Open-Economy Macroeconomics Notes

Page 1: Closed vs. Open Economies

• Closed Economy: Does not interact with other economies in the world.

• Open Economy: Interacts freely with other world economies.

Page 2: The Flow of Goods & Services

• Exports: Domestically-produced goods and services sold abroad.

• Imports: Foreign-produced goods and services sold domestically.

• Net Exports ($NX$): Also known as the trade balance, calculated as:   $NX = \text{value of exports} - \text{value of imports}$

Page 3: Trade Surpluses and Deficits

• Trade Deficit: An excess of imports over exports (NX < 0).

• Trade Surplus: An excess of exports over imports (NX > 0).

• Balanced Trade: When exports equal imports ($NX = 0$).

Page 4: Variables Influencing Net Exports

Key influences include consumer preferences, relative prices of goods at home and abroad, consumer incomes, exchange rates, transportation costs, and government policies.

Page 5: The Flow of Capital

• Foreign Direct Investment (FDI): Domestic residents actively manage foreign investments (e.g., McDonalds opening an outlet in Moscow).

• Foreign Portfolio Investment (FPI): Domestic residents purchase foreign stocks or bonds, providing loanable funds to foreign firms.

Page 6: Net Capital Outflow ($NCO$)

• Net Capital Outflow ($NCO$): Also called net foreign investment; defined as:   $NCO = \text{domestic residents’ purchases of foreign assets} - \text{foreigners’ purchases of domestic assets}$

Page 7: Imbalances in Asset Trade

• 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.

Page 8: The Equality of $NX$ and $NCO$

• Accounting Identity: $NCO = NX$

• Every transaction affecting $NX$ affects $NCO$ by the same amount. For example, if a foreigner buys a U.S. good, U.S. exports ($NX$) increase, and because the foreigner pays with assets, U.S. $NCO$ rises accordingly.

Page 9: Impact of Imports on $NCO$

When a U.S. citizen buys foreign goods, imports rise and $NX$ falls. The payment in U.S. dollars/assets means the other country acquires U.S. assets, causing U.S. $NCO$ to fall.

Page 10: Saving, Investment, and International Flows

• Accounting Identity: $Y = C + I + G + NX$

• National Saving ($S$): $S = Y - C - G$

• Relationship: $S = I + NX$ or $S = I + NCO$

• When S > I, excess funds flow abroad (NCO > 0). When S < I, foreigners finance domestic investment (NCO < 0).

Page 11: The Nominal Exchange Rate

• Definition: The rate at which one country's currency trades for another, expressed as foreign currency per unit of domestic currency.

• Rates as of 29 January 2014 per US$:   - Canadian dollar: $1.12$   - Euro: $0.73$   - Japanese yen: $102.34$   - Mexican peso: $13.41$

Page 12: Appreciation and Depreciation

• Appreciation (’’strengthening’’): An increase in currency value measured by the foreign currency it can buy.

• Depreciation (’’weakening’’): A decrease in currency value.

• 2007 Example: The U.S. dollar depreciated $9.5\,\%$ against the Euro and appreciated $1.5\,\%$ against the S. Korean Won.

Page 13: The Real Exchange Rate

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

• Formula:   $\text{Real exchange rate} = \frac{e \times P}{P^<em>}$   (where $e$ is the nominal exchange rate, $P$ is the domestic price, and $P^</em>$ is the foreign price).

Page 14: Real Exchange Rate Example

• Data: Big Mac costs $2.50\,\text{US\$}$, $400\,\text{yen}$ in Japan; $e = 120\,\text{yen}$ per $.</p></li><li><p><strong>Calculation</strong>:$e \times P = (120) \times (2.50) = 300\,\text{yen per U.S. Big Mac}$.</p></li><li><p><strong>Result</strong>:$\frac{300}{400} = 0.75\,\text{Japanese Big Macs per U.S. Big Mac}$.</p></li></ul><h3 id="6fc8dd96-ee82-424b-a528-bfc7218e11a1" data-toc-id="6fc8dd96-ee82-424b-a528-bfc7218e11a1" collapsed="false" seolevelmigrated="true">Page 15: The Law of One Price</h3><ul><li><p><strong>Concept</strong>: A good should sell for the same price in all markets.</p></li><li><p><strong>Arbitrage</strong>: If coffee is$\$4$in <strong>Seattle</strong> and$\$5 in Boston, traders buy in Seattle and sell in Boston, eventually equalizing prices.

Page 16: Purchasing-Power Parity (PPP)

• Theory: A unit of any currency should buy the same quantity of goods in all countries. Based on the law of one price, it implies nominal exchange rates adjust to equalize the price of a basket of goods across countries.

Page 17: PPP Formula

• For a "basket" containing a Big Mac:   e \times P = P^*

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

Page 18: PPP Implications

• The nominal exchange rate between two countries equals the ratio of their price levels.

• If inflation is higher in Mexico than the U.S., the dollar appreciates against the peso.

• If inflation is higher in the U.S. than in Japan, the dollar depreciates against the yen.