basics of open market economies.ppt

7/27/2019 Basics of Open Market Economies.ppt

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Open-Economy

Macroeconomics: Basic

Concepts


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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 withother 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.


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THE INTERNATIONAL FLOW

OF GOODS AND CAPITAL An Open Economy

The United States is a very large and open

economyit imports and exports hugequantities of goods and services.

Over the past four decades, international trade

and finance have become increasingly

important.


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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 areproduced abroad and sold domestically.

Net exports (NX)are the value of a nations

exports minus the value of its imports. Net exports are also called the trade

balance.


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A trade deficitis 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

zeroexports and imports are exactly equal.


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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 domesticcurrency to buy foreign currencies.

The incomes of consumers at home and abroad.

The costs of transporting goods from country tocountry.

The policies of the government toward internationaltrade.

Fi 1 Th I i li i f h U S


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Figure 1 The Internationalization of the U.S.Economy

Percent

of GDP

0

5

10

15

1950 1955 1960 1965 1970 1975 1980 19901985 20001995

Exports

Imports

Copyright 2004 South-Western


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The Flow of Financial Resources: Net

Capital Outflow Net capital outflow refers to the purchase of

foreign assets by domestic residents minus the

purchase of domestic assets by foreigners. When a U.S. resident buys stock in Telmex, the

Mexican phone company, the purchase raises U.S. net

capital outflow.

When a Japanese residents buys a bond issued by theU.S. government, the purchase reduces the U.S. net

capital outflow.


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Determinants of Net Capital Outflow

Variables that InfluenceNet 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.


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Monetary Economy Revisited Again:

Net Exports = Net Capital Flow 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 Boeing exports a plane to Japan, NX rises, but, in the

simplest case Boeing obtains yen, which increase NCO. In the

more complex case, the Japanese company may purchase dollars,but someone with dollars is ending up with yen. If the Japanese

buyers get a loan from Boeing, Boeing has acquired a foreign

financial asset.


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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 = YC - G


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Therefore,

S = I + NX

Lastly since NX is equal to NCO,S = I + NCO

National Saving can be saved in two ways,through domestic investment of in foreign assets.

Remember, S underlies the supply of loanablefunds and I, and now NCO, underlies the demandfor loanable funds.


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Table 1 International Flows of

Goods and Capital: Summary

Copyright2004 South-Western


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S, I and Net Capital Outflow Note in the succeeding panels that SI = NCO.

Until the 1980s, NCO and hence the trade deficit wassmall. After 1980, we have had a recurring trade deficit(NCO is negativethe ROW is holding US financialassets.

Is the recurring deficit a problem? 1980-1987 NCO went from -.5% to3.0% of GDP, 2.1% came

from a drop in S (the Reagan budget deficits). Therefore, the tradedeficit helped sustain I. If not, I would have fallen affecting futuregrowth.

1991-2000 NCO went from -.3% to3.7% attributable not to a

decline in savings (which increased) but to increases in investment(primarily in the info. Tech sector). The NCO helped fuel theinvestment boom.

Whether because S fell or I rose, NCO can help to sustain I andtherefore future growth, BUT we must grow to help pay off thedebt. In many developing countries, this has NOT occurred

leading to higher interest payments.

Fi 2 N ti l S i D ti I t t


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Figure 2 National Saving, Domestic Investment,and Net Capital Outflow

Percent

of GDP20

18

16

14

12

10

1960 1965 199519901985198019751970

(a) National Saving and Domestic Investment (as a percentage of GDP)

2000

Domestic investment

National saving


Fi 2 N ti l S i D ti I t t


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Figure 2 National Saving, Domestic Investment,and Net Capital Outflow

Percent

of GDP4

4

3

2

1

0

1

2

3

Net capital

outflow

(b) Net Capital Outflow (as a percentage of GDP)

1960 1965 199519901985198019751970 2000



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THE PRICES FOR INTERNATIONAL

TRANSACTIONS: REAL AND NOMINAL

EXCHANGE RATES International transactions are influenced by

international prices.

The two most important international pricesare the nominal exchange rate and the real

exchange rate.


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Nominal Exchange Rates

The nominal exchange rate is the rate at which aperson can trade the currency of one country forthe currency of another.

The nominal exchange rate is expressed in twoways: In units of foreign currency per one U.S. dollar.

And in units of U.S. dollars per one unit of the foreigncurrency.

http://www.xe.com/ucc/ a internet based currencyconverter (cant be used on tests!)
http://www.xe.com/ucc/http://www.xe.com/ucc/


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Assume the exchange rate between the Japaneseyen and U.S. dollar is 80 yen to one dollar.

One U.S. dollar trades for 113 yen (10/24/2007). One yen trades for 1/113 (= 0.00885) of a dollar.

Appreciation refers to an increase in the value of acurrency 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 120 yen)

Depreciation refers to a decrease in the value of a

currency as measured by the amount of foreigncurrency it can buy. If it buys less there is a depreciation of the dollar (say

80 yen).


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Real Exchange Rates

The real exchange rate is the rate at which a person cantrade the goods and services of one country for the goodsand services of another.

Trading depends on the physical quantities that can beexchanged at given exchange rates AND the prices of thegood in each country

Example, a Honda in Japan costs 4,000,000 yen and$20,000 in the US. Assuming an exchange rate of 100yen/dollar, the Honda costs Y2,000,000 in the US. Thus,Hondas are as expensive in the US OR two times moreexpensive in Japan.


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Real Exchange Rates

The real exchange rate depends on the nominalexchange rate and the prices of goods in the twocountries measured in local currencies. Real Exchange Rate = Exchange Rate x PUS

PROW Example above EP/P*= 100 yen/dollar x $20,000

Y4,000,000

= HondaJAPAN/1 HondaUS

The real exchange rate is a key determinant ofhow much a country exports and imports.

Real Exchange Rate = Exchange Rate x PUSPROW


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

that U.S. goods have become cheaper relative to foreigngoods and so net exports rise. Encourages consumers both at home and abroad to buy more U.S.

goods and fewer goods from other countries.As a result, U.S.exports rise, and U.S. imports fall, and both of these changes raiseU.S. net exports.

An appreciation in the U.S. real exchange rate means thatU.S. goods have become more expensive compared toforeign goods, so U.S. net exports fall. Discourages consumers both at home and abroad to from buying

U.S. goods and encourages buying more goods from othercountries. As a result, U.S. exports fall, and U.S. imports rise, andboth of these changes decrease U.S. net exports.


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A FIRST THEORY OF

EXCHANGE-RATE DETERMINATION:

PURCHASING-POWER PARITY Thepurchasing-power parity theory is the

simplest and most widely accepted theoryexplaining the variation of exchange rates and

posits that a unit of any given currency should beable to buy the same quantity of goods in allcountries

The theory of purchasing-power parity is based ona 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.


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If the law of one price were not true, unexploited

profit opportunities would exist and arbitrage

would occur (arbitrage is a fancy term for tradingor 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 currencywould have the same purchasing power in all

countries.


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Implications of Purchasing-Power Parity

If the purchasing power of the dollar is always thesame at home and abroad, then the exchange ratewould be constant.

The nominal exchange rate between the currenciesof two countries must reflect the different pricelevels in those countries and the real exchange ratewould be equal to 1.

Therefore, if a central bank prints large quantitiesof money, the price level rises (QTofM) and itsvalue in buying goods and services and othercurrencies falls.

Figure 3 Money Prices and the Nominal Exchange


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Figure 3 Money, Prices, and the Nominal ExchangeRate 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. 19215 100)



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Limitations of Purchasing-Power Parity

The Big Mac Index http://www.economist.com/displaystory.cfm?story_id=1730909

New Index Starbucks

http://www.economist.com/displaystory.cfm?story_id=2361072

Why dont 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.
http://www.economist.com/displaystory.cfm?story_id=1730909http://www.economist.com/displaystory.cfm?story_id=2361072http://www.economist.com/displaystory.cfm?story_id=2361072http://www.economist.com/displaystory.cfm?story_id=1730909


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Summary

Net exports are the value of domestic goods

and services sold abroad minus the value of

foreign goods and services solddomestically.

Net capital outflow is the acquisition of

foreign assets by domestic residents minusthe acquisition of domestic assets by

foreigners.


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Summary

An economys net capital outflow always

equals its net exports.

An economys saving can be used to eitherfinance investment at home or to buy assets

abroad.


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Summary

The nominal exchange rate is the relative

price of the currency of two countries.

The real exchange rate is the relative priceof the goods and services of two countries.


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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.


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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 thosecountries.

basics of open market economies.ppt

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