractive
relative to Mexico’s goods.
Exports to Mexico increase,
imports from Mexico decrease,
so U.S. net exports increase.

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 Variables that Influence Net Exports
 Consumers’ preferences for foreign and domestic
goods
 Prices of goods at home and abroad
 Incomes of consumers at home and abroad
 The exchange rates at which foreign currency
trades for domestic currency
 Transportation costs
 Govt policies

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 10

 The U.S. Economy’s Increasing Openness
Percent of GDP

Trade deficit = 5%
of GDP in 2007:Q4

Imports

Exports
 II. The Flow of Capital
Net capital outflow (NCO):
= [domestic residents’ purchases of foreign assets]
- (MINUS) [foreigners’ purchases of domestic assets]

NCO is also called net foreign

investment.
OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 12
 The Flow of Capital
The flow of capital abroad takes two forms:

1. Foreign direct investment (FDI):

Domestic residents actively manage the
foreign investment, (e.g., McDonalds opens a
fast-food outlet in Moscow)

2. Foreign portfolio investment

(FPI):
Domestic residents purchase foreign stocks or
bonds, supplying “loanable funds” to a foreign
firm.
OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 13
 The Flow of Capital
NCO measures the imbalance in a country’s trade
in assets:
 When NCO > 0, “capital outflow”
Domestic purchases of foreign assets exceed
foreign purchases of domestic assets.
 When NCO < 0, “capital inflow”
Foreign purchases of domestic assets exceed
domestic purchases of foreign assets.

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 14

 Variables that Influence NCO
Real interest rates paid on foreign assets
Real interest rates paid on domestic
assets
Perceived risks of holding foreign assets
Govt policies affecting foreign ownership
of domestic assets

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 15

 III. The Equality of NX and NCO
An accounting identity: NCO = NX
 arises because every transaction that affects
NX also affects NCO by the same amount
(and vice versa)
When a foreigner purchases a good from the U.S.:
 U.S. exports and NX increase
 the foreigner pays with currency or assets,
so the U.S. acquires some foreign assets,
causing NCO to rise.

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 16

 The Equality of NX and NCO
An accounting identity: NCO = NX

When a U.S. citizen buys foreign goods,

 U.S. imports rise, NX falls
 the U.S. buyer pays with U.S. dollars or
assets, so the other country acquires
U.S. assets, causing U.S. NCO to fall.

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 17

 Saving, Investment, and International
Flows of Goods & Assets
Y = C + I + G + NX accounting identity
Y – C – G = I + NX rearranging terms
S = I + NX since S = Y – C – G
S = I + NCO since NX = NCO
 When S > I, the excess loanable funds flow
abroad in the form of positive net capital outflow.
 When S < I, foreigners are financing some of the
country’s investment, and NCO < 0.

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 18

 Case Study: The U.S. Trade Deficit
 The U.S. trade deficit reached record levels in
2006 and remained high in 2007-2008.
 Recall, NX = S – I = NCO.
A trade deficit means I > S,
so the nation borrows the difference
from foreigners.
 In 2007, foreign purchases of U.S. assets
exceeded U.S. purchases of foreign assets by
$775 million.
 Such deficits have been the norm since 1980…
OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 19
 U.S. Saving, Investment, and NCO, 1950-2007

Investment
(% of GDP)

Saving

NCO
 Case Study: The U.S. Trade Deficit
Why U.S. saving has been less than investment:
 In the 1980s and early 2000s,
huge budget deficits and low private saving
depressed national saving.
 In the 1990s,
national saving increased as the economy grew,
but domestic investment increased even faster
due to the information technology boom.

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 21

 Case Study: The U.S. Trade Deficit
 Is the U.S. trade deficit a problem?
 The extra capital stock from the ’90s investment
boom may well yield large returns.
 The fall in saving of the ’80s and ’00s,
while not desirable, at least did not depress
domestic investment, as firms could borrow
from abroad.
 A country, like a person, can go into debt
for good reasons or bad ones.
A trade deficit is not necessarily a problem,
but might be a symptom of a problem.
OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 22
 Case Study: The U.S. Trade Deficit
as of 12-31-2007
People abroad owned $20.1 trillion in U.S. assets.
U.S. residents owned $17.6 trillion in foreign assets.
U.S.’ net indebtedness to other countries = $2.5 trillion.
Higher than every other country’s net indebtedness.
So, U.S. is “the world’s biggest debtor nation.”
 So far, the U.S. earns higher interest rates on foreign
assets than it pays on its debts to foreigners.
 But if U.S. debt continues to grow, foreigners may
demand higher interest rates, and servicing the debt
would become a drain on U.S. income.

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 23

 IV. The Nominal Exchange Rate
 Nominal exchange rate: the rate at which
one country’s currency trades for another
 We express all exchange rates as foreign currency
per unit of domestic currency.
USD/VND : 23.500
EUR/VND: 35.200

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 24

 Appreciation and Depreciation
 Appreciation (or “strengthening”):
an increase in the value of a currency
as measured by the amount of foreign currency
it can buy
 Depreciation (or “weakening”):
a decrease in the value of a currency
as measured by the amount of foreign currency
it can buy
 Examples: During 2007, the U.S. dollar…
 depreciated 9.5% against the Euro
 appreciated 1.5% against the S. Korean Won
OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 25
 The Real Exchange Rate
 Real exchange rate: the rate at which the
g&s of one country trade for the g&s of another
exP
 Real exchange rate = P*
where
P = domestic price
P* = foreign price (in foreign currency)
e = nominal exchange rate, (i.e., foreign
currency per unit of domestic currency)

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 26

 Example With One Good
A Big Mac costs $2.50 in U.S., 400 yen in Japan,
e = 120 yen per $
 e x P = price in yen of a U.S. Big Mac
= (120 yen per $) x ($2.50 per Big Mac)
= 300 yen per U.S. Big Mac
 Compute the real exchange rate:
exP 120 x 2.5
=
P* 400
= 0.75 Japanese Big Macs per US Big Mac

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 27

 Interpreting the Real Exchange Rate
“The real exchange rate =
0.75 Japanese Big Macs per U.S. Big Mac”
Correct interpretation:
To buy a Big Mac in the U.S.,
a Japanese citizen must sacrifice
an amount that could purchase
0.75 Big Macs in Japan.

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 28

ACTIVE LEARNING 2
Compute a real exchange rate
e = 10 pesos per $
price of a tall Starbucks Latte
P = $3 in U.S., P* = 24 pesos in Mexico
A. What is the price of a US latte measured in
pesos?
B. Calculate the real exchange rate,
measured as Mexican lattes per US latte.

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ACTIVE LEARNING 2
Answers
e = 10 pesos per $
price of a tall Starbucks Latte
P = $3 in U.S., P* = 24 pesos in Mexico
A. What is the price of a US latte in pesos?
e x P = (10 pesos per $) x (3 $ per US latte)
= 30 pesos per US latte
B. Calculate the real exchange rate.
exP 30 pesos per U.S. latte
=
P* 24 pesos per Mexican latte
= 1.25 Mexican lattes per US latte
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The Real Exchange Rate With Many Goods
P = U.S. price level, (e.g., CPI, measures the price
of a basket of goods
P* = foreign price level
Real exchange rate
= (e x P)/P*
= price of a domestic basket of goods relative to
price of a foreign basket of goods
 If U.S. real exchange rate appreciates,
U.S. goods become more expensive relative to
foreign goods.
OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 31
 V. The Law of One Price
Law of one price: Suthe notion that a good
should sell for the same price in all markets
 coffee sells for $4/pound in Seattle and
$5/pound in Boston, and can be costlessly
transported.
 There is an opportunity for arbitrage,
making a quick profit by buying coffee in
Seattle and selling it in Boston.
 Such arbitrage drives up the price in Seattle
and drives down the price in Boston, until the
two prices are equal.
OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 32
 V. Purchasing-Power Parity (PPP)
Purchasing-power parity:
a theory of exchange rates whereby a unit of any
currency should be able to buy the same quantity of
goods in all countries
 based on the law of one price
 implies that nominal exchange rates adjust
to equalize the price of a basket of goods across
countries

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 33

 Purchasing-Power Parity (PPP)
 Example: The “basket” contains a Big Mac.
P = price of US Big Mac (in dollars)
P* = price of Japanese Big Mac (in yen)
e = exchange rate, yen per dollar
 According to PPP, e x P = P*

price of US price of Japanese

Big Mac, in yen Big Mac, in yen

P*
 Solve for e: e =
P
OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 34
 PPP and Its Implications
 PPP implies that the nominal
P*
exchange rate between two countries e =
P
should equal the ratio of price levels.
 If the two countries have different inflation rates,
then e will change over time:
 If inflation is higher in Mexico than in the U.S.,
then P* rises faster than P, so e rises –
the dollar appreciates against the peso.
 If inflation is higher in the U.S. than in Japan,
then P rises faster than P*, so e falls –
the dollar depreciates against the yen.
OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 35
 Limitations of PPP Theory
Two reasons why exchange rates do not always adjust
to equalize prices across countries:
 Many goods cannot easily be traded
 Examples: haircuts, going to the movies
 Price differences on such goods cannot be
arbitraged away
 Foreign, domestic goods not perfect substitutes
 E.g., some U.S. consumers prefer Toyotas over
Chevys, or vice versa
 Price differences reflect taste differences

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 36

 Limitations of PPP Theory
 Nonetheless, PPP works well in many cases,
especially as an explanation of long-run trends.
 For example, PPP implies:
the greater a country’s inflation rate,
the faster its currency should depreciate
(relative to a low-inflation country like the US)
 The data support this prediction…

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 37

Inflation & Depreciation in a Cross-Section
of 31 Countries
10,000.0
Ukraine
1,000.0
Romania
Avg annual Brazil
100.0
depreciation Argentina
relative to
10.0 Mexico
US dollar
Canada
1993-2003 1.0 Kenya
(log scale)
Japan
0.1
0.1 1.0 10.0 100.0 1,000.0
Avg annual CPI inflation
1993-2003 (log scale)
ACTIVE LEARNING 3
Chapter review questions
1. Which of the following statements about a country
with a trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving
D. Y < C + I + G
2. A Ford Escape SUV sells for $24,000 in the U.S.
and 720,000 rubles in Russia.
If purchasing-power parity holds, what is the
nominal exchange rate (rubles per dollar)?
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ACTIVE LEARNING 3
Answers
1. Which of the following statements about a country
with a trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving not true!
D. Y < C + I + G

A trade deficit means NX < 0.

Since NX = S – I,
a trade deficit implies I > S.
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ACTIVE LEARNING 3
Answers
2. A Ford Escape SUV sells for $24,000 in the
U.S. and 720,000 rubles in Russia.
If purchasing-power parity holds, what is the
nominal exchange rate (rubles per dollar)?
P* = 720,000 rubles
P = $24,000
e = P*/P = 720,000/24,000 = 30 rubles per
dollar

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CHAPTER SUMMARY

 Net exports equal exports minus imports.

Net capital outflow equals domestic residents’
purchases of foreign assets minus foreigners’
purchases of domestic assets.
 Every international transaction involves the
exchange of an asset for a good or service,
so Net Exports equal Net Capital Outflow.

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CHAPTER SUMMARY

 Saving can be used to finance domestic

investment or to buy assets abroad. Thus,
saving equals domestic investment plus net
capital outflow.
 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 the two
countries. 43
CHAPTER SUMMARY

 According to the theory of purchasing-power parity,

a unit of any country’s currency should be able to
buy the same quantity of goods in all countries.
 This theory implies that the nominal exchange rate
between two countries should equal the ratio of the
price levels in the two countries.
 It also implies that countries with high inflation
should have depreciating currencies.

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