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© 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.
– An open economy is one that interacts freely with
other economies around the world.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
THE INTERNATIONAL FLOW OF
GOODS AND CAPITAL
• The Flow of Goods: Exports, Imports, and Net
Exports
– 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.
© 2007 Thomson South-Western
The Flow of Goods: Exports, Imports, Net
Exports
• Exports are goods and services that are
produced domestically and sold abroad.
• Imports are goods and services that are
produced abroad and sold domestically.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
The Flow of Goods: Exports, Imports, Net
Exports
• A trade deficit 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
• Balanced trade refers to when net exports are
zero—exports and imports are exactly equal.
© 2007 Thomson South-Western
The Flow of Goods: Exports, Imports, Net
Exports
• What about Korea?
• Korea has a trade deficit / surplus / balanced?
• South Korea's trade surplus unexpectedly narrowed in April as
import costs accelerated because of price increases for oil and
natural resources, the government said. The trade surplus
narrowed 27 percent, to $799 million, from $1.10 billion a year
earlier, the Ministry of Commerce, Industry and Energy said in
a preliminary report. Exports rose 17.8 percent, to $30.15
billion, while imports jumped 19.9 percent, to $29.35 billion,
the figures showed. Exports were raised by demand for
semiconductors, automobiles, steel and machinery.
• New York Times, May 2, 2007
© 2007 Thomson South-Western
The Flow of Goods: Exports, Imports, 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.
© 2007 Thomson South-Western
The Flow of Goods: Exports, Imports, Net
Exports
• Factors That Affect Net Exports
• 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.
© 2007 Thomson South-Western
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
© 2007 Thomson South-Western
The Flow of Financial Resources: Net
Capital Outflow
• Net capital outflow refers to the purchase of
foreign assets by domestic residents minus the
purchase of domestic assets by foreigners.
• A U.S. resident buys stock in the Toyota
corporation and a Mexican buys stock in the
Ford Motor corporation.
© 2007 Thomson South-Western
The Flow of Financial Resources: Net
Capital Outflow
• When a U.S. resident buys stock in Telmex, the
Mexican phone company, the purchase raises
U.S. net capital outflow.
• When a Japanese residents buys a bond issued
by the U.S. government, the purchase reduces
the U.S. net capital outflow.
© 2007 Thomson South-Western
The Flow of Financial Resources: Net
Capital Outflow
• Variables that Influence Net Capital Outflow
• 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.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
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
© 2007 Thomson South-Western
Saving, Investment, and Their
Relationship to the International Flows
• National saving (S) equals Y – C – G so:
S = I + NX
• or
Saving
=
S
=
Domestic + Net Capital
Investment
Outflow
I
+
NCO
© 2007 Thomson South-Western
Table 1 International Flows of Goods and Capital: Summary
© 2007 Thomson South-Western
Figure 2 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
© 2007 Thomson South-Western
Figure 2 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
© 2007 Thomson South-Western
FDI in Korea
• According to the United Nations Conference
on Trade and Development (UNCTAD)’s
World Investment Report for 2007, Korea’s
foreign direct investment (FDI) net inflows
shrank 29.8% from the previous year to
US$4.95 billion in 2006.
• Accordingly, Korea ranked 47th in terms of
total FDI last year, 20 notches lower than the
27th the nation marked in 2005. The steep
drop came as global retailers like Carrefour
(US$1.6 billion) and Wall Mart (US$900
million) withdrew their investment from Korea.
Korea’s withdrawn FDI rose 54% from a year
earlier to US$5.16 billion.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
Nominal Exchange Rates
• 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.
© 2007 Thomson South-Western
Nominal Exchange Rates
• Assume the exchange rate between the
Japanese yen and U.S. dollar is 80 yen to one
dollar.
• One U.S. dollar trades for 80 yen.
• One yen trades for 1/80 (= 0.0125) of a dollar.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
Nominal Exchange Rates
• If a dollar buys more foreign currency, there is
an appreciation of the dollar.
• If it buys less there is a depreciation of the
dollar.
© 2007 Thomson South-Western
Nominal Exchange Rates – Won vs. Dollar
2000-01-04
2001-01-02
2002-01-02
2003-01-02
2004-01-02
2005-01-03
2006-01-02
2007-01-02
1122.5 KRW
1279 KRW
1317.4 KRW
1190 KRW
1195.1 KRW
1038 KRW
1010 KRW
925.4 KRW
© 2007 Thomson South-Western
Nominal Exchange Rates – Won vs. Dollar
© 2007 Thomson South-Western
Real Exchange Rates
• The real exchange rate is the rate at which a
person can trade the goods and services of one
country for the goods and services of another.
© 2007 Thomson South-Western
Real Exchange Rates
• The real exchange rate compares the prices of
domestic goods and foreign goods in the
domestic economy.
• If a case of German beer is twice as expensive as
American beer, the real exchange rate is 1/2 case of
German beer per case of American beer.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
Real Exchange Rates
• The real exchange rate is a key determinant of
how much a country exports and imports.
Nominal exchange rate ×Domestic price
Real exchange rate =
Foreign price
© 2007 Thomson South-Western
Real Exchange Rates
• A depreciation (fall) in the U.S. real exchange
rate means that U.S. goods have become
cheaper relative to foreign goods.
• This encourages consumers both at home and
abroad to buy more U.S. goods and fewer
goods from other countries.
© 2007 Thomson South-Western
Real Exchange Rates
• As a result, U.S. exports rise, and U.S. imports
fall, and both of these changes raise U.S. net
exports.
• Conversely, 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.
© 2007 Thomson South-Western
A FIRST THEORY OF
EXCHANGE-RATE DETERMINATION:
PURCHASING-POWER PARITY
• The purchasing-power parity theory is the
simplest and most widely accepted theory
explaining the variation of currency exchange
rates.
© 2007 Thomson South-Western
The Basic Logic of Purchasing-Power
Parity
• Purchasing-power parity is a theory of
exchange rates whereby a unit of any given
currency should be able to buy the same
quantity of goods in all countries.
• According to the purchasing-power parity
theory, a unit of any given currency should be
able to buy the same quantity of goods in all
countries.
© 2007 Thomson South-Western
The Basic Logic of Purchasing-Power
Parity
• The theory of purchasing-power parity is based
on a principle called the law of one price.
• According to the law of one price, a good must
sell for the same price in all locations.
• If the law of one price were not true,
unexploited profit opportunities would exist.
• The process of taking advantage of differences
in prices in different markets is called arbitrage.
© 2007 Thomson South-Western
The Basic Logic of Purchasing-Power
Parity
• If arbitrage occurs, eventually prices that
differed in two markets would necessarily
converge.
• According to the theory of purchasing-power
parity, a currency must have the same
purchasing power in all countries and exchange
rates move to ensure that.
© 2007 Thomson South-Western
Implications of Purchasing-Power Parity
• If the purchasing power of the dollar is always
the same at home and abroad, then the
exchange rate cannot change.
• The nominal exchange rate between the
currencies of two countries must reflect the
different price levels in those countries.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
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
© 2007 Thomson South-Western
Limitations of Purchasing-Power Parity
• 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.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western