305_PPT_WK12.1-Ch17_STUDENT_F24

Openness in Economy

• An open economy has three dimensions:

  • Openness in Goods Markets:

    • Ability for consumers and firms to choose between domestic and foreign goods.

    • Countries may limit free trade through tariffs (taxes on imported goods) and quotas (restrictions on the quantity of goods that can be imported).

  • Openness in Financial Markets:

    • Ability of investors to choose between domestic and foreign financial assets (bonds and equity).

    • Capital controls may be imposed restricting foreign assets held by domestic residents and vice versa.

  • Openness in Factor Markets:

    • Firms can choose where to locate production, and workers can choose where to work (e.g., NAFTA of 1993).

    • This aspect plays a smaller role in the short and medium run.

Coordinated Economic Outcomes

• The assumption of closed economies is not representative of world economies.

• Economies tend to move together significantly.

  • Example: Financial Crisis of 2008 started in the U.S. and affected nearly every country globally.

Openness in Goods Markets: Net Exports

• U.S. exports and imports as ratios of GDP since 1960:

  • Exports and imports have more than tripled in relation to GDP, making the U.S. a more open economy.

  • Trade volume has increased even more globally.

Measuring Openness

• Tradable Goods:

  • Goods that compete with foreign products in domestic or foreign markets.

  • Represent about 60% of aggregate output in the U.S. today.

• Export Ratios among Selected OECD Countries (2017):

  • U.S.: 12.3%

  • Germany: 47.2%

  • Japan: 16.1%

  • Austria: 53.9%

  • U.K.: 28.7%

  • Switzerland: 65.0%

  • Chile: 30.5%

  • Netherlands: 86.4%

  • Indicates U.S. has a among the smallest export ratios among wealthy nations.

Can Exports Exceed GDP?

• Exports can exceed GDP due to intermediate goods being included in the count.

• Example: Singapore had an export ratio of 173% in 2017.

• Understanding imports and exports in an open economy requires measuring goods in domestic currency, necessitating exchange rates.

Nominal Exchange Rates

• Definition: Price of domestic currency in terms of foreign currency.

  • Formula: Et = FC/DC

  • Example:

    • Et = 0.8 €/$ means 1$ is worth 0.8 euros.

    • Inverse: 1/Et = 1.25 means 1 euro is worth 1.25$.

Variations in Exchange Rates

• Nominal exchange rates fluctuate in foreign exchange markets.

• Nominal Appreciation (Et ↑):

  • Price increase of domestic currency against foreign currency.

• Nominal Depreciation (Et ↓):

  • Price decrease of domestic currency against foreign currency.

Fixed Exchange Rate Systems

• Fixed exchange rates maintain a constant exchange rate between currencies without requiring country agreements.

• Nominal Revaluation (E% ↑):

  • Government increases the value of the domestic currency.

• Nominal Devaluation (E% ↓):

  • Government decreases the value of the domestic currency.

The Real Exchange Rate (ε)

• Definition: Relative price of domestic goods compared to foreign goods.

• Formula: ε = (EP / P^)

  • Ep: Price of domestic goods in foreign currency.

  • P*: Price of foreign goods in foreign currency.

Changes in The Real Exchange Rate (ε)

• Real Appreciation (↑ ε):

  • Domestic goods can buy more foreign goods.

  • Occurs if E ↑ or (P/P*) ↑.

• Real Depreciation (↓ ε):

  • Domestic goods can buy fewer foreign goods.

  • Occurs if E ↓ or (P/P*) ↓.

• In the short run, variations in ε are mainly caused by changes in E.

Purchasing Power Parity (PPP)

• Definition: Long-run condition where ε = 1 due to arbitrage.

• Indicates that the same goods should cost the same in different markets, calculated in the same currency.

• In the long run, variations in nominal exchange rate are driven by differences in foreign and domestic inflation rates.

• Short run variations in ε are mostly caused by changes in E.