Chapter 18 - Open-Economy Macroeconomics: Basic Concepts

• Closed economy- an economy that does not interact with other economies in the world
• Open economy- an economy that interacts freely with other economies around the world

18.1: The International Flows of Goods and Capital

The Flow of Goods: Exports, Imports, and Net Exports:

• Net exports- the value of a nation’s exports minus the value of its imports; also called the trade balance
• Trade balance- the value of a nation’s exports minus the value of its imports; also called net exports
• Trade surplus- the excess of exports over imports

The Flow of Financial Resources: Net Capital Outflow:

• Net capital outflow- the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners
• Important variables that influence net capital outflow
  • The real interest rates paid on foreign assets
  • The real interest rates paid on domestic assets
  • The perceived economic and political risks of holding assets abroad
  • The government policies that affect foreign ownership of domestic assets

The Equality of Net Exports and Net Capital Outflow:

• The net capital outflow (NCO) must always equal net exports (NX)
  • NCO=NX
  • This equation holds because every transaction that affects one side of this equation affects the other side by the exact same amount
  • Known as an identity equation

Saving, Investment, and Their Relationship to the International Flows:

• A nation’s savings and investment are crucial to its long-run economic growth
• Saving, investment, and international capital flows are linked
  • When a nation’s saving exceeds its domestic investment, its net capital outflow is position, indicating that the nation is using some of its savings to buy assets abroad

18.2: The Prices for International Transactions: Real and Nominal Exchange Rates

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

Real Exchange Rates:

• Real exchange rates- the rate at which a person can trade the goods and services of one country for the goods and services of another

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

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
• ALL BASED ON ONE PRINCIPAL “Law of one price”
  • This law asserts that a good must sell for the same price in all locations

Implications of Purchasing-Power Parity:

• The nominal exchange rate between the currencies of two countries must reflect the price levels in those countries
  • When price levels change, the nominal exchange rates change

Limitations of Purchasing-Power Parity:

• Many goods are not easily traded
• When tradable goods are not always perfect substitutes when they are produced in different countries

\