Transcript Open-Economy Macroeconomics: Basic Concepts

Open-Economy
Macroeconomics: Basic
Concepts
Closed Vs. Open Economies
• 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 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
• 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.
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.
• 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.
– 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.
Determinants of 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.
– 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.
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
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.
– 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.
Determinants of 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.
Monetary Economy Revisited Again:
Net Exports = Net Capital Flow
• For an economy as a whole, net exports (NX) and net
capital outflow (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.
– Example: If Boeing exports a plane to Japan, NX rises, but, in the
simplest case Boeing obtains yen, which increase NCO. In the
more complex case, the Japanese company may purchase dollars,
but someone with dollars is ending up with yen. If the Japanese
buyers get a loan from Boeing, Boeing has acquired a foreign
financial asset.
Saving, Investment, and Their
Relationship to the International Flows
• Net exports (NX) is a component of GDP:
Y = C + I + G + NX, or
Y - C - G = I + NX
• National saving (S) is the income of the
nation that is left after paying for current
consumption and government purchases or
S=Y–C-G
• Therefore,
S = I + NX
• Lastly since NX is equal to NCO,
S = I + NCO
• National Saving can be saved in two ways,
through domestic investment of in foreign assets.
• Remember, S underlies the supply of loanable
funds and I, and now NCO, underlies the demand
for loanable funds.
Table 1 International Flows of
Goods and Capital: Summary
Copyright©2004 South-Western
S, I and Net Capital Outflow
• Note in the succeeding panels that S – I = NCO.
• Until the 1980s, NCO and hence the trade deficit was
small. After 1980, we have had a recurring trade deficit
(NCO is negative – the ROW is holding US financial
assets.
• Is the recurring deficit a problem?
– 1980-1987 NCO went from -.5% to –3.0% of GDP, 2.1% came
from a drop in S (the Reagan budget deficits). Therefore, the trade
deficit helped sustain I. If not, I would have fallen affecting future
growth.
– 1991-2000 NCO went from -.3% to –3.7% attributable not to a
decline in savings (which increased) but to increases in investment
(primarily in the info. Tech sector). The NCO helped fuel the
investment boom.
– Whether because S fell or I rose, NCO can help to sustain I and
therefore future growth, BUT we must grow to help pay off the
debt. In many developing countries, this has NOT occurred
leading to higher interest payments.
Figure 2 National Saving, Domestic Investment,
and Net Capital Outflow
(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 Capital Outflow
(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
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.
• 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.
• http://www.xe.com/ucc/ a internet based currency
converter (can’t be used on tests!)
• Assume the exchange rate between the Japanese
yen and U.S. dollar is 80 yen to one dollar.
– One U.S. dollar trades for 113 yen (10/24/2007).
– One yen trades for 1/113 (= 0.00885) of a dollar.
• Appreciation refers to an increase in the value of a
currency as measured by the amount of foreign
currency it can buy.
– If a dollar buys more foreign currency, there is an
appreciation of the dollar. (say 120 yen)
• Depreciation refers to a decrease in the value of a
currency as measured by the amount of foreign
currency it can buy.
– If it buys less there is a depreciation of the dollar (say
80 yen).
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.
• Trading depends on the physical quantities that can be
exchanged at given exchange rates AND the prices of the
good in each country
• Example, a Honda in Japan costs 4,000,000 yen and
$20,000 in the US. Assuming an exchange rate of 100
yen/dollar, the Honda costs Y2,000,000 in the US. Thus,
Hondas are ½ as expensive in the US OR two times more
expensive in Japan.
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 Rate = Exchange Rate x PUS
PROW
– Example above EP/P*= 100 yen/dollar x $20,000
Y4,000,000
= ½ HondaJAPAN/1 HondaUS
• The real exchange rate is a key determinant of
how much a country exports and imports.
• Real Exchange Rate = Exchange Rate x PUS
PROW
• A depreciation (fall) in the U.S. real exchange rate means
that U.S. goods have become cheaper relative to foreign
goods and so net exports rise.
– 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, and both of these changes raise
U.S. net exports.
• 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.
– Discourages consumers both at home and abroad to from buying
U.S. goods and encourages buying more goods from other
countries. As a result, U.S. exports fall, and U.S. imports rise, and
both of these changes decrease U.S. net exports.
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 exchange rates and
posits that a unit of any given currency should be
able to buy the same quantity of goods in all
countries
• 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 countries.
• If the law of one price were not true, unexploited
profit opportunities would exist and arbitrage
would occur (arbitrage is a fancy term for trading
or buying low and selling high)..
• If arbitrage occurs, eventually prices that differed
in two markets would necessarily converge, and
exchange rates move to ensure that a currency
would have the same purchasing power in all
countries.
Implications of Purchasing-Power Parity
• If the purchasing power of the dollar is always the
same at home and abroad, then the exchange rate
would be constant.
• The nominal exchange rate between the currencies
of two countries must reflect the different price
levels in those countries and the real exchange rate
would be equal to 1.
• Therefore, if a central bank prints large quantities
of money, the price level rises (QTofM) and its
value in buying goods and services and other
currencies falls.
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
• The Big Mac Index
• http://www.economist.com/displaystory.cfm?story_id=1730909
• New Index Starbucks
• http://www.economist.com/displaystory.cfm?story_id=2361072
• Why don’t real exchange rates always equal one?
– 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.
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 purchasingpower 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.