Chapter 18 Macroeconomic in an open economy

Macro Economics Pearson

Open Economy

an economic system that engages in trade and investment with other countries. It utilizes both imports and exports to function in a global market.

Closed Economy

an economic system that does not engage in trade or investment with other countries. It relies solely on domestic production and consumption.

balance of payments

a record of all economic transactions between residents of a country and the rest of the world over a specific period, including trade, investment, and financial transfers.

current account

the part of the BoP that record the country’s net exports, net income on investments and net transfers of funds. It reflects the trade balance and primary income.

financial account

the part of the B o P that records purchases of assets a country has made abroad and foreign purchases of assets in the country…

capital account

the part of the B o P that records relatively minor transactions such as migrants’ transfers and sales and purchases of non produced, nonfinancial assets

trade balance

, the difference between the value of the goods a country exports and the value of the goods a country imports.

•Positive = trade surplus

•Negative = trade deficit

balance of services

The difference between the value of services a country exports and the value of services it imports.

capital outflows

purchases of assets overseas by americans

capital inflows

purchases of American assets by foreigners

Foreign portfolio investments

stock and bonds

foreign direct investment

physical assets like factories

net capital flows

the difference between capital inflows and capital outflows in an economy.

net foreign investment

the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreign residents.

capital account

refers only to the relatively minor transactions like migrants’ transfers or sales and purchases of non-produced non-financial assets, like intellectual property or natural resource rights. It records all transactions related to capital transfers and foreign investment, excluding trade in goods and services.

depreciate

The value of the $U S will fall, relative to the value of the yen.

appreciate

Increase in market value relative to the yen (or generally any other currency).

speculators

Individuals or entities that buy and sell financial instruments, commodities, or currencies to profit from fluctuations in market prices.

real exchange rate

= nominal exchange rate *( domestic price level/ foreign price level)

purchasing power parity

Economic theory stating that in the long run, exchange rates should adjust so that identical goods cost the same in different countries.

What stops purchasing power parity from occurring?

1.Not all products can be traded internationally (especially services).

2.Products and consumer preferences are different across countries; prices are determined by supply but also by demand.

3.Countries impose barriers to trade, like tariffs (taxes on imports) and quotas (numerical limits on imports).

floating currency

is the outcome of a country allowing its currency’s exchange rate to be determined by demand and supply.

fixed exchange rate system

one under which countries agree to keep the exchange rates among their currencies fixed for long periods.

The Bretton Woods system

was a monetary order that set fixed exchange rates between major currencies and established the US dollar as the world's primary reserve currency, linked to gold.

pegging

is a type of fixed exchange rate system where a country's currency value is tied to another major currency or a basket of currencies.

destabilizing speculation

involves trading activities that take advantage of expected changes in exchange rates, leading to increased volatility and potential crises in currency markets.

speculative attacks

are rapid selling of a currency by investors anticipating a decline in its value, often leading to devaluation or financial instability.

saving and investment equation

current account balance + financial account balance =0

current account balance =-financial account balance

net export = net foreign investment

National saving

= private saving + public saving

private saving

= national income - consumption -taxes

government saving =

taxes - government spending

saving and investment equation

national saving = investment + net foreign investment

S=I+NFI

twin deficits

refers to the simultaneous deficits in a country's budget and current account, highlighting the connection between fiscal policy and trade balance.

policy channels

are the mechanisms through which government policies affect economic variables, including interest rates, exchange rates, and overall economic activity.

monetary policy in an open economy

more effective

Fiscal Policy in an open economy

fiscal policy is less effective in an open economy than in a closed economy.