Open-Economy Macroeconomics: Basic Concepts

Open-Economy Macroeconomics: Basic Concepts

Introduction

  • International trade provides substantial benefits, allowing specialization and access to a greater variety of goods and services.

  • Trade can improve living standards by enabling countries to specialize in goods and services where they have a comparative advantage.

  • Macroeconomics often initially ignores international interactions for simplicity, assuming a closed economy.

  • An open economy interacts freely with other economies around the world, introducing new macroeconomic issues.

18-1 The International Flows of Goods and Capital

18-1a The Flow of Goods: Exports, Imports, and Net Exports

  • Exports: Domestically produced goods and services sold abroad.

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

  • Net Exports (NX): The difference between the value of a country’s exports and the value of its imports. Also known as the trade balance. NX = \text{Value of Exports} - \text{Value of Imports}

  • Trade Surplus: Exports are greater than imports (NX > 0).

  • Trade Deficit: Exports are less than imports (NX < 0).

  • Balanced Trade: Exports equal imports (NX = 0).

  • Factors Influencing Net Exports:

    • Consumer tastes for domestic and foreign goods

    • Prices of goods at home and abroad

    • Exchange rates

    • Consumer incomes at home and abroad

    • Transportation costs

    • Government policies toward international trade

  • Case Study: The Increasing Openness of the U.S. Economy

    • International trade and finance have significantly increased in importance for the U.S. economy over the past six decades.

    • In the 1950s, imports and exports were approximately 4-5% of GDP, but have since risen to about three times that level.

    • The U.S.'s largest trading partners include China, Canada, Mexico, Japan, Germany, South Korea, and the United Kingdom.

    • Improved transportation (larger merchant ships, long-distance jets) and telecommunications have facilitated international trade.

    • Government trade policies, such as NAFTA and GATT, have reduced trade barriers, further increasing international trade.

    • Technological advancements have shifted economies toward lighter, easier-to-transport goods like consumer electronics and movies.

  • In The News: The Complicated Politics of Trade Agreements

    • The Trans-Pacific Partnership (TPP) is an example of how difficult it is to ratify a trade deal.

    • The TPP divided both parties, with President Obama supporting it and Democratic presidential candidates opposing it.

    • Manufacturing workers and environmentalists were largely against the deal, while big businesses were mostly in favor.

    • The impact of the TPP might be modest, with the biggest threat to jobs in the United States being domestic policy, not free-trade agreements.

    • The TPP involves economic reform, higher labor standards, and environmental protection in developing countries.

18-1b The Flow of Financial Resources: Net Capital Outflow

  • Net Capital Outflow (NCO): The difference between the purchase of foreign assets by domestic residents and the purchase of domestic assets by foreigners. NCO = \text{Purchase of Foreign Assets by Domestic Residents} - \text{Purchase of Domestic Assets by Foreigners}

  • Foreign Direct Investment: Active management of a foreign investment (e.g., McDonald’s opening a restaurant in Russia).

  • Foreign Portfolio Investment: Passive investment in a foreign asset (e.g., an American buying stock in a Russian corporation).

  • Factors Influencing Net Capital Outflow:

    • Real interest rates paid on foreign assets

    • Real interest rates paid on domestic assets

    • Perceived economic and political risks of holding assets abroad

    • Government policies affecting foreign ownership of domestic assets

18-1c The Equality of Net Exports and Net Capital Outflow

  • For an economy as a whole, net capital outflow (NCO) must always equal net exports (NX). NCO = NX

  • This is an accounting identity.

18-1d Saving, Investment, and Their Relationship to the International Flows

  • In an open economy, a nation’s saving must equal its domestic investment plus its net capital outflow. S = I + NCO

  • In a closed economy, net capital outflow is zero, so saving equals investment. S = I

  • The financial system stands between saving, investment, and net capital outflow.

  • When a nation’s saving exceeds its domestic investment, its net capital outflow is positive, indicating that the nation is using some of its saving to buy assets abroad.

  • When a nation’s domestic investment exceeds its saving, its net capital outflow is negative, indicating that foreigners are financing some of this investment by purchasing domestic assets.

18-1e Summing Up

  • Trade Surplus: exports > imports, NX > 0, Y > C + I + G, S > I, NCO > 0

  • Trade Deficit: exports < imports, NX < 0, Y < C + I + G, S < I, NCO < 0

  • Balanced Trade: exports = imports, NX = 0, Y = C + I + G, S = I, NCO = 0

  • Case Study: Is the U.S. Trade Deficit a National Problem?

    • The United States has been called “the world’s largest debtor” due to borrowing in world financial markets to finance trade deficits.

    • There is no single cause for trade deficits; they can arise under a variety of circumstances.

    • Unbalanced fiscal policy (1980-1987): Lower national saving due to increased government budget deficit.

    • Investment boom (1991-2000): Increased investment in information technology.

    • Economic downturn and recovery (2000-2015): Fluctuations in saving and investment due to economic conditions and government response.

    • A trade deficit is not necessarily a problem, but it can be a symptom of a problem.

18-2 The Prices for International Transactions: Real and Nominal Exchange Rates

18-2a Nominal Exchange Rates

  • Nominal Exchange Rate: The rate at which a person can trade the currency of one country for the currency of another.

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

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

18-2b Real Exchange Rates

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

  • Formula: \text{Real Exchange Rate} = \frac{\text{Nominal Exchange Rate} \times \text{Domestic Price}}{\text{Foreign Price}}

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

  • A depreciation in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods, leading to increased net exports.

  • An appreciation in the U.S. real exchange rate means that U.S. goods have become more expensive compared to foreign goods, leading to decreased net exports.

  • FYI: The Euro

    • Many European nations adopted the euro as their common currency, starting on January 1, 2002.

    • Monetary policy for the euro area is set by the European Central Bank (ECB).

    • Benefits of a common currency include easier trade.

    • Costs include the loss of individual national monetary policy.

18-3 A First Theory of Exchange-Rate Determination: Purchasing-Power Parity

18-3a The Basic Logic of Purchasing-Power Parity

  • Purchasing-Power Parity: 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.

  • Based on the law of one price, which asserts that a good must sell for the same price in all locations.

  • Arbitrage: Taking advantage of price differences for the same item in different markets.

18-3b Implications of Purchasing-Power Parity

  • The nominal exchange rate between the currencies of two countries depends on the price levels in those countries. e = \frac{P^*}{P}

  • When a central bank increases the money supply, causing the price level to rise, it also causes that country’s currency to depreciate.

  • Case Study: The Nominal Exchange Rate During a Hyperinflation

    • Hyperinflation illustrates the link among money, prices, and the nominal exchange rate.

    • The German hyperinflation of the early 1920s shows that when the money supply grows quickly, the price level increases, and the currency depreciates.

18-3c Limitations of Purchasing-Power Parity

  • Purchasing-power parity is not completely accurate because:

    • Many goods are not easily traded.

    • Even tradable goods are not always perfect substitutes when produced in different countries.

  • Case Study: The Hamburger Standard

    • The Economist magazine collects data on the price of a Big Mac in different countries to analyze purchasing-power parity.

    • The predicted exchange rate is the one that makes the cost of a Big Mac the same in two countries.

18-4 Conclusion

  • The chapter developed basic concepts for studying open economies.

  • A nation’s trade balance is related to the international flow of capital.

  • National saving can differ from domestic investment in an open economy.

  • The nominal and real exchange rates are important concepts.

  • Purchasing-power parity is a theory of how exchange rates are determined.