Transcript real exchange rate

A Macroeconomic Theory
of the Open Economy
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
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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.
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.
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.
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.
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.
A U.S. resident buys stock in the Toyota
corporation and a Mexican buys stock in the
Ford Motor corporation.
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.
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.
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 every transaction
that affects one side must also affect the
other side by the same amount. (double-entry
bookkeeping, 複式簿記)
•複式簿記舉例:
•電腦廠出口電腦賺得美金100萬
出口 +100
外國資產(美金) +100 => NCO +100
Balance of Payments
• A country’s balance of payments accounts
are a summary of the country’s transactions
with other countries.
• A country’s balance of payments on current
account, or current account, is its balance of
payments on goods and services plus net
international transfer payments and factor
income.
• The merchandise trade balance, or trade
balance, is the difference between a
country’s exports and imports of goods.
• A country’s balance of payments on
financial account, or simply its financial
account, is the difference between its sales of
assets to foreigners and its purchases of
assets from foreigners during a given period.
• A fundamental rule of balance of payments
accounting for any country is:
current account (CA) +
financial account (FA) = 0
Or,
CA = –FA
Table 29-1
CURRENT ACCOUNT
The Balance of
Payments, 2010
(billions of dollars)
Exports of goods
$1,289
Imports of goods
−1,935
−646
Balance of trade
Exports of services
549
Imports of services
−403
Balance of services
146
Income received on investments
663
Income payments on investments
−498
Net income on investments
The sum of the
balance of trade
and the balance
of services equals
net exports.
165
Net transfers
−136
Balance on current account
−471
FINANCIAL ACCOUNT
Increase in foreign holdings of assets in
the United States
Increase in U.S. holdings of assets in
foreign countries
Balance on financial account
BALANCE ON CAPITAL ACCOUNT
Statistical discrepancy
Balance of payments
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
1,259
−1,005
254
0
217
0
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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
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
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
A Strong Dollar Hurts McDonald’s Profits
• The recession of 2007-2009 was a period of
prosperity for McDonald’s.
Its success continued into 2010, but with limited
growth in the U.S. market, McDonald’s has been
expanding in foreign markets.
• Since McDonald’s revenue comes from many
different currencies, its revenue and profits are
affected by fluctuations in the value of the dollar in
foreign exchange markets.
• For McDonald’s, the revenue measured in local
currencies is less than the revenue in terms of
dollars. Since the value of the dollar has
increased, converting foreign currencies to dollars
has yielded fewer dollars.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
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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.
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.
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.
• 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
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
• Nominal exchange rate = 30 NTD/USD
• Real exchange rate
= Nominal exchange rate
x
𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑃𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙
𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑃𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙
• Nominal exchange rate = E foreign dollar per
domestic dollar
Pforeign
• Real exchange rate = e e  E 
Pdomestic
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.
• The real exchange rate is a key determinant
of how much a country exports and imports.
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.
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.
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
• 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.
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.
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.
• Suppose a hamburger is $1 USD in US. If the
law of one price is true, the same hamburger
should be $1 x Exchange rate NTD in Taiwan.
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 purchasing-power
parity, a currency must have the same
purchasing power in all countries and
exchange rates move to ensure that.
• Law of one price:
phamburger,US  E  phamburger,TW N
• Purchasing Power Parity (PPP):
PUS  E  PTW N
• PPP implies:
E  PUS
real exchange rate  e 
1
PTW N
• PPP implies:
E PTW N PUS


E
PTW N
PUS
 TWN inflation rate - US inflation rate
Making
the
The Big Mac Theory of
Exchange Rates
Connection
The Economist magazine
regularly compares the prices of Big Macs in
different countries. If purchasing power parity
holds, you should be able to take the dollars
required to buy a Big Mac in the United States and
exchange them for the amount of foreign currency
needed to buy a Big Mac in any other country.
Is the price of a Big Mac in Buenos
Aires the same as the price of a Big
Mac in New York?
COUNTRY
BIG MAC PRICE
IMPLIED EXCHANGE RATE
ACTUAL EXCHANGE RATE
Mexico
32.0 pesos
7.86 pesos per dollar
11.70 pesos per dollar
Japan
320 yen
78.62 yen per dollar
78.40 yen per dollar
United Kingdom
2.39 pounds
0.59 pound per dollar
0.61 pound per dollar
Switzerland
6.50 Swiss francs
1.60 Swiss francs per dollar
0.81 Swiss francs per dollar
Indonesia
22,534 rupiahs
5,537 rupiahs per dollar
8,523 rupiahs per dollar
Canada
4.73 Canadian dollars
1.16 Canadian dollars
per U.S. dollar
0.95 Canadian dollars
per U.S. dollar
China
14.7 yuan
3.61 yuan per dollar
6.45 yuan per dollar
MyEconLab Your Turn:
Test your understanding by doing related problem 2.11 at the end of this chapter.
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Solved Problem 30.2
Calculating Purchasing Power Parity Exchange Rates Using Big Macs
Fill in the missing values in the following table. Remember that the implied exchange rate
shows what the exchange rate would be if purchasing power parity held for Big Macs.
Assume that the Big Mac is selling for $4.07 in the United States. Explain whether the U.S.
dollar is overvalued or undervalued relative to each currency and predict what will happen
in the future to each exchange rate. Finally, calculate the implied exchange rate between
the Polish zloty and the Brazilian real (plural: reais) and explain which currency is
undervalued in terms of Big Mac purchasing power parity.
IMPLIED
EXCHANGE RATE
ACTUAL
EXCHANGE RATE
COUNTRY
BIG MAC PRICE
Brazil
9.50 reals
1.54 reals per dollar
Poland
8.63 zlotys
2.80 zlotys per dollar
South Korea
3,700 won
1,056 won per dollar
Malaysia
7.20 ringgits
2.97 ringgits per dollar
Solving the Problem
Step 1: Review the chapter material.
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Solved Problem 30.2
Calculating Purchasing Power Parity Exchange Rates Using Big Macs
Step 2: Fill in the table. To calculate the purchasing power parity exchange rate, divide
the foreign currency price of a Big Mac by the U.S. price.
IMPLIED
EXCHANGE RATE
ACTUAL
EXCHANGE RATE
COUNTRY
BIG MAC PRICE
Brazil
9.50 reais
2.33 reais per dollar
1.54 reais per dollar
Poland
8.63 zlotys
2.12 zlotys per dollar
2.80 zlotys per dollar
South Korea
3,700 won
909 won per dollar
1,056 won per dollar
Malaysia
7.20 ringgits
1.77 ringgits per dollar
2.97 ringgits per dollar
Step 3: Explain whether the U.S. dollar is overvalued or undervalued against the
other currencies. The dollar is overvalued if the actual exchange rate is greater than the
implied exchange rate, and it is undervalued if the actual exchange rate is less than the
implied exchange rate.
Step 4: Calculate the implied exchange rate between the zloty and the real. The
implied exchange rate between the zloty and the real is 8.63 zlotys/9.50 reais, or 0.91
zlotys per real. We can calculate the actual exchange rate by taking the ratio of zlotys per
dollar to reais per dollar: 2.80 zlotys/1.54 reais, or 1.82 zlotys per real. Therefore, the zloty
is undervalued relative to the real because our Big Mac purchasing power parity
calculation tells us that it should take fewer zlotys to buy a real than it actually does.
MyEconLab Your Turn: Test your understanding by doing related problem 2.12 at the end of this chapter.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
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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.
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.
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.
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.