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Chapter 6
Open-Economy
Macroeconomics: Basic
Concepts
© 2007 Thomson South-Western
Open-Economy Macroeconomics:
Basic Concepts
 Open and Closed Economies

A closed economy is one that does not interact
with other economies in the world.


There are no exports, no imports, and no capital
flows for a closed economy.
An open economy is one that trades goods,
services and capital freely with other
economies around the world.
Open-Economy Macroeconomics:
Basic Concepts
 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.
THE INTERNATIONAL FLOW
OF GOODS AND CAPITAL
 The Flow of Goods: Exports, Imports, and Net
Exports




Turkey is an open economy—it imports and
exports large quantities of goods and services.
After 1980s, international trade and finance
have become increasingly important.
Trade liberalization: free flow of goods and
services across borders.
Financial liberalization: free flow of capital
across borders.
The Flow of Goods: Exports,
Imports, Net Exports
 Net exports (NX) are the value of a nation’s
exports minus the value of its imports.
 Net exports are also called the trade balance.
 A trade deficit is a situation in which net
exports (NX) are negative. Turkey has
traditionally had a trade deficit with the rest of
the world.

Trade deficit: Imports > Exports
The Flow of Goods: Exports,
Imports, Net Exports
 A trade surplus is a situation in which net
exports (NX) are positive. During WW II
years, Turkey had a trade surplus.

Trade surplus: Exports > Imports
 Balanced trade refers to when net exports are
zero—exports and imports are exactly equal.
Turkey's foreign trade
1000 $
150 000 000
140 000 000
130 000 000
120 000 000
110 000 000
100 000 000
90 000 000
80 000 000
exports
imports
70 000 000
60 000 000
50 000 000
40 000 000
30 000 000
20 000 000
10 000 000
2003
1999
1995
1991
1987
1983
1979
1975
1971
1967
1963
1959
1955
1951
1947
1943
1939
1935
1931
1927
1923
0
19
5
19 0
6
19 0
1970
8
19 0
8
19 3
1984
8
19 5
8
19 6
1987
8
19 8
8
19 9
1990
9
19 1
1992
9
19 3
94
1
19 9 9
9 5
19 6(2
9
19 7(2)
1998( )
9 2
20 9(2)
0
20 0(2)
2001( )
0 2
20 2(2)
0
20 3(2)
04 )
(2
)
Turkey's Trade Deficit / GNP (% )
12.0
10.0
8.0
6.0
4.0
2.0
0.0
Figure 1 The Internationalization of the
U.S. Economy
Percent
of GDP
15
Imports
10
Exports
5
0
1950 1955
1960 1965 1970 1975 1980 1985 1990 1995 2000
2005
The Flow of Goods: Exports,
Imports, Net Exports
 Factors That Affect Net Exports



The prices of goods at home and abroad. If
price of Turkish goods relative to other goods
go up, what happens to NX?
The exchange rates at which people can use
domestic currency to buy foreign currencies. If
lira appreciates, what happens to trade
balance?
The policies of the government toward
international trade: tariffs and quotas on
imports. İf tariffs increase, what happens to
NX?
The Flow of Goods: Exports,
Imports, Net Exports
 Factors That Affect Net Exports



The incomes of consumers at home and
abroad. If per capita GDP increases in Turkey
relative to others, what happens to NX?
The costs of transporting goods from country
to country. İf transportation costs decrease,....
The tastes of consumers for domestic and
foreign goods. İf Turks start liking Italian
furniture, what happens?
The Flow of Capital: Net Capital
Outflow
 Net capital outflow (NCO) refers to the
purchase of foreign assets (lending) by
domestic residents (banks, firms, etc.) minus
the purchase of domestic assets (lending) by
foreigners.
 Two types: Foreign portfolio investment (FPI)
and Foreign direct investment (FDI).
Difference: FDI takes control of the
enterprise, FPI does not. FPI is short term,
FDI is long term.
 NCO is the opposite of Net Capital İnflows
(NCI):
NCO = - NCI.
Flow of Capital: FPI Examples:
 A Turkish firm buys stock in General Motors
(+NCO) and a Mexican bank buys stocks of
Vestel (-NCO).
 Turkish bank buys stocks of Telmex, the
Mexican phone company, +NCO, -NCI.
 Japanese company buys a Turkish Treasury
Bond, -NCO, +NCI.
 Turkish bank or firm borrows money from a
foreign bank or firm (ex: Deutsche Bank), NCO, +NCI. Akbank lends money to Albanian
bank: +NCO, -NCI.
Flow of Capital: FDI Examples:
 British company buys Migros: -NCO, +NCI.
 Bank of Greece buys Finansbank: -NCO,
+NCI.
 Koç Holding buys Grundig: +NCO, -NCI.
The Flow of Capital: Factors
 Variables that Influence NCO



The real interest rates being paid on foreign
assets affect FPI. How much (RIR) does the
US Treasury Bond pay? (~1%)
The real interest rates (RIR) being paid on
domestic assets. How much RIR does Turkish
treasury bond pay? (~13%)
Currently, Turkish treasury bonds pay nominal
19%. İf expected inflation is 6%, real interest
rate is 13%: probably largest in the world.
The Flow of Capital: Factors
 Variables that Influence NCO


Risk of default (country risk). The perceived
economic and political risks of holding assets
abroad. Russian government issued a
moratorium (postponement of foreign debt
repayments) in 1998. Foreign Investors pulled
their money out of Russia: Capital Flight.
The government policies that affect foreign
ownership of domestic assets. Are there
restrictions on foreigners buying Turkish
banks, companies, land (FDI) or stocks, bonds
(FPI)?
The Equality of Net Exports and
Net Capital Outflow
 For an economy as a whole, NX and 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. Ex: When TR
buys net imports of $100 worth of goods,
must pay with some Turkish assets.
The Equality of Net Exports and
Net Capital Outflow
NCO = NX
 Ex: Turkey’s imports exceed its exports by $
52 billion in 2006. This means Turkey must
sell something and receive dollars to pay for
extra imports. Turkey sells stocks or bonds,
i.e. (Foreign portfolio investment). Turkey
borrows, foreigners lend. Or foreigners buy or
start a company in Turkey (foreign direct
investment). Then, NX = -$52 billion = NCO
is negative, NCI is +52 billion.
Saving, Investment, and Their
Relationship to the International Flows
 Net exports is a component of GDP:
Y = C + I + G + NX
 National saving is the income of the nation
that is left after paying for current
consumption and government purchases:
Y – C – G = I + NX
Saving, Investment, and Their
Relationship to the International Flows
 National saving (S) equals Y – C – G so:
S = I + NX
 or, since NX = NCO (-NCI),
Saving
=
S
=
Domestic + Net Capital
Investment
Outflow
I
+
NCO
Table 1 International Flows of Goods
and Capital: Summary
Figure 2: US National Saving, Domestic
Investment, and Net Foreign Investment
(a) National Saving and Domestic Investment (as a percentage of GDP)
Percent
of GDP
20
Domestic investment
18
16
14
National saving
12
10
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Figure 2: US National Saving, Domestic
Investment, and Net Foreign Investment
(b) Net Capital Outflow (as a percentage of GDP)
Percent
of GDP
2
Net capital
outflow
1
0
1
2
3
4
5
6
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
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.
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.
Nominal Exchange Rates
 The nominal exchange rate is expressed in
two ways:


İn units of TLs per one unit of the foreign
currency (dollars): 1.34 TL/USD
Or in units of foreign currency (dollars) per one
YTL: 0.746 USD/TL
 Define ETL/USD as the nominal exchange rate.
İt shows how many TLs one can buy with 1
dollar.
Nominal Exchange Rates
 Appreciation refers to an increase in the
value of a currency as measured by the
amount of foreign currency it can buy.
 Depreciation refers to a decrease in the value
of a currency as measured by the amount of
foreign currency it can buy.
Nominal Exchange Rates (NER)
 Today, EYTL/USD = 1,28 TL/USD. If a crisis
occurs and EYTL/USD= 1,38 TL/USD tomorrow,
this means lira has appreciated or
depreciated?
 If one lira buys less (more) dollars then there
is a depreciation (appreciation) of the lira.
How Are Exchange Rates
Determined?
 The purchasing-power parity (PPP) theory is
the most widely accepted theory of how
exchange rates are determined in the longrun.
 PPP is based on the law of one price: The
same goods must have the same price in all
countries.
Purchasing-Power Parity Theory
 1 ton Turkish steel sold at 134 YTL is the
same as 1 ton American steel sold for 100
dollar. So according to the law of one price,
the exchange rate must be 1.34 YTL/dollar.
(there is only one price of steel in the world).
 Assume tariffs and transportation costs are
zero.
 Assume the goods produced in both
countries are the same. Ex: Turkish steel is a
perfect substitute for American steel.
The Basic Logic of PurchasingPower Parity
 If the law of one price were not true, then
traders would buy from the cheap country
and sell to the expensive country and make
profit. This activity is called arbitrage.
 For example, if price of Turkish steel is 100
YTL and the price of American steel is 100
dollars. Then I would buy a lot of steel from
Turkey and sell to the US. Everybody would
do the same.
The Basic Logic of PurchasingPower Parity
 Then through arbitrage, price of steel in
Turkey would increase and price of steel in
US would increase and they would become
equal.
 But in reality, many goods are not perfect
substitutes. German tractors are not the same
as Turkish tractors.
Implications of Purchasing-Power
Parity
 The nominal exchange rate between the
currencies of two countries must reflect the
different price levels in those countries:
EYTL / USD
PTUR

PUS
 This means that if the price level increases 10
% in Turkey and 5 % in the US, lira will
depreciate against dollar by 10-5 = 5%.
Implications of Purchasing-Power
Parity
 When the central bank prints large quantities
of money, the money loses value both in
terms of the goods and services it can buy
and in terms of the amount of other
currencies it can buy.
Real Exchange Rates
 The real exchange rate (RER) is the ratio of
prices of goods produced in Turkey and
prices of goods produced in other countries.
 İf law of one price and PPP theory is correct,
then RER = 1 and constant. But real data tells
us a different story.
Real Exchange Rates
 If one Turkish tractor is 8000 euros and one
German tractor is 10 000 euros, then the real
exchange rate is 0,80 German tractor per
Turkish tractor.
RERGER/TUR = 0,80 German tractor/ Turkish
tractor
 According to PPP, Real Exchange Rate must
be equal to one because a lot of people
would buy Turkish tractors and sell to
Germany.
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.
RERUS/TUR = PTUR / (EYTL/USDx PUS)
Real Exchange Rates
 Ex: Suppose price of one ton of US wheat is
100 dollars in US, and one ton of Turkish
wheat is 145 TL in Turkey. Then
RERUS/TUR =
= 145 TL/TRw. / (1,34 TL/USD x 100 USD/USw.)
= 1,08 US wheat / Turkish wheat
Real Exchange Rates
 RER is a key determinant of how much a
country exports and imports.
 A depreciation (fall) in Turkey’s real exchange
rate means that Turkish goods have become
cheaper relative to foreign goods.
 This encourages consumers both at home
and abroad to buy more Turkish goods and
fewer goods from other countries. Turkish net
exports increase.
Real Exchange Rates
 As a result, Turkish exports rise, and Turkish
imports fall, and both of these changes raise
Turkish net exports.
 Conversely, an appreciation in the Turkish
real exchange rate means that Turkish goods
have become more expensive compared to
foreign goods, so Turkish net exports fall.
This is the situation these days because TL is
appreciating against other currencies:
EYTL/USD falling, RERUS/TUR rising.
Figure 3: Money, Prices, and the Nominal Exchange Rate During
the German Hyperinflation
Indexes
(Jan. 1921 = 100)
1,000,000,000,000,000
Money supply
10,000,000,000
Price level
100,000
1
Exchange rate
.00001
.0000000001
1921
1922
1923
1924
1925
Critique of PPP Theory: Why PPP
cannot explain NERs?
Many goods are not easily traded or
shipped from one country to another. Ex:
Haircuts, houses, etc. are nontradables.
2. Tradable goods are not always perfect
substitutes when they are produced in
different countries. İs German cheese the
same as Turkish cheese? Tastes are
different.
3. Tariffs and transportation costs are large.
1.