Open-Economy Macroeconomics: Basic Concepts

Prepared by:Nishant Agrawal

Closed Vs. Open Economies

• Open and Closed Economies

– A closed economy is one that does not interact with other

economies in the world.

• There are no exports, no imports, and no capital flows.

• An open economy is one that interacts freely with other

economies around the world.

– An open economy interacts with other countries in two ways.

• It buys and sells goods and services in world product markets.

• It buys and sells capital assets in world financial markets.

The International Flow Of Goods & Capital

• An Open Economy

– The United States is a very large and open economy—it

imports and exports huge quantities of goods and

services.

– Over the past four decades, international trade and

finance have become increasingly important.

The Flow of Goods: Exports, Imports, Net Exports

• Exports are goods and services that are produced

domestically and sold abroad.

• Imports are goods and services that are produced

abroad and sold domestically.

• Net exports (NX) are the value of a nation’s exports

minus the value of its imports.

• Net exports are also called the trade balance.

Determinants of Net Exports

• Factors That Affect Net Exports

– The tastes of consumers for domestic and foreign goods.

– The prices of goods at home and abroad.

– The exchange rates at which people can use domestic currency to

buy foreign currencies.

– The incomes of consumers at home and abroad.

– The costs of transporting goods from country to country.

– The policies of the government toward international trade.

The Flow of Financial Resources : Net Capital Outflow

• Net capital outflow (net foreign investment) =

purchase of foreign assets by domestic residents - the purchase

of domestic assets by foreigners.

– Net capital outflow can be either positive or negative.

– When it is positive domestic resident purchase more asset

than foreigners buy domestic assets.

– When it is negative domestic resident purchase less asset than

foreigners buy domestic assets.

Determinants of Net Capital Outflow

• Variables that Influence Net Capital Outflow

– The real interest rates being paid on foreign assets.

– The real interest rates being 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 & Net Capital Flow

• Open economy interacts with the rest of the world in

two ways,

– In world markets for G & S

– World financial markets

1.Net Export = Export – Import 2.Net capital outflow (net foreign investment) =

purchase of foreign assets by domestic residents - the

purchase of domestic assets by foreigners.

The Equality of Net Exports & Net Capital OutFlow

• For an economy as a whole, net exports (NX) and net capital

outflow (NCO) must balance each other so that:

NCO = NX

– This holds true because every transaction that affects one side

must also affect the other side by the same amount.

– Example: If Reliance exports a Oil to Japan, NX rises and

Reliance obtains Rs.

• A trade deficit is a situation in which net exports

(NX) are negative.

– Imports > Exports

• A trade surplus is a situation in which net exports

(NX) are positive.

– Exports > Imports

• Balanced trade refers to when net exports are zero

—exports and imports are exactly equal.

Saving, Investment, and Their Relationship to the International Flows

• Net exports (NX) is a component of GDP:

Y = C + I + G + NX, or

Y - C - G = I + NX

• National saving (S) is the income of the nation that is

left after paying for current consumption and

government purchases or

S = Y – C - G

S = I + NX

• Lastly since NX is equal to NCO,

S = I + NCO

• Nation's saving must be equal to domestic investment + Net

capital outflow.

• In other world, When Indian citizen save dollar of their

income for future that can be used finance purchase of

capital abroad.

• For Closed Economy NCO = 0 so S = I

• For Open economy S = I + NCO

Table 1 International Flows of Goods and Capital: Summary

Copyright©2004 South-Western

The Prices For International Transactions: Real And Nominal Exchange Rates

• International transactions are influenced by

international prices.

• The two most important international prices are the

nominal exchange rate and the real exchange rate.

Nominal Exchange Rates

• The nominal exchange rate is the rate at which a person can

trade the currency of one country for the currency of

another.

• The nominal exchange rate is expressed in two ways:

– In units of foreign currency per one U.S. dollar.

– And in units of U.S. dollars per one unit of the foreign currency.

• Assume the exchange rate between the Indian Rs. and U.S. dollar is

Rs.50 to one dollar.

– One U.S. dollar trades for Rs. 50 (10/24/2007).

– One Rs. trades for 1/50 (= 0.02) of a dollar.

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

measured by the amount of foreign currency it can buy.

– If a dollar buys more foreign currency, there is an appreciation of

the dollar. (say Rs. 55)

• Depreciation refers to a decrease in the value of a currency as

measured by the amount of foreign currency it can buy.

– If it buys less there is a depreciation of the dollar (say Rs.40).

Real Exchange Rates

• The real exchange rate is the rate at which a person can trade the

goods and services of one country for the goods and services of

another.

• Trading depends on the physical quantities that can be exchanged at

given exchange rates and the prices of the good in each country

• Example, a Honda in India costs Rs.24,00,000 and $20,000 in the US.

Assuming an exchange rate of 60 Rs/dollar, the Honda costs

Rs.12,00,000 in the US.

• Thus, Honda is two times more expensive in India.

Real Exchange Rates

• The real exchange rate depends on the nominal exchange rate and the

prices of goods in the two countries measured in local currencies.

– Real Exchange Rate = Exchange Rate x Domestic Price

Foreign Price

– Example above EP/P*= 60 Rs/dollar x $20,000

Rs.24,00,000

= ½

• The real exchange rate is a key determinant of how much a country

exports and imports.

• When Studying an economy as whole, macroeconomists

focus on overall price rather than the prices of individual

items.

• Price index for US basket (P),

• Price index for foreign basket (P*)

• Nominal exchange rate B/W US dollar & foreign currencies (e)

Real exchange rate between US and other countries.

• Real Exchange Rate = (e x P) / ( P* )

Continue…

• A depreciation (fall) in the U.S. real exchange rate means

that U.S. goods have become cheaper relative to foreign

goods and so net exports rise.

• An Appreciation in the U.S. real exchange rate means that

U.S. goods have become more expensive compared to

foreign goods, so U.S. net exports fall.

PURCHASING-POWER PARITY

• The purchasing-power parity theory is the simplest and most widely

accepted theory explaining the variation of exchange rates and

currency should be able to buy the same quantity of goods in all

countries

• The theory of purchasing-power parity is based on a principle called

the law of one price.

– According to the law of one price, a good must sell for the same price in all

countries.

• If the law of one price were not true, unexploited profit

opportunities would exist and arbitrage would occur

(arbitrage is a fancy term for trading or buying low and

selling high)

• If arbitrage occurs, eventually prices that differed in two

markets would necessarily converge, and exchange rates

move to ensure that a currency would have the same

purchasing power in all countries.

Implications of Purchasing-Power Parity

• If the purchasing power of the dollar is always the same at

home and abroad, then the exchange rate would be

constant.

• Therefore, if a central bank prints large quantities of money,

the price level rises and its value in buying goods and

services and other currencies falls.

Figure 3 Money, Prices, and the Nominal Exchange Rate During the German Hyperinflation

10,000,000,000

1,000,000,000,000,000

100,000

1

.00001

.00000000011921 1922 1923 1924

Exchange rate

Money supply

Price level

1925

Indexes(Jan. 1921 5 100)

Copyright © 2004 South-Western

Limitations of Purchasing-Power Parity

• Why don’t real exchange rates always equal one?

– Many goods are not easily traded or shipped from one

country to another.

– Tradable goods are not always perfect substitutes when they

are produced in different countries.

Summary

• Net exports are the value of domestic goods and

services sold abroad minus the value of foreign

goods and services sold domestically.

• Net capital outflow is the acquisition of foreign

assets by domestic residents minus the acquisition

of domestic assets by foreigners.

Summary

• An economy’s net capital outflow always equals its

net exports.

• An economy’s saving can be used to either finance

investment at home or to buy assets abroad.

Summary

• The nominal exchange rate is the relative price of

the currency of two countries.

• The real exchange rate is the relative price of the

goods and services of two countries.

Summary

• When the nominal exchange rate changes so that

each dollar buys more foreign currency, the dollar is

said to appreciate or strengthen.

• When the nominal exchange rate changes so that

each dollar buys less foreign currency, the dollar is

said to depreciate or weaken.

Summary

• According to the theory of purchasing-power parity, a unit of currency should buy the same quantity of goods in all countries.

• The nominal exchange rate between the currencies of two countries should reflect the countries’ price levels in those countries.

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