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Chapter
31
Open-Economy
Macroeconomics:
Basic Concepts
Key Questions for Chapter 31
• Define Net Exports, Trade Balance, Trade
Surplus, Trade Deficit, Net Capital Outflow.
• How is saving related to Trade?
• What is the Nominal Exchange Rate? How is
it found?
• What is the Real Exchange Rate? How is it
found?
• What is the Theory of Purchasing Power
Parity? Does it really work?
2
International Flows of Goods & Capital
• Closed economy
– Does not interact with other economies in the
world
• Open economy
– Interacts freely with other economies around
the world
3
International Flows of Goods & Capital
• Flow of goods: exports, imports,& net exports
• Exports
– Goods & services produced domestically and
sold abroad
• Imports
– Goods and services produced abroad and sold
domestically
4
International Flows of Goods & Capital
• Flow of goods: exports, imports,& net exports
• Net exports
– Value of a nation’s exports minus the value of
its imports
– Also called trade balance
• Trade balance
– Value of a nation’s exports minus the value of
its imports
– Also called net exports
5
International Flows of Goods & Capital
• Flow of goods: exports, imports,& net exports
• Trade surplus
– Excess of exports over imports
• Trade deficit
– Excess of imports over exports
• Balanced trade
– Exports equal imports
6
International Flows of Goods & Capital
• Factors - influence a country’s exports,
imports, and net exports:
• Tastes of consumers for domestic & foreign goods
• Prices of goods at home and abroad
• Exchange rates
– People use domestic currency to buy foreign currencies
• Incomes of consumers at home and abroad
• Cost of transporting goods from country to country
• Government policies toward international trade
7
International Flows of Goods & Capital
• Flow of financial resources: net capital outflow
• Net capital outflow
– Purchase of foreign assets by domestic
residents
• Foreign direct investment
• Foreign portfolio investment
– Minus the purchase of domestic assets by
foreigners
8
International Flows of Goods & Capital
• Variables that influence net capital outflow
– Real interest rates paid on foreign assets
– Real interest rates paid on domestic assets
– Perceived economic and political risks of
holding assets abroad
– Government policies that affect foreign
ownership of domestic assets
9
International Flows of Goods & Capital
• Equality of net exports & net capital outflow
• Net exports (NX)
– Imbalance between a country’s exports and
its imports
• Net capital outflow (NCO)
– Imbalance between amount of foreign assets
bought by domestic residents and the
amount of domestic assets bought by
foreigners
• Identity: NCO = NX
10
International Flows of Goods & Capital
• Equality of net exports & net capital outflow
• When NX > 0 (trade surplus)
– Selling more goods and services to foreigners
than it is buying from them
– From net sale of goods and services
• Receives foreign currency
• Buy foreign assets
• Capital - flowing out of the country: NCO > 0
11
International Flows of Goods & Capital
• Equality of net exports & net capital outflow
• When NX < 0 (trade deficit)
– Buying more goods and services from
foreigners than it is selling to them
– The net purchase of goods and services
• Needs financed
• Selling assets abroad
• Capital - flowing into the country: NCO < 0
12
International Flows of Goods & Capital
• Saving, investment, & relationship to
international flows
• Open economy: Y = C + I + G + NX
• National saving: S = Y – C – G
• Y – C – G = I + NX
• S = I + NX
• NX = NCO
• S = I + NCO
• Saving = Domestic investment + Net capital
outflow
13
International Flows of Goods & Capital
• Trade surplus: Exports > Imports
• Net exports > 0; Y > Domestic spending (C+I+G)
• S > I and NCO > 0
• Trade deficit: Exports < Imports
• Net exports < 0; Y < Domestic spending (C+I+G)
• S < I and NCO < 0
• Balanced trade : Exports = Imports
• Net exports = 0; Y = Domestic spending (C+I+G)
• S = I and NCO = 0
14
•What is Net Capital
Outflow?
•What does it affect?
•What affects it?
• In groups, report (using both words and
graphs) how each variable influences Net
Capital Outflow:
h
–The real interest rate paid on foreign assets
–The real interest rates paid on domestic
assets
–The perceived economic and political risks
of holding assets abroad
–The governmental policies that affect
foreign ownership of domestic assets
Table
1
International flows of goods and capital: summary
Trade deficit
Exports < Imports
Net Exports < 0
Y<C+I+G
Saving < Investment
Net Capital Outflow < 0
Balanced trade
Trade surplus
Exports = Imports
Net Exports = 0
Y=C+I+G
Saving = Investment
Net Capital Outflow = 0
Exports > Imports
Net Exports > 0
Y>C+I+G
Saving > Investment
Net Capital Outflow > 0
This table shows the three possible outcomes for an open economy.
17
Is the U.S. trade deficit a national
problem?
• Past two decades
– Borrowed heavily in world financial markets to
finance large trade deficits
• Before 1980,
– National saving & domestic investment were close
• Small net capital outflow
• After 1980
– National saving fell substantially below investment
• Net capital outflow - a large negative number
• Capital inflow
– U.S. is going into debt
18
Is the U.S. trade deficit a national
problem?
• Changes in capital flows
– Arise from changes in saving
– Arise from changes in investment
• 1980 to 1987
– Increase flow of capital
• Decline in national saving
– Decline public saving
» Increase in government budget deficit
19
Is the U.S. trade deficit a national
problem?
• 1991 to 2000
– Increase flow of capital
• Saving increased
• Budget surplus
• Investment increased
• 2000 to 2006
– Increase in capital flow
– Investment boom – abated
– Budget deficits
– National saving - fell to extraordinarily low levels
20
Figure 2
National saving, domestic investment,& net capital outflow (a)
Panel (a) shows national saving and domestic investment as a percentage of GDP. You can see
from the figure that national saving has been lower since 1980 than it was before 1980. This fall
in national saving has been reflected primarily in reduced net capital outflow rather than in
21
reduced domestic investment.
Figure 2
National saving, domestic investment,& net capital outflow (b)
Panel (b) shows net capital outflow as a percentage of GDP. You can see from the figure that
national saving has been lower since 1980 than it was before 1980. This fall in national saving
has been reflected primarily in reduced net capital outflow rather than in reduced domestic
22
investment.
Prices for International Transactions
• Nominal exchange rate
– Rate at which a person can trade currency of
one country for currency of another
• Appreciation (strengthen): Increase in the
value of a currency
• Measured by the amount of foreign currency it
can buy
• Depreciation (weaken): Decrease in the value
of a currency
• Measured by the amount of foreign currency it
can buy
23
Prices for International Transactions
• Real exchange rate
– Rate at which a person can trade goods and
services of one country
• For goods and services of another
Nominal exchange rate  Domestic price
Real exchange rate 
Foreign price
• Real exchange rate = (e ˣ P) / P*
• e – nominal exchange rate between the U.S.
dollar and foreign currencies
• P – price index for U.S. basket
• P* - price index for foreign basket
24
Purchasing-Power Parity
• Purchasing-power parity
– 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
– Based on law of one price
• A good must sell for the same price in all
locations
25
Purchasing-Power Parity
• The basic logic of purchasing-power parity
• Arbitrage
– Take advantage of price differences for the
same item in different markets
• Parity
– Equality
• Purchasing-power
– Value of money in terms of quantity of goods
it can buy
26
Purchasing-Power Parity
• Implications of purchasing-power parity
• If purchasing power of the dollar is always
the same at home and abroad then the real
exchange rate cannot change
• Nominal exchange rate between the
currencies of two countries must reflect the
price levels in those countries
27
Purchasing-Power Parity
• Limitations of purchasing-power parity
• Theory of purchasing-power parity does not
always hold in practice
1. Many goods are not easily traded
2. Even tradable goods are not always perfect
substitutes
• When they are produced in different countries
• No opportunity for profitable arbitrage
28
Purchasing-Power Parity
• Limitations of purchasing-power parity
• Real exchange rates fluctuate over time
• Large & persistent movements in nominal
exchange rates typically reflect changes in
price levels at home and abroad
29
The hamburger standard
• Data on - basket of goods consisting of
– “Two all-beef patties, special sauce, lettuce, cheese,
pickles, onions, on a sesame seed bun”
• “Big Mac” - sold by McDonald’s around the world
• July 2007, price of a Big Mac = $3.41 in U.S.
• According to purchasing power parity
– Cost of “Big Mac” – same in both countries
– Predicted exchange rate = Price in foreign country
(in foreign currency) divided by price in U.S.
30
Big Mac
3.57
2.29
3697.99
320
$3.69
$3.50
$3.60
Money Neutrality
3.57
2.29
3697.99
320
$3.69
$3.50
$3.60
It does not matter what your money supply, prices will eventually return
to a normal state. To use the words of economics, classical dichotomy
tells us prices do not affect real variables.
Key Questions for Chapter 31 Review
• Define Net Exports, Trade Balance, Trade
Surplus, Trade Deficit, Net Capital Outflow.
• How is saving related to Trade?
• What is the Nominal Exchange Rate? How is
it found?
• What is the Real Exchange Rate? How is it
found?
• What is the Theory of Purchasing Power
Parity? Does it really work?
33
Question 1
 When a country's central bank increases the
money supply, its
 a. price level rises and its currency appreciates
relative to other currencies in the world.
 b. price level rises and its currency depreciates
relative to other currencies in the world.
 c. price level falls and its currency appreciates
relative to other currencies in the world.
 d. price level falls and its currency depreciates
relative to other currencies in the world.
 e. price level falls but its currency remains the
same relative to other currencies in the world.
Question 2
 When a country's central bank decreases the
money supply, its
 a. price level rises and its currency appreciates
relative to other currencies in the world.
 b. price level falls and its currency appreciates
relative to other currencies in the world.
 c. price level rises and its currency depreciates
relative to other currencies in the world.
 d. price level falls and its currency depreciates
relative to other currencies in the world.
 e. price level rises but its currency remains the
same relative to other currencies in the world.
Question 3
 When a country's central bank increases the money supply, a
unit of money
 a. gains value both in terms of the domestic goods and
services it can buy and in terms of the foreign currency it can
buy.
 b. gains value in terms of the domestic goods and services it
can buy, but loses value in terms of the foreign currency it can
buy.
 c. loses value in terms of the domestic goods and services it
can buy, but gains value in terms of the foreign currency it can
buy.
 d. loses value both in terms of the domestic goods and
services it can buy and in terms of the foreign currency it can
buy.
 e. loses value in terms of the domestic goods it can buy, but
not services, and loses value in terms of the foreign currency it
can buy.
Question 4
 You hold currency from a foreign country. If that
country has a higher rate of inflation than the United
States, then over time the foreign currency will buy
 a. more goods in that country and buy more dollars.
 b. more goods in that country but buy fewer dollars.
 c.
fewer goods in that country but buy more dollars.
 d. fewer goods in that country and buy fewer
dollars.
 e. fewer goods in that country but the same
number of dollars.
Question 5
• If a country had a trade surplus of $50 billion
and then its exports rose by $30 billion and
its imports rose by $20 billion, its net exports
would now be
• a. $0 billion.
• b. $20 billion.
• c. $40 billion.
• d. $60 billion.
• e. $100 billion.