Open-Economy Macroeconomics Notes

Open vs. Closed economy

  • Closed Economy: A closed economy does not interact with other economies (no exports, imports, or capital flows).

  • Open Economy: An open economy interacts freely with other economies

    • buying and selling goods/services in world product markets (flow of g&s)

    • buying and selling capital assets in world financial markets (flow of capital)

  • Increasing Importance: International trade and finance have become increasingly important over the past decades.

Why Trade?

  • Higher Output and Incomes: Open economies tend to produce more output and have higher incomes than closed economies.

  • Trade Benefits: Trade leads to specialization and growth, increasing world output and global living standards. (comparative vs. absolute advantage)

Absolute and Comparative Advantage

  • Absolute Advantage: The ability of an economy to produce a greater quantity of a good/service than competitors using the same amount of resources.

  • Comparative Advantage: The ability of an economy to produce goods/services at a lower opportunity cost than other economic actors.

The International Flow of Goods and Capital

1. The Flow of Goods & Services

  • Exports: Goods and services produced domestically and sold abroad.

  • Imports: Goods and services produced abroad and sold domestically.

  • Net Exports (NX): Value of exports - value of imports (also called the trade balance).
    NX=Exports−ImportsNX = Exports - Imports

  • Trade Balance:

    • Trade Deficit: Imports > Exports, NX is negative.

    • Trade Surplus: Exports > Imports, NX is positive.

    • Balanced Trade: Exports = Imports, NX is zero.

  • Globally, trade deficits in some countries must equal trade surpluses in other countries.

Variables that Affect Net Exports

  • Consumer tastes for domestic and foreign goods.

  • Prices of goods at home and abroad.

  • Exchange rates between foreign and domestic currency.

  • Incomes of consumers at home and abroad.

  • Costs of transporting goods internationally.

  • Government policies toward international trade.

  • (Trade as % of GDP → Openness of an economy - Vietnam had low VA)

2. The Flow of Capital

  • Net Capital Outflow (NCO): Domestic residents' purchases of foreign assets minus foreigners' purchases of domestic assets (trong nước mua ngoài nước - ngoài nước mua trong nước)

  • NCO is also called net foreign investment

  • Capital Flow Examples:

    • U.S. resident buys stock in Hong Kong (SEHK) → raises NCO of US

    • Japanese resident buys a bond issued by the U.S. government → Reduce NCO of US

  • Forms of Capital Flow:

    • Foreign Direct Investment (FDI): Domestic residents actively manage the foreign investment (e.g., KFC opens in Hanoi).

    • Foreign Portfolio Investment: Domestic residents purchase foreign stocks or bonds, supplying “loanable funds” to a foreign firm.

  • NCO Imbalance:

    • NCO > 0 (Capital Outflow): Domestic purchases of foreign assets exceed foreign purchases of domestic assets.

    • NCO < 0 (Capital Inflow): Foreign purchases of domestic assets exceed domestic purchases of foreign assets.

Variables that Influence NCO

  • Real interest rates paid on foreign assets (rủi ro tỉ giá)

  • Real interest rates paid on domestic assets.

  • Perceived risks of holding foreign assets.

  • Government policies affecting foreign ownership of domestic assets (the flow of capital had high sensitivity)

3. The Equality of NX and NCO

  • Accounting Identity: NCO=NXNCO = NX(dòng di chuyển vốn = dòng di chuyển xuất khẩu)

  • Arises because every transaction that affects NX also affects NCO by the same amount (and vice versa).

  • Eg: When a foreigner purchases a good from VN

    • VN exports → NX increases

    • The foreigner pays with currency or assets (thu ngoại tệ = có tài sản ở nước ngoài) → VN acquires some foreign assets → NCO rises

Identity in Open Economy

  • Open Economy GDP: Y=C+I+G+NXY = C + I + G + NX

  • Rearranging Terms: Y–C–G=I+NXY – C – G = I + NX

  • National Saving (S): S=I+NXS = I + NX (since S=Y–C–GS = Y – C – G)

  • Saving and Investment: S=I+NCOS = I + NCO (since NX=NCONX = NCO)

  • Loanable Funds Flow:

    • When S > I, excess loanable funds flow abroad (positive NCO). (Japan has high savings but limited domestic investment opportunities.)

    • When S < I, foreigners finance some of the country’s investment (NCO < 0). (The U.S. often invests more than it saves domestically.)

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.

1. Nominal Exchange Rates

  • Definition: The rate at which one country’s currency trades for another.

  • Expression:

    • In units of foreign currency per one domestic currency (e.g., One VND trades for 1/25,000 USD).

    • In units of domestic currency per one unit of foreign currency (e.g., One USD trades for 25,000 VND).

  • Depreciation (Weakening): A decrease in the value of a currency as measured by the amount of foreign currency it can buy.

  • Appreciation (Strengthening): An increase in the value of a currency as measured by the amount of foreign currency it can buy.

Nominal Exchange Rates: Devaluation & Revaluation

  • Devaluation: Deliberate downward adjustment of the official exchange rate by the central bank. (phá giá - có sự can thiệp của nhà nước)

  • Depreciation: A fall in the value of a currency due to supply and demand-side factors. (do quy luật cung - cầu thị trường)

  • Revaluation: An upward change in the currency's value. (nâng giá)

2. Real Exchange Rates

  • Definition: The rate at which a person can trade the goods and services of one country for the goods and services of another.

  • Th real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy.

Real Exchange Rate Formula

  • The relative price of domestic goods in terms of foreign goods.

  • Example: U.S. Big Mac per VN Big Mac.

  • Real exchange rate formula: ϵ=e×PP∗\epsilon = e \times \frac{P}{P^*} = ($ per unit VN good) / ($ per unit US good)

    • e = Nominal exchange rate

    • P = Domestic price

    • P* = Foreign price

Real Exchange Rate With Many Goods

  • PP = VN price level (e.g., Consumer Price Index)

  • P∗P^* = foreign price level

  • Real exchange rate = e×PP∗\frac{e \times P}{P^*} = price of a domestic basket of goods relative to price of a foreign basket of goods

  • If VN real exchange rate appreciates, this indicates that domestic goods have become more expensive relative to foreign goods, potentially leading to a decrease in exports and an increase in imports.

Real Exchange Rate Impact on Trade

  • The real exchange rate is a key determinant of how much a country exports and imports.

  • A depreciation (fall) in the VN real exchange rate means that VN goods have become cheaper relative to foreign goods.

  • This encourages consumers both at home and abroad to buy more VN goods and fewer goods from other countries.

  • As a result, VN exports rise, and VN imports fall, and both of these changes raise VN net exports.

A First Theory of Exchange Rate Determinant: Purchasing-Power Parity (PPP)

Basic Logic

  • 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.

  • Implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries

  • The theory of purchasing-power parity is based on a principle called the law of one price.

  • Law of One Price: A good must sell for the same price in all markets.

PPP Example: Big Mac Index

  • P = price of VN Big Mac (in VND)

  • P* = price of US Big Mac (in $)

  • e = exchange rate, $ per VND

  • According to PPP: e×P=P∗e \times P = P^*

  • Solve for e: e=P∗Pe = \frac{P^*}{P}

Implications of PPP

  • PPP implies that the nominal exchange rate between two countries should equal the ratio of price levels.

  • If the two countries have different inflation rates, then e will change over time: e=P∗Pe = \frac{P^*}{P}

    • If inflation is higher in VN then in the US, then P rises faster than P*, so e falls

    • We say the VND depreciates against the dollar

  • The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries.

  • 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.

Limitations of PPP Theory

  • Two reasons why exchange rates do not always adjust to equalize prices across countries:

    • Many goods cannot easily be traded (e.g., haircuts, movies).

    • Foreign, domestic goods not perfect substitutes (e.g., consumer preferences).

  • Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends.

  • For example, PPP implies: the greater a country’s inflation rate, the faster its currency should depreciate (relative to a low-inflation country like the US).

  • The data support this prediction…