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VI
THE MACROECONOMICS OF OPEN ECONOMIES
Open-Economy
Macroeconomics:
Basic Concepts
13
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 (that is, no borrowing (of money) from
foreigners and no lending (of money) to foreigners).
• An open economy is one that interacts freely
with other economies around the world.
An Open Economy
• An open economy interacts with other countries
in two ways.
• It buys and sells goods and services in world
product markets. (This is called free international
trade.)
• It buys and sells capital assets in world financial
markets. That is, it allows its citizens to borrow
money from or lend money to foreigners. (This is
called free international finance.)
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.
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.
• Net exports could be positive, negative or zero.
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 is a situation in which net
exports are zero.
• Exports = Imports
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 sell
domestic currency to buy foreign currencies.
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. That is, the level of barriers
(such as tariffs and quotas on imports) imposed
against free trade.
The U.S. is an Open Economy
• 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.
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
Copyright © 2004 South-Western
Increasing openness of the U.S.
economy: reasons
• Improvements in transportation
• Advances in telecommunications
• Goods produced with modern technology are
often light and easy to transport
• International agreements have gradually
lowered tariffs, import quotas, and other trade
barriers
The Flow of Financial Resources: Net Capital
Outflow
• Net Capital Outflow (NCO)
• = purchase of foreign assets by domestic
residents - purchase of domestic assets by
foreigners
• = lending to foreigners - borrowing from
foreigners.
• = capital outflow – capital inflow
• = Net Capital Outflow
Net Capital Outflow
• Net Capital Outflow can be:
• Positive, when we lend more than we borrow
• Zero, when we lend just as much as we borrow
• Negative, when we lend less than we borrow
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.
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.
The Equality of Net Exports and Net Capital Outflow
• Net exports (NX) and net capital outflow (NCO)
are closely linked.
• For an economy as a whole, NX and NCO must
balance each other so that:
NCO = NX
• This holds true because excess purchases of
goods and services from foreigners must be
paid for with excess sales of assets.
The Equality of Net Exports and Net Capital Outflow
• Suppose
• Exports = $120
• Imports = $100
• Net Exports = $20
• Foreigners got $100 by selling us their stuff.
Then they spent an additional $20 on our stuff.
How did they get the additional $20?
• We must have given them a loan of $20. That is
our net lending to them must have been $20.
• Therefore, Net Capital Outflow = $20
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
S = I + NX
S = I + NCO
Table 1 International Flows of Goods
and Capital: Summary
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
Copyright © 2004 South-Western
Figure 2 National Saving, Domestic Investment, and
Net Foreign Investment
(b) Net Capital Outflow (as a percentage of GDP)
Percent
of GDP
4
3
2
Net capital
outflow
1
0
–1
–2
–3
–4
1960
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © 2004 South-Western
Is the U.S. trade deficit a national
problem?
• After 1980, national saving fell considerably
below investment and, therefore, net capital
outflow became a large negative number
• The gap was caused by
• Falling saving during the 1980s, and
• Rising investment during the 1990s. Therefore,
• Foreign debt stabilized investment in the 1980s
and amplified it in the 1990s.
• Would we be able to get a high enough return
on the investments to repay our foreign debts?
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:
• In units of foreign currency per one U.S. dollar.
• And in units of U.S. dollars per one unit of the
foreign currency.
Nominal Exchange Rates
• Assume the exchange rate between the
Japanese yen (¥) and U.S. dollar is 100 yen to
one dollar.
• $1.00 = ¥100
• $0.01 = ¥1.
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
• If the price of a dollar increases (say, from
¥100 to ¥120), there is an appreciation of the
dollar.
• If the price of a dollar decreases (say, from
¥100 to ¥80), there is a depreciation of the
dollar.
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.
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.
Real Exchange Rates
• Suppose:
• Price of U.S. wheat is P = $4.00 per ton
• Price of French wheat is P* = €2.00 per ton
• Price of a dollar is e = €3.00 per dollar
• Note that:
• Price of a ton of U.S. wheat is $4.00 or,
equivalently, €12.00 (because each dollar is worth 3
euros)
• Therefore, a ton of U.S. wheat costs the same as 6
tons of French wheat
• Therefore, the real exchange rate = 6.
Real Exchange Rates
• Recap: How did we get 6 as the real exchange
rate?
• We multiplied 3 and 4 and divided the result by 2.
That is,
• We calculated e × P / P*.
Real Exchange Rates
• Suppose:
• Price of U.S. wheat is P = $4.00 per ton
• Price of French wheat is P* = €6.00 per ton
• Price of a dollar is e = €3.00 per dollar
• Note that:
• Price of a ton of U.S. wheat is $4.00 or,
equivalently, €12.00 (because each dollar is worth 3
euros)
• Therefore, a ton of U.S. wheat costs the same as 2
tons of French wheat
• Therefore, the real exchange rate = 2.
Real Exchange Rates
• Recap: How did we get 2 as the real exchange
rate?
• We multiplied 3 and 4 and divided the result by 6.
That is,
• We calculated e × P / P*.
• Therefore, we see that, in general,
• Real Exchange Rate = e × P / P*.
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.
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
Real Exchange Rates: Effect of Depreciation
• 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.
• As a result, U.S. exports rise, and U.S. imports
fall. Therefore,
• U.S. net exports increase.
Real Exchange Rates: Effect of Appreciation
• 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.
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.
The Basic Logic of Purchasing-Power Parity
• 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.
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.
The Basic Logic of Purchasing-Power Parity
• 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.
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.
Price level in U.S.  Value of a dollar in yen  Price level in Japan
Nominal value of a dollar in yen 
Price level in Japan
Price level in the U.S.
The Basic Logic of Purchasing-Power Parity
Price level in U.S.  Value of a dollar in yen  Price level in Japan
• The purchasing-power parity equation above can be
rewritten in two ways:
value of dollar in yen  price in U.S.
1
price in Japan
Nominal value of a dollar in yen 
Price level in Japan
Price level in the U.S.
The Basic Logic of Purchasing-Power Parity
value of dollar in yen  price in U.S.
1
price in Japan
• We just saw that the purchasing-power parity equation
can be rewritten as the equation above
• This equation simply means that
• The real exchange rate = 1.
Implications of Purchasing-Power Parity
Price level in Japan
Nominal value of a dollar in yen 
Price level in the U.S.
• We also saw that purchasing-power parity implies the
equation above. This equation means that:
• The nominal exchange rate between the currencies of
two countries must reflect the different price levels in
those countries.
• When prices rise in the U.S., the dollar is worth less in
yen.
Implications of Purchasing-Power Parity
• When the central bank prints large quantities of
money, the money loses value in two ways:
• It buys fewer goods and services, as we saw in
chapter 30, and
• It buys smaller amounts of other currencies, as we
saw in the previous slide
Figure 3 Money, Prices, and the Nominal Exchange
Rate During the German Hyperinflation
Indexes
(Jan. 1921 5 100)
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
Copyright © 2004 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.
The Hamburger Standard
• See The Economist’s
Web site
• See this Web site
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.
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.
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.
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.
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.