MACROECONOMICS

Open-Economy Macroeconomics:
Basic Concepts
 Prices
for International Transactions: Real and
Nominal Exchange Rates
 Nominal Exchange Rates - rate at which a person can
trade the currency of one country for the currency of
another. (In real case, bank may post slightly different prices
for buying and selling yen. The difference gives the bank
some profit. But in section, we can ignore these differences.)
 Nominal exchange rate as units of foreign currency per
U.S. dollar, such as 80 yen per dollar.
 If exchange rate changes => dollar buys more foreign currency =>

appreciation of the dollar (strong).

 If the exchange rate changes => dollar buys less foreign currency =>

depreciation of the dollar (Weak).

Open-Economy Macroeconomics:
Basic Concepts
 For any country, there are many nominal exchange
rates. (U.S. dollar can be used to buy Japanese yen,
British pounds, Mexican pesos, and so on).
 Studies the changes in the exchange rate => use

indexes that average these many exchange rates =>

exchange-rate index - turns these many exchange
rates into a single measure of the international value of
a currency.
 So, when talk about the dollar appreciating or

depreciating => referring to an exchange-rate index

that includes many individual exchange rates.
 Open-Economy Macroeconomics:
Basic Concepts
 Real Exchange Rates
 the rate at which a person trade goods and
services of one country for goods and services of another.
 For example, a pound of Swiss cheese is twice as

expensive as a pound of American cheese => real

exchange rate is ½ pound of Swiss cheese per pound of
American cheese.
Open-Economy Macroeconomics:
Basic Concepts
 Real and nominal exchange rates are closely related.
 For example
A bushel of American rice sells for $100 and a bushel of
Japanese rice sells for 16,000 yen.
 If nominal exchange rate is 80 yen per dollar => price for

American rice of $100 per bushel is equivalent to 8,000

yen per bushel => American rice is half as expensive as
Japanese rice => real exchange rate
is ½ bushel of Japanese rice per bushel of American rice.
 Formula:
 Open-Economy Macroeconomics:
Basic Concepts
 Real exchange rate depends on
 Nominal exchange rate
 Prices of goods in the two countries measured in the local currencies.

 Why does the real exchange rate matter?

 Real exchange rate is a key determinant of how much a country exports and
imports.
 Example: Imagine you decide to take a seaside vacation in Florida, or in

Mexico. You should consider:

 Price of a hotel room in Miami (measured in dollars) vs price of a hotel room in
Mexico (measured in pesos)
 Exchange rate between pesos and dollars.

 If you decide where to vacation by comparing costs => you are basing on the real

exchange rate.
Open-Economy Macroeconomics:
Basic Concepts
 Real exchange rate measures the price of a basket of goods and
services available domestically relative to a basket of goods and
services available abroad.
 A country’s real exchange rate is a key determinant of its net
exports of goods and services.
 A depreciation (fall) in U.S. real exchange rate => U.S. goods have
become cheaper relative to foreign goods => encourages
consumers both at home and abroad to buy more U.S. goods and
fewer goods from other countries => U.S. exports rise and U.S.
imports fall => both of these changes raise U.S. net exports.
 Appreciation (rise) in U.S. real exchange rate => U.S. goods have
become more expensive compared to foreign goods => U.S. net
exports fall.
 Open-Economy Macroeconomics:
Basic Concepts
 Purchasing-power parity.
 A unit of any given currency should be able to buy the same
quantity of goods in all countries.
 Describes the forces that determine exchange rates in the long

run.
 The Basic Logic of Purchasing-Power Parity
 Law of one price - a good must sell for the same price in all
locations => opportunities for profit left unexploited.
 For example, person could buy coffee in Seattle for $4 a pound

and then sell it in Dallas for $5 a pound, making a profit of $1 per

pound from the difference in price => Arbitrage - advantage of
price differences for the same item in different markets
Open-Economy Macroeconomics:
Basic Concepts
 As people took advantage of this arbitrage
opportunity => increase the demand for
coffee in Seattle and increase the supply in
Dallas => price of coffee would rise in
Seattle (in response to greater demand)
and fall in Dallas (in response to greater
supply).
 This process would continue until the
prices were the same in the two markets.
Open-Economy Macroeconomics:
Basic Concepts
 Lawof one price applies to the international
marketplace.
 If a dollar (or any other currency) could buy more coffee
in the U.S than in Japan => international traders could
profit by buying coffee in U.S and selling it in Japan =>
export of coffee from U.S to Japan => drive up U.S.
price of coffee and drive down the Japanese price.
 If a dollar could buy more coffee in Japan than in U.S

=> traders buy coffee in Japan and sell it in U.S => drive
down U.S. price of coffee and drive up Japanese price.
Open-Economy Macroeconomics:
Basic Concepts
 Law of one price - a dollar must buy the same amount
of coffee in all countries => Theory of purchasing-power
parity => a currency must have the same purchasing
power in all countries => a U.S. dollar must buy the same
quantity of goods in the U.S and Japan, and a Japanese
yen must buy the same quantity of goods in Japan and
the U.S.
 Parity means equality, and purchasing power refers to

the value of money in terms of the quantity of goods it

can buy => Purchasing-power parity - a unit of a
currency must have the same real value in every country.
 Open-Economy Macroeconomics:
Basic Concepts
 Implications of Purchasing-Power Parity
 Nominal exchange rate between the currencies
of two countries depends on the price levels in
those countries.
 If a dollar buys the same quantity of goods in U.S

(where prices are measured in dollars) as in

Japan (where prices are measured in yen) => the
number of yen per dollar must reflect
the prices of goods in U.S and Japan.
 Open-Economy Macroeconomics:
Basic Concepts
 For example, costs 500 yen in Japan and $5 in the United States =>
nominal exchange rate must be 100 yen per dollar (500 yen/$5 5 100
yen per dollar).
 However, purchasing power of the dollar not the same in the two
countries.
 Formula:

 P - the price of a basket of goods in the United States (measured in dollars),

 P - price of a basket of goods in Japan (measured in yen)

 e - nominal exchange rate (the number of yen a dollar can buy).

 Open-Economy Macroeconomics:
Basic Concepts
 At home, the price level is P => purchasing
power of $1 at home is 1/P => a dollar can
buy 1/P units of goods.
 Abroad, a dollar exchanged into e units of
foreign currency, which in turn have
purchasing power e /P*.
 Open-Economy Macroeconomics:
Basic Concepts
 Ifthe 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.
 Nominal exchange rate equals ratio of foreign price
level (measured in units of the foreign currency) to
domestic price level (measured in units of the domestic
currency).
 Key implication of Purchasing-Power Parity - Nominal
exchange rates change when
price levels change.
Open-Economy Macroeconomics:
Basic Concepts
 Price level in any country adjusts to bring the quantity of
money supplied and the quantity of money demanded into
balance.
 Because the nominal exchange rate depends on the price
levels, it also depends on the money supply and demand in
each country.
 When a central bank in any country increases the money supply =>
rise price level => depreciate country’s currency relative to other
currencies in the world.
 When the central bank prints large quantities of money => money

loses value both in terms of the goods and services and in terms of
the amount of other currencies.
 The Macroeconomics of Open
Economies
 Supply and Demand for Loanable Funds
and for Foreign-Currency Exchange
To understand the forces at work in an open economy, we focus on supply
and
demand in two markets. The first is the market for loanable funds, which
coordinates the economy’s saving, investment, and flow of loanable funds
abroad (called
the net capital outflow). The second is the market for foreign-currency
exchange,
which coordinates people who want to exchange the domestic currency for
the
currency of other countries. In this section, we discuss supply and demand in
each
of these markets separately. In the next section, we put these markets
together to
explain the overall equilibrium for an open economy
 Open-Economy Macroeconomics:
Basic Concepts
 The Market for Loanable Funds
A nation saves a dollar of its income => use that dollar to
finance the purchase of domestic capital or to finance the
purchase of an asset abroad.

 Nationalsaving (S) - Demand for loanable funds comes

from domestic investment (I) - Net capital
outflow (NCO).
 Open-Economy Macroeconomics:
Basic Concepts
 The purchase of a capital asset adds to the demand for
loanable funds, regardless of whether that asset is located at
home (I) or abroad (NCO).
 Because net capital outflow can be either positive or
negative => add to or subtract from the demand for loanable
funds that arises from Domestic investment.
 When NCO > 0 => net outflow of capital => net purchase of
capital overseas adds to the demand for domestically
generated loanable funds.
 When NCO < 0 => net inflow of capital; the capital resources
coming from abroad reduce the demand for domestically
generated loanable funds.
 Open-Economy Macroeconomics:
Basic Concepts
 Quantity of loanable funds supplied and the quantity of
loanable funds demanded
depend on the real interest rate.
 Higher real interest rate => higher return to saving =>
encourages people to save => raises the quantity of loanable
funds supplied => higher cost of borrowing to finance capital
projects => discourages investment => reduces the quantity
of loanable funds demanded.
 In open economy, demand for loanable funds comes not only

from those want loanable funds to buy domestic capital goods but
also from those who want loanable funds to buy foreign assets.
Open-Economy Macroeconomics:
Basic Concepts
 Interestrate adjusts to bring the supply and demand for
loanable funds into balance.
 If interest rate below the equilibrium level => quantity of loanable
funds supplied < quantity demanded => shortage of loanable
funds => push the interest rate upward.
 If interest rate above the equilibrium level => quantity of loanable

funds supplied > quantity demanded => surplus of loanable funds

=> drive the interest rate downward.
 At equilibrium interest rate, the supply of

loanable funds = the demand - the amount people want to save =

desired quantities of domestic investment and net capital outflow
The Market for Loanable Funds
 Open-Economy Macroeconomics:
Basic Concepts
 The Market for Foreign-Currency Exchange
 The second market in our model of the open
economy => market for foreign currency exchange.
 Imbalance between the purchase and sale of capital

assets abroad (NCO) equals the imbalance between

exports and imports of goods and services (NX).
Open-Economy Macroeconomics:
Basic Concepts
 For example
 when U.S. economy runs trade surplus (NX>0) => foreigners buy
more U.S. goods and services than Americans buy foreign
goods and services.
 What are Americans doing with this? => buying foreign assets

=> U.S. capital is flowing abroad (NCO >0).

 If U.S runs trade deficit (NX <0) => Americans are spending

more on foreign goods and services than they are earning from
selling goods and
services abroad => Some of this spending must be financed by
selling American assets
abroad => foreign capital is flowing into the U.S (NCO < 0).
 Open-Economy Macroeconomics:
Basic Concepts
 Net
capital outflow represents the quantity of dollars
supplied for the purpose of buying foreign assets.
 For example, when U.S. mutual fund buy Japanese
government bond => change dollars into yen => it supplies
dollars in the market for foreign-currency exchange.
 Net exports represent the quantity of dollars demanded
for the purpose of buying U.S. goods and services.
 For example, when Japanese airline buy a plane made by
Boeing => change its yen into dollars => it demands dollars in
the market for foreign-currency exchange.
 Open-Economy Macroeconomics:
Basic Concepts
 Whatprice balances the supply and demand in the
market for foreign-currency exchange?
 Real exchange rate is the relative price of domestic and
foreign goods => key determinant of net exports.
 When U.S. real exchange rate appreciates => U.S.

goods become more expensive relative to foreign goods

=> U.S. goods less attractive to consumers both at
home and abroad => exports from U.S fall, and imports
into U.S rise => net exports fall => reduces quantity of
dollars demanded in the market for foreign-currency
exchange.
 Open-Economy Macroeconomics:
Basic Concepts
 Higher real exchange rate => U.S. goods more
expensive and reduces the quantity of dollars
demanded to buy those goods.
 The supply curve is vertical because the quantity of
dollars supplied for net capital outflow does not
depend on the real exchange rate. (net capital
outflow depends on the real interest rate. => When
discussing the market for foreign-currency exchange,
we take the real interest rate and net capital outflow
as given.)
 Open-Economy Macroeconomics:
Basic Concepts
 At first, net capital outflow not depend on exchange rate.
 Higher exchange value of the U.S. dollar not only makes
foreign goods less expensive for American buyers but also
makes foreign assets less expensive.
 Stronger dollar make foreign assets more attractive
(American investor turn the foreign asset, as well as any
profits earned on it, back into dollars).
 For example, increase in value of the dollar => less expensive
for an American to buy stock in a Japanese company (any
dividends that the stock pays will be in yen) => yen are
exchanged for dollars => the higher value
of the dollar means dividends will buy fewer dollars than before.
Open-Economy Macroeconomics:
Basic Concepts
 Changes in exchange rate influence both the cost of buying foreign assets and
the benefit of owning them, and these two effects offset each other
 Model of the open economy => net capital outflow does not depend on the real
exchange rate => real exchange rate moves to ensure equilibrium in this
market => adjusts
to balance the supply and demand for dollars just as the price => adjusts to
balance supply and demand for that good.
 If real exchange rate below the equilibrium level => quantity of dollars supplied
would be less than the quantity demanded => shortage of dollars would push
the value of the dollar upward.
 If real exchange rate were above equilibrium level => quantity of dollars
supplied would exceed the quantity demanded => surplus of dollars drive the
value of the dollar downward.
 At equilibrium real exchange rate, the demand for dollars by foreigners arising
from U.S. net exports of goods and services exactly balances the supply of
dollars from Americans arising from U.S. net capital outflow.
The Market for Foreign-Currency
Exchange
 Purchasing-Power Parity as a
Special Case
 Purchasing-power parity - a dollar (or any other currency) must buy
the same quantity of goods and services in every country => real
exchange rate is fixed, and all changes in the nominal exchange rate
between two currencies reflect changes in the price levels in the two
countries.
 According to theory of purchasing-power parity, international trade
responds quickly to international price differences.
 If goods were cheaper in one country than in another => exported from the first
country and imported into the second until the price difference disappeared.
 Theory of purchasing-power parity assumes that net exports are highly

responsive to small changes in real exchange rate.

 If net exports were in fact so responsive, the

demand curve would be horizontal.

 Purchasing-Power Parity as
a Special Case
 Thus, the theory of purchasing-power parity can be
viewed as a special case of the model considered
here.
 In practice, foreign and domestic goods are not
always perfect substitutes, and there are costs
that impede trade.
 Real exchange rate changes over time, as in fact it
often does in the real world.
THANK YOU