Open-Economy Macroeconomics: Basic Concepts

Basic Concepts of Open Economy Macroeconomics

Closed vs. Open Economies

Closed Economy: An economy that does not interact with any other economies in the world.
Open Economy: An economy that interacts freely with other economies throughout the world.

The International Flow of Goods and Services

Definitions of Trade Components

Exports: Domestically-produced goods and services that are sold to buyers abroad.
Imports: Foreign-produced goods and services that are sold to domestic buyers.
Net Exports (NX): Also referred to as the trade balance, this is defined as the value of a nation's exports minus the value of its imports.

Trade Balances

Net exports ( $NX$ ) measures the imbalance in a country’s trade of goods and services:

Trade Deficit: A situation where there is an excess of imports over exports (NX < 0).
Trade Surplus: A situation where there is an excess of exports over imports (NX > 0).
Balanced Trade: A state where exports are exactly equal to imports ( $NX = 0$ ).

Variables Influencing Net Exports

Several factors determine the level of a country's net exports:

Consumer Preferences: The tastes of consumers for foreign versus domestic goods.
Relative Prices: The prices of goods at home compared to prices of goods abroad.
Consumer Incomes: The incomes of consumers both domestically and abroad.
Exchange Rates: The rates at which foreign currency trades for domestic currency.
Transportation Costs: The costs associated with moving goods between countries.
Government Policies: Regulations and policies toward international trade.

The International Flow of Capital

Forms of Capital Flow

The flow of capital abroad, often representing domestic residents investing in foreign assets, takes two primary forms:

Foreign Direct Investment (FDI): This occurs when domestic residents actively manage a foreign investment. For example, McDonald’s opening a fast-food outlet in Moscow.
Foreign Portfolio Investment (FPI): This occurs when domestic residents purchase foreign stocks or bonds, thereby supplying "loanable funds" to a foreign firm without active management.

Net Capital Outflow (NCO)

Net Capital Outflow (NCO): Defined as the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. It is also commonly referred to as net foreign investment.
Capital Outflow (NCO > 0): Domestic purchases of foreign assets exceed foreign purchases of domestic assets.
Capital Inflow (NCO < 0): Foreign purchases of domestic assets exceed domestic purchases of foreign assets.

The Equality of NX and NCO

There is an accounting identity such that:

$NCO = NX$

This identity arises because every transaction that affects $NX$ must also affect $NCO$ by the exact same amount, and vice versa.

Example 1: When a foreigner purchases a good from the U.S.: * U.S. exports and $NX$ increase. * The foreigner pays with currency or assets. Consequently, the U.S. acquires foreign assets, causing $NCO$ to rise.
Example 2: When a U.S. citizen buys foreign goods: * U.S. imports rise and $NX$ falls. * The U.S. buyer pays with U.S. dollars or assets. Consequently, the foreign country acquires U.S. assets, causing U.S. $NCO$ to fall.

Saving, Investment, and International Flows

National Income Accounting Identity

The relationship between domestic production and spending in an open economy is represented by the following identity:

$Y = C + I + G + NX$

By rearranging the terms to isolate national saving ( $S$ ), where $S = Y - C - G$ :

$Y - C - G = I + NX$ $S = I + NX$

Because $NX = NCO$ , we can state:

$S = I + NCO$

Implications of the Identity

When S > I: The excess loanable funds from national saving flow abroad in the form of a positive net capital outflow (NCO > 0).
When S < I: Domestic investment exceeds national saving. In this case, foreigners are financing a portion of the country’s investment, resulting in a negative net capital outflow (NCO < 0).

Exchange Rates

The Nominal Exchange Rate

The nominal exchange rate is the rate at which one country's currency trades for another. It is expressed as units of foreign currency per unit of domestic currency.

Exchange Rates as of 29 January 2014 (per US$):

Canadian dollar: $1.12$
Euro: $0.73$
Japanese yen: $102.34$
Mexican peso: $13.41$

Appreciation and Depreciation

Appreciation (Strengthening): An increase in the value of a currency, measured by the increased amount of foreign currency it can buy.
Depreciation (Weakening): A decrease in the value of a currency, measured by the decreased amount of foreign currency it can buy.

Historical Examples (2007):

The U.S. dollar depreciated $9.5\%$ against the Euro.
The U.S. dollar appreciated $1.5\%$ against the South Korean Won.

The Real Exchange Rate

The real exchange rate is the rate at which the goods and services of one country trade for the goods and services of another.

Formula:

$\text{Real Exchange Rate} = \frac{e \times P}{P^*}$

Where:

$e$ = nominal exchange rate (foreign currency per unit of domestic currency).
$P$ = domestic price level.
$P^*$ = foreign price level (expressed in foreign currency).

Example: Calculation with One Good (Big Mac)

U.S. Price ( $P$ ): $\$2.50$
Japan Price ( $P^*$ ): $400\text{ yen}$
Nominal Exchange Rate ( $e$ ): 120\text{ yen per } \

Step 1: Compute price of U.S. Big Mac in yen ( $e \times P$ ) 120\text{ yen}/\ \times \ $2.50 = 300\text{ yen}$

Step 2: Compute the real exchange rate $\frac{300\text{ yen per U.S. Big Mac}}{400\text{ yen per Japanese Big Mac}} = 0.75\text{ Japanese Big Macs per U.S. Big Mac}$

Purchasing-Power Parity (PPP)

The Law of One Price

This is the notion that a good should sell for the same price in all markets.

Arbitrage: If coffee sells for $\$4/\text{pound}$ in Seattle and $\$5/\text{pound}$ in Boston (with zero transport costs), traders will buy in Seattle and sell in Boston for a quick profit.
This process drives the price up in Seattle and down in Boston until they are equal.

Theory of Purchasing-Power Parity

Purchasing-Power Parity is a theory of exchange rates stating that a unit of any given currency should be able to buy the same quantity of goods in all countries. It is based on the Law of One Price and implies that nominal exchange rates adjust to equalize the price of a basket of goods across different nations.

Mathematical Representation of PPP

Using the Big Mac basket example:

$P$ = price of U.S. Big Mac (in dollars)
$P^*$ = price of Japanese Big Mac (in yen)
$e$ = exchange rate (yen per dollar)

Under PPP: $e \times P = P^*$

Solving for the nominal exchange rate ( $e$ ): $e = \frac{P^*}{P}$

Implications of PPP

PPP implies that the nominal exchange rate between two countries should equal the ratio of their price levels. Changes in inflation rates cause $e$ to change over time:

Higher Foreign Inflation: If inflation is higher in Mexico than in the U.S., $P^*$ rises faster than $P$ . Therefore, $e$ rises, and the dollar appreciates against the peso.
Higher Domestic Inflation: If inflation is higher in the U.S. than in Japan, $P$ rises faster than $P^*$ . Therefore, $e$ falls, and the dollar depreciates against the yen.