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Principles of Economics
Session 15
Topics To Be Covered
Open and Closed Economies
Flow of Goods and Capital
Equality of Net Exports and Net Foreign
Investment
Nominal and Real Exchange Rate
Purchasing Power Parity Theory
The Market for Loanable Funds
Topics To Be Covered
The Market for Foreign-Currency Exchange
Marginal Propensity to Import
Output Determination in Open Economy
Balance of Payments
BP Curve
IS-LM-BP Model
Monetary and Fiscal Policies in Open Economy
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.
An Open Economy
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 Flow of Goods
 Exports
are domestically produced goods
and services that are sold abroad. They
mainly depend on exchange rates.
EX = f (e)
 Imports are foreign produced goods and
services that are sold domestically. They
mainly depend on output.
IM = f (Y)
The Flow of Goods
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
The Flow of Goods
 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.
The Internationalization of
the
Chinese
Economy
Percent
of GDP
50
40
30
20
10
0
1950 1955
1960
1965
1970
1975
1980 1985 1990 1995 2000
The Flow of Capital
Net foreign investment refers to the
purchase of foreign assets by domestic
residents minus the purchase of domestic
assets by foreigners.
A Chinese resident buys stock in the
Toyota corporation and an American buys
stock in the Sohu corporation.
The Flow of Capital
When a Chinese resident buys stock in
IBM, the purchase raises Chinese net
foreign investment.
When a Japanese resident buys a bond
issued by the Chinese government, the
purchase reduces the Chinese net foreign
investment.
The Equality of NX and NFI
 Net
exports (NX) and net foreign
investment (NFI) are closely linked.
 For an economy as a whole, NX and NFI
must balance each other so that:
NFI = NX
 This
holds true because every transaction
that affects one side must also affect the
other side by the same amount.
Saving, Investment, and 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 the
International Flows
National saving (S) equals Y-C-G so:
S = I + NX
or
Saving
=
Domestic +
Foreign
Investment
Investment
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.
The nominal exchange rate is expressed
in two ways:
 In
units of foreign currency per one Chinese
yuan.
 And in units of Chinese yuan per one unit of
the foreign currency.
Nominal Exchange Rates
 Assume
the exchange rate between the
U.S. dollar and the Chinese yuan is one
dollar to 8 yuan.
 One
U.S. dollar trades for 8 yuan.
 One yuan trades for 1/8 (=0.125) of a dollar.
Nominal Exchange Rates
 If
one yuan buys more foreign
currency, there is an appreciation of
the yuan.
 If it buys less there is a depreciation of
the yuan.
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.
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
Real
Nominal exchange rate x Domestic price
Exchange 
Foreign price
Rate
The
real exchange rate is a key
determinant of how much a
country exports and imports.
Real Exchange Rates
 A depreciation (fall)
in the Chinese real
exchange rate means that Chinese goods
have become cheaper relative to foreign
goods.
 This encourages consumers both at home
and abroad to buy more Chinese goods
and fewer goods from other countries.
Real Exchange Rates
 As
a result, Chinese exports rise, and
Chinese imports fall, and both of these
changes raise Chinese net exports.
 Conversely, an appreciation in the
Chinese real exchange rate means that
Chinese goods have become more
expensive compared to foreign goods, so
Chinese net exports fall.
Purchasing-Power Parity
 The
purchasing-power parity theory
(PPP theory) is the simplest and most
widely accepted theory explaining the
variation of currency exchange rates.
 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.
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.
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.
Basic Logic of
Purchasing-Power Parity
 If
arbitrage occurs, eventually prices that
differed in two markets would necessarily
converge.
 According to the theory of purchasingpower parity, a currency must have the
same purchasing power in all countries
and exchange rates move to ensure that.
Implications of
Purchasing-Power Parity
 If
the purchasing power of 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.
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.
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.
Fixed vs. Floating
Exchange Rates
 A country
has a fixed exchange rate if it
pegs its currency at a given exchange rate
and stands ready to defend that rate.
 Exchange rates which are determined by
market supply and demand are called
flexible exchange rates or floating
exchange rates.
The Market for
Loanable Funds
The market for loanable funds (capital
market) is one in which those who want
to save supply funds and those who want
to borrow to invest demand funds.
It is the market in which financial
resources (money, bonds, stocks) are
traded.
The Market for
Loanable Funds
S = I + NFI
At the equilibrium interest rate, the
amount that people want to save exactly
balances the desired quantities of
investment and net foreign investment.
The Market for
Loanable Funds
The supply of loanable funds comes from
national saving (S).
The demand for loanable funds comes
from domestic investment (I) and net
foreign investment (NFI).
The Market for
Loanable Funds
 The
supply and demand for loanable
funds depend on the real interest rate.
 A higher real interest rate encourages
people to save and raises the quantity of
loanable funds supplied.
 The interest rate adjusts to bring the
supply and demand for loanable funds
into balance.
Real
Interest
Rate
The Market for
Loanable Funds
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate
Demand for loanable
funds (for domestic
investment and net
foreign investment)
Equilibrium
quantity
Quantity of
Loanable Funds
The Market for
Loanable Funds
At the equilibrium interest rate, the
amount that people want to save exactly
balances the desired quantities of domestic
investment and net foreign investment.
The Market for
Foreign-Currency Exchange
 The
two sides of the foreign-currency
exchange market are represented by NFI and
NX.
 NFI represents the imbalance between the
purchases and sales of capital assets.
 NX represents the imbalance between exports
and imports of goods and services.
The Market for
Foreign-Currency Exchange
 In
the market for foreign-currency exchange,
the Chinese yuan is traded for foreign
currencies.
 For an economy as a whole, NFI and NX must
balance each other out, or:
NFI = NX
The Market for
Foreign-Currency Exchange
The price that balances the supply
and demand for foreign-currency is
the real exchange rate.
The Market for
Foreign-Currency Exchange
 The
demand curve for foreign currency is
downward sloping because a higher
exchange rate makes domestic goods
more expensive.
 The supply curve is vertical because the
quantity of dollars supplied for net
foreign investment is unrelated to the real
exchange rate.
The Market for
Foreign-Currency Exchange
Real
Exchange
Rate
Supply of RMB
(from net foreign investment)
Equilibrium
real exchange
rate
Demand for RMB
(for net exports)
Equilibrium
quantity
Quantity of RMB Exchanged
into Foreign Currency
The Market for
Foreign-Currency Exchange
 The
real exchange rate adjusts to balance
the supply and demand for RMB.
 At the equilibrium real exchange rate,
the demand for RMB to buy net exports
exactly balances the supply of RMB to be
exchanged into foreign currency to buy
assets abroad.
Marginal Propensity to Import
 The marginal propensity to import
(MPm) refers to the increase in the dollar
value of imports resulting from each
dollar increase in the value of GDP.
 Im port
MPm 
GDP
Output Determination
in Open Economy
Output=Expenditure
Expenditure
C = a + bY Slope(E1 )=b
E1 =C(Y) +I (r )+G
E2 =C(Y) +I(r )+G-IM(Y）
IM = mY
E2 = a +I+G+(b-m)Y
45°
0
Y2 Y1
Slope(E2 )=b-m
Output
Output Determination
in Open Economy
Expenditure
E2 =C(Y) +I(r )+G
+ EX(e) -IM(Y）
E1 =C(Y) +I(r )+G-IM(Y）
1. An
increase
in export…
0
Output=Expenditure
45°
Y2
Y1
2. …leads to an increase in output
Output
Equilibrium Output
in Open Economy
Planned aggregate expenditure in an open
economy equals:
E  C  I  G  EX  IM
In equilibrium:
Y  C  I  G  EX  IM
Y  a  bY  I  G  EX  mY
1
Y
( a  I  G  EX )
1b  m
The Open Economy Multiplier
1
Y
( a  I  G  EX )
1b  m
b = MPC
m = MPm
1 – b + m = 1 – MPC + MPm = MPS +MPm
The multiplier is:
1
Multiplier 
MPS ＋MPm
The Open Economy Multiplier
The multiplier in the closed economy is:
1
Multiplier 
MPS
The multiplier in the open economy is:
1
Multiplier 
MPS ＋MPm
The Balance of Payments
The balance of payment is a statement
showing all of a nation’s transactions
with the rest of the world for a given
period. It includes purchases and sales of
goods and services, gifts, government
transactions, and capital movements.
The Balance of Payments
Suppose the initial international
transaction was that a Chinese company
exported a plane to the U.S. for $100
million. The Chinese central bank bought
$10 million for CNY 80 million.
What was Chinese balance of payments
like for that year?
The Balance of Payments
Debit
Credit
Current Account
Export
Import
100,000,000
0
Balance on current account
100,000,000
Capital Account
Private
Official Reserves
Balance on capital account
90,000,000
10,000,000
100,000,000
The Balance of Payments
Net Debits (-) or Credits (+)
Current Account
Export
100,000,000
Import
0
Balance on current account
100,000,000
Capital Account
Private
Official Reserves
Balance on capital account
Statistical Discrepancy
Balance of Payments
－90,000,000
－10,000,000
－ 100,000,000
0
0
The Balance of Payments
United States Balance of Payments, 1999 (in billion dollars)
CURRENT ACCOUNT
(1) Net export of goods
(2) Net export of services
(3) Net investment income
(4) Net transfer payments
(5) Balance on current account (1 + 2 + 3 + 4)
CAPITAL ACCOUNT
(6) Change in private U.S. assets abroad (increase is –)
(7) Change in foreign private assets in the United States
(8) Change in U.S. government assets abroad (increase is –)
(9) Change in foreign government assets in the U.S.
(10) Balance on capital account (6 + 7 + 8 + 9)
STATISTICAL DISCREPENCY
BALANCE OF PAYMENTS (5 + 10 + 11)
– 347.2
79.6
– 24.7
– 46.6
– 338.9
– 381.0
706.2
8.3
44.5
378.0
– 39.1
0
The Balance of Payments
A country’s current account is the sum of its:
 net
exports (exports minus imports),
 net income received from investments abroad, and
 net transfer payments from abroad.
Exports earn foreign exchange and are a
credit (+) item on the current account.
Imports use up foreign exchange and are a
debit (–) item.
The Balance of Payments
The balance of trade is the difference
between a country’s exports of goods and
services and its imports of goods and
services.
A trade deficit occurs when a country’s
exports are less than its imports.
The Balance of Payments
Investment income consists of holdings of
foreign assets that yield dividends, interest,
rent, and profits paid to U.S. asset holders
(a source of foreign exchange).
Net transfer payments are the difference
between payments from the United States
to foreigners and payments from
foreigners to the United States.
The Balance of Payments
The balance on current account consists of net
exports of goods, plus net exports of services, plus
net investment income, plus net transfer payments.
It shows how much a nation has spent relative to
how much it has earned.
For each transaction recorded in the current
account, there is an offsetting transaction recorded
in the capital account.
The Balance of Payments
The capital account records the changes in
assets and liabilities.
The balance on capital account in the United
States is the sum of the following (measured
in a given period):
 the
change in private U.S. assets abroad
 the change in foreign private assets in U.S.
 the change in U.S. government assets abroad
 the change in foreign government assets in U.S.
The Balance of Payments
In the absence of errors, the balance on
capital account would equal the negative of
the balance on current account.
If the capital account is positive, the change
in foreign assets in the country is greater
than the change in the country’s assets
abroad, which is a decrease in the net wealth
of the country.
The BP Curve
The BP curve is a graph of all combinations
of interest (r) and output (Y) that result
in foreign exchange market equilibrium.
Deriving the BP Curve
The BP Curve
Net Foreign Investment
r
r2
r
r2
E2
r1
E2
r1
E1
NFI2 NFI1
BP Curve
NFI
E1
Y1
Y2
Y
Deriving the BP Equation
NX  EX  IM
 ( g1  m1e )  ( g2  nY  m2 e )
 g  nY  me
n =marginal propensity to import
e =real exchange rate
g＞ 0, n ＞ 0, m ＞ 0
NFI  a( r *  r )
r* =foreign interest rate
r =domestic interest
a ＞ 0
Deriving the BP Equation
BP  NX＋NFI  0
g  nY  me  a( r *  r )  0
g m
n
r  r*   e  Y
a a
a
Deriving the BP Curve
An increase in income (GDP) increases the
import, decreases the net export, in turn
decreases NFI.
NFI decrease is responsive to a higher interest.
GDP
increases
Import
increases
NX
decreases
NFI
decreases
Interest
rate
increases
The BP Curve
r
BP Surplus
BP＞0
B
BP
A
BP Deficit
BP＜0
C
F
G
D
IS
Y
The BP Curve
If there exists an BP surplus, the supply of
foreign currencies is greater than the
demand for them. Foreign currencies are
likely to depreciate, while the domestic
currency tends to appreciate.
If there exists an BP deficit, the demand for
foreign currencies is greater than the supply.
Foreign currencies are likely to appreciate,
while the domestic currency tends to
depreciate.
Exchange Rate and
BP Curve Changes
r
BP(e1)
BP(e2)
Lower exchange
rate moves the BP
curve rightward
Y
The IS-LM-BP Model
r
LM
BP
Equilibrium
interest rate
E
IS
Equilibrium output
Y
The IS-LM-BP Model
r
LM
BP1
BP2
r2
E2
r1
E1
IS2
IS1
Y1
Y2
Y
The IS-LM-BP Model
At E1, both the goods market and money market are in
equilibrium, but the foreign exchange market is not,
for BP is of deficit. The demand for foreign exchange is
greater than the supply. The domestic currency will
depreciate. The BP curve tends to move downward
 The depreciation of domestic currency will lead to
more NX, thus driving the IS curve rightward. Finally
the three markets reach an equilibrium at E2.

Fiscal Policy and IS-LM-BP in
Floating Exchange Rate Context
r
LM
E2
r2
BP2
E3
r3
BP1
r1
IS2
E1
Y1
IS3
Y3 Y2
IS1
Y
Fiscal Policy and IS-LM-BP in
Floating Exchange Rate Context
 An
expansionary fiscal policy moves the IS
curve rightward, and the goods market and
money market is in equilibrium at E2.
 At E2, there exists BP surplus in the foreign
exchange market, the domestic currency
tends to appreciate.
 The appreciation will decrease the NX, and
thus pushing IS curve leftward until E3.
Fiscal Policy and IS-LM-BP in
Floating Exchange Rate Context
 In
the open economy, the expansionary fiscal
policy has crowding-out effect not only on
the domestic investment, but on net export.
 Therefore, the multiplier effect of
expansionary fiscal policy is not significant.
In Japan, for example, the multiplier is
estimated to be only 1.2.
Monetary Policy and IS-LM-BP in
Floating Exchange Rate Context
r
LM1
LM2
BP1
r1
r3
BP2
E1
E3
r2
IS2
E2
IS1
Y1
Y2
Y3
Y
Monetary Policy and IS-LM-BP in
Floating Exchange Rate Context
 If
the central bank effects an expansionary
monetary policy, the LM curve moves to the
right.
 The goods market and money market are of
equilibrium at E2, but the foreign exchange
market faces a BP deficit—demand for
foreign currency is greater than supply.
 The domestic currency tends to depreciate,
which moves the BP curve downward.
Monetary Policy and IS-LM-BP in
Floating Exchange Rate Context
 The
depreciation of domestic currency
encourages export, thus moving the IS
curve rightward.
 The open economy equilibrate at E3.
 In the open economy, the monetary
policy is very effective.
Fiscal Policy and IS-LM-BP in
Fixed Exchange Rate Context
r
LM1
LM2
r2
r3
E2
r1
BP
E3
E1
Y1
IS2
Y2 Y3
IS1
Y
Fiscal Policy and IS-LM-BP in
Fixed Exchange Rate Context
 Suppose
the government adopts an
expansionary policy, the IS curve moves
rightward.
 At E2, the goods and money markets reach
an equilibrium, but the foreign exchange
market does not. There exists the BP surplus.
As a result, the domestic currency
depreciate.
Fiscal Policy and IS-LM-BP in
Fixed Exchange Rate Context
 Since
the rates between currencies should
remain fixed, the central bank is obliged to
buy foreign currencies.
 The purchase of foreign currencies increases
the supply of domestic currency, shifting the
LM curve right.
 Fiscal policies in the fixed exchanged foreign
rate context are effective.
Monetary Policy and IS-LM-BP in
Fixed Exchange Rate Context
r
LM1
BP
E1
r1
r2
LM2
E2
IS
Y1 Y2
Y
Monetary Policy and IS-LM-BP in
Fixed Exchange Rate Context
 If
the central bank increases its money
supply, the LM curve shifts right.
 At E2, the goods and money market are of
equilibrium, while the foreign exchange
market isn’t, for there exists an BP deficit.
 The strong demand for foreign currencies
will lead to the depreciation of domestic
currencies.
Monetary Policy and IS-LM-BP in
Fixed Exchange Rate Context
 To
keep the fixed exchange rates constant,
the central bank has to sell foreign
currencies it holds as reserves.
 The selling of foreign currencies means the
reduction of money supply, this will bring
back the LM curve.
 So monetary policies in the open economy is
of little or even no effect.
Assignment
Review Chapter 31 and 34
What are the benefits and harms of
keeping the Chinese currency from
depreciation during the Asian financial
crises? (Group work)
Revision for the Final Exam
Review the whole book.
Answer multiple-choice questions in your handouts.
Pay special attention to the following questions:







58—4
78—1
130—6
153—8
169—6
187—9
224—3
58—6
79—7
153—2
169—2
186—1
206—9
264—1
Revision for the Final Exam
How is China’s GDP in recent years and its
prospect in the future?
Discuss China’s fiscal and monetary policies.
How are China’s price level and employment
in recent years? What measures has the
government taken to improve them?
Thanks