Open-Economy Macroeconomics: Basic Concepts
Prepared by:Nishant Agrawal
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 & 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.
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.
The Flow of Financial Resources : Net Capital Outflow
• Net capital outflow (net foreign investment) =
purchase of foreign assets by domestic residents - the purchase
of domestic assets by foreigners.
– Net capital outflow can be either positive or negative.
– When it is positive domestic resident purchase more asset
than foreigners buy domestic assets.
– When it is negative domestic resident purchase less asset than
foreigners buy domestic assets.
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.
The Equality of Net Exports & Net Capital Flow
• Open economy interacts with the rest of the world in
two ways,
– In world markets for G & S
– World financial markets
1.Net Export = Export – Import 2.Net capital outflow (net foreign investment) =
purchase of foreign assets by domestic residents - the
purchase of domestic assets by foreigners.
The Equality of Net Exports & Net Capital OutFlow
• 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 Reliance exports a Oil to Japan, NX rises and
Reliance obtains Rs.
• 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.
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
S = I + NX
• Lastly since NX is equal to NCO,
S = I + NCO
• Nation's saving must be equal to domestic investment + Net
capital outflow.
• In other world, When Indian citizen save dollar of their
income for future that can be used finance purchase of
capital abroad.
• For Closed Economy NCO = 0 so S = I
• For Open economy S = I + NCO
Table 1 International Flows of Goods and Capital: Summary
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.
• Assume the exchange rate between the Indian Rs. and U.S. dollar is
Rs.50 to one dollar.
– One U.S. dollar trades for Rs. 50 (10/24/2007).
– One Rs. trades for 1/50 (= 0.02) 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 Rs. 55)
• 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 Rs.40).
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 India costs Rs.24,00,000 and $20,000 in the US.
Assuming an exchange rate of 60 Rs/dollar, the Honda costs
Rs.12,00,000 in the US.
• Thus, Honda is two times more expensive in India.
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 Domestic Price
Foreign Price
– Example above EP/P*= 60 Rs/dollar x $20,000
Rs.24,00,000
= ½
• The real exchange rate is a key determinant of how much a country
exports and imports.
• When Studying an economy as whole, macroeconomists
focus on overall price rather than the prices of individual
items.
• Price index for US basket (P),
• Price index for foreign basket (P*)
• Nominal exchange rate B/W US dollar & foreign currencies (e)
Real exchange rate between US and other countries.
• Real Exchange Rate = (e x P) / ( P* )
Continue…
• 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.
• 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.
PURCHASING-POWER PARITY
• The purchasing-power parity theory is the simplest and most widely
accepted theory explaining the variation of exchange rates and
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.
• Therefore, if a central bank prints large quantities of money,
the price level rises 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
10,000,000,000
1,000,000,000,000,000
100,000
1
.00001
.00000000011921 1922 1923 1924
Exchange rate
Money supply
Price level
1925
Indexes(Jan. 1921 5 100)
Copyright © 2004 South-Western
Limitations of Purchasing-Power Parity
• 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 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.
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