ECON 3212 – Exam 2 Study Guide

Open Economy Identity

• Key Idea: In an open economy model, spending does not have to equal output (i.e., $Y = C + I + G$ can differ).

  • A country can exceed its production by borrowing from abroad.

  • Conversely, it can spend less than it produces and lend funds to other countries.

Savings and Investment Identity

• Rearrangement: The identity can be expressed as:

  • $Y - C - G = I + NX$$$Y - C - G = I + NX$$

  • Where:

  • S = Savings, I = Investment, NX = Net Exports

  • Thus, we see that: $S = I + NX$$$S = I + NX$$

  • It can also be expressed as: $S - I = NX$$$S - I = NX$$

  • Close Economy Insight: In a closed economy, $NX = 0$$$NX = 0$$ (no net exports).

  • Equivalence to Net Capital Outflow (NCO):

  • $S - I = NCO$$$S - I = NCO$$

Trade Surplus and Trade Deficit

• Definitions:

  • $NX = ext{net exports} = ext{exports} - ext{imports}$$$NX = ext{net exports} = ext{exports} - ext{imports}$$ (also referred to as trade balance).

  • If $NCO > 0$$$NCO > 0$$:

  • $S > I$$$S > I$$ → excess lending to foreigners (trade surplus).

  • If $NCO < 0$$$NCO < 0$$:

  • $S < I$$$S < I$$ → financed by foreign investments (trade deficit).

  • Questionable Perception: Is a trade deficit inherently negative? Depends on perspective.

Bilateral Trade Balance

• Definition: The trade balance between two specific countries.

• Top 5 U.S. Trade Partners:

  1. Mexico

  2. Canada

  3. China

  4. Germany

  5. Japan

Small Open Economy Model

• Characteristics:

  • Simplified Assumptions:

  1. Does not assume that interest rate (r) adjusts to make savings (S) equal to investment (I).

  2. Small economies do not significantly affect global markets (e.g., Bermuda, Bahamas).

  3. Perfect capital mobility: Residents have unrestricted access to world markets.

• World Interest Rate Concept:

  • $$r = r^$(where$$$ (where $$r^$$ is the interest rate determined globally).

  • Substitute $r^*$$$r^*$$ in the identity adding $NX$$$NX$$.

Exchange Rates and Trade

• Definition: Exchange rates represent the value of one currency in terms of another.

• Nominal Exchange Rates Examples:

  • $1 ext{ USD} = 0.89 ext{ EUR}$$$1 ext{ USD} = 0.89 ext{ EUR}$$

  • $1 ext{ EUR} = 1.13 ext{ USD}$$$1 ext{ EUR} = 1.13 ext{ USD}$$

  • $1 ext{ GBP} = 0.76 ext{ USD}$$$1 ext{ GBP} = 0.76 ext{ USD}$$

  • $1 ext{ CAD} = 1.40 ext{ USD}$$$1 ext{ CAD} = 1.40 ext{ USD}$$

  • $1 ext{ JPY} = 143.16 ext{ USD}$$$1 ext{ JPY} = 143.16 ext{ USD}$$

  • $1 ext{ MXN} = 20.04 ext{ USD}$$$1 ext{ MXN} = 20.04 ext{ USD}$$

• Appreciation vs. Depreciation:

  • Appreciation refers to an increase in the value of a currency.

  • Depreciation refers to a decrease in its value.

  • Example:

  • Initial exchange (1/1): $1 ext{ USD} = 1.30 ext{ CAD}$$$1 ext{ USD} = 1.30 ext{ CAD}$$

  • New exchange: $1 ext{ USD} = 1.39 ext{ CAD}$$$1 ext{ USD} = 1.39 ext{ CAD}$$

  • Conclusion: USD appreciates while CAD depreciates.

Real Exchange Rate

• Definition: The real exchange rate shows the relative value of goods between two countries.

• Interpretation:

  • If U.S. prices increase, the real exchange rate (e) will fall.

  • If foreign prices increase, e will rise.

• Equations:

  • Change expression: ext{%} ext{e} = ext{%} e + ext{%} P^* - ext{%} P$$ ext{%} ext{e} = ext{%} e + ext{%} P^* - ext{%} P$$

  • Influence of inflation on currency: ext{%} e = ext{%} e + ( ext{π}^* - ext{π})$$ ext{%} e = ext{%} e + ( ext{π}^* - ext{π})$$

• Implication of Inflation: Higher inflation generally leads to currency depreciation.

Law of One Price

• Definition: Identical goods must be priced the same in different locations, preventing price discrepancies at the same time.

• Arbitrage: Taking advantage of price differences for guaranteed profit.

Purchasing Power Parity (PPP)

• Concept: An extension of the Law of One Price to international markets.

• Exchange Rate Implication: The exchange rate between two countries should reflect the ratio of their price levels.

• Expectation: Nominal exchange rates should converge to balance purchasing power, though the process is slow and imperfect.

Relationship Between Real Exchange Rate and NX

• If the real exchange rate is low:

  • Domestic goods are cheaper and foreign goods are more expensive, resulting in higher demand for domestic goods.