In this chapter, look for the answers to these
questions:
• How are international flows of goods and
assets related?
13
Open-Economy Macroeconomics:
Basic Concepts
• What’s the difference between the real and
nominal exchange rate?
• What is “purchasing-power parity,” and how
does it explain nominal exchange rates?
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Introduction
• One of the Ten Principles of Economics
from Chapter 1:
Trade can make everyone better off.
• This chapter introduces basic concepts of
international macroeconomics:
• the trade balance (trade deficits, surpluses)
• international flows of assets
• exchange rates
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© 2007 Thomson South-Western
Open-Economy Macroeconomics:
Basic Concepts
• 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.
© 2007 Thomson South-Western
Open-Economy Macroeconomics: Basic
Concepts
THE INTERNATIONAL FLOW OF
GOODS AND CAPITAL
• An open economy interacts with other
countries in two ways.
• The Flow of Goods: Exports, Imports, and Net
Exports
– It buys and sells goods and services in world
product markets.
– It buys and sells capital assets in world financial
markets.
© 2007 Thomson South-Western
– 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.
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The Flow of Goods: Exports, Imports, Net
Exports
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.
• 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.
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The Flow of Goods: Exports, Imports, Net
Exports
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Variables that affect NX
What do you think would happen to U.S. net exports if:
• 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.
A.
Canada experiences a recession (falling incomes, rising
unemployment)
U.S. net exports would fall due to a fall in Canadian consumers’
purchases of U.S. exports
B.
U.S. consumers decide to be patriotic and buy more products
“Made in the U.S.A.”
U.S. net exports would rise due to a fall in imports
C.
Prices of Mexican goods rise faster than prices of U.S. goods
This makes U.S. goods more attractive relative to Mexico’s goods.
Exports to Mexico increase, imports from Mexico decrease,
so U.S. net exports increase.
9
© 2007 Thomson South-Western
The Flow of Financial Resources: Net
Capital Outflow
Figure 1 The Internationalization of the U.S. Economy
Percent
of GDP
15
Imports
10
Exports
5
0
1950 1955
1960 1965 1970 1975 1980 1985 1990 1995 2000
© 2007 Thomson South-Western
2005
• Net capital outflow refers to the purchase of foreign assets
by domestic residents minus the purchase of domestic
assets by foreigners.
• NCO is also called net foreign investment.
• A U.S. resident buys stock in the Toyota corporation and a
Mexican buys stock in the Ford Motor corporation.
• 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 the U.S.
government, the purchase reduces the U.S. net capital
outflow.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
2
The Flow of Capital
The flow of capital abroad takes two forms:
Foreign direct investment:
Domestic residents actively manage the foreign
investment, e.g., McDonalds opens a fast-food outlet
in Moscow.
Foreign portfolio investment:
Domestic residents purchase foreign stocks or bonds,
supplying “loanable funds” to a foreign firm.
The Flow of Capital
NCO measures the imbalance in a country’s trade
in assets:
• When NCO > 0, “capital outflow”
Domestic purchases of foreign assets exceed foreign
purchases of domestic assets.
• When NCO < 0, “capital inflow”
Foreign purchases of domestic assets exceed domestic
purchases of foreign assets.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
The Flow of Financial Resources: Net
Capital Outflow
The Equality of Net Exports and Net
Capital Outflow
• Variables that Influence Net Capital Outflow
• For an economy as a whole, NX and NCO must
balance each other so that:
NCO = NX
• 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.
© 2007 Thomson South-Western
The Equality of NX and NCO
• When a U.S. citizen buys foreign goods,
• U.S. imports rise, NX falls
• the U.S. buyer pays with U.S. dollars or assets, so
the other country acquires U.S. assets, causing U.S.
NCO to fall.
© 2007 Thomson South-Western
• arises because every transaction that affects NX also
affects NCO by the same amount (and vice versa)
• When a foreigner purchases a good from the U.S.,
• U.S. exports and NX increase
• the foreigner pays with currency or assets,
so the U.S. acquires some foreign assets,
causing NCO to rise.
© 2007 Thomson South-Western
Saving, Investment, and Their
Relationship to the International Flows
• Net exports is a component of GDP:
Y = C + I + G + NX
• National saving is the income of the nation that is
left after paying for current consumption and
government purchases:
Y – C – G = I + NX
• National saving (S) equals Y – C – G so:
S = I + NX
Saving = Domestic Investment + Net Capital Outflow
S
=
I
+
NCO
© 2007 Thomson South-Western
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Table 1 International Flows of Goods and Capital: Summary
Case Study: The U.S. Trade Deficit
• In 2004, the U.S. had a record trade deficit.
• Recall, NX = S – I = NCO.
A trade deficit means I > S, so the nation
borrows the difference from foreigners.
• In 2004, foreign purchases of U.S. assets
exceeded U.S. purchases of foreign assets
by $585 million.
• Such deficits have been the norm since
1980…
© 2007 Thomson South-Western
© 2007 Thomson South-Western
10%
Investment
20%
8%
6%
16%
4%
2%
12%
Saving
0%
NCO
(right scale)
8%
-2%
-4%
2005
2000
1995
1990
1985
1980
1975
1970
1965
-6%
1960
4%
Net Capital Outflow (% of GDP)
Saving, Investment (% of GDP)
U.S. Saving, Investment, and NCO
Case Study: The U.S. Trade Deficit
Why U.S. saving has been less than
investment:
– In the 1980s and early 2000s, huge budget
deficits and low private saving depressed
national saving.
– In the 1990s, national saving increased as the
economy grew, but domestic investment
increased even faster due to the information
technology boom.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Case Study: The U.S. Trade Deficit
Case Study: The U.S. Trade Deficit
• Is the U.S. trade deficit a problem?
– The extra capital stock from the ’90s
investment boom may well yield large returns
– The fall in saving of the ’80s and ’00s, while
not desirable, at least did not depress
domestic investment, as firms could borrow
from abroad
• A country, like a person, can go into debt
for good reasons or bad ones.
• A trade deficit is not necessarily a
problem, but might be a symptom of a
© 2007 Thomson South-Western
as of 12-31-2004
People abroad owned $12.5 trillion in U.S. assets.
U.S. residents owned $10 trillion in foreign assets.
U.S.’ net indebtedness to other countries = $2.5
trillion.
Higher than every other country’s net indebtedness.
So, U.S. is “the world’s biggest debtor nation.”
• So far, the U.S. earns higher interest rates on foreign
assets than it pays on its debts to foreigners.
• But if U.S. debt continues to grow, foreigners may
demand higher interest rates, and servicing the debt
would become a drain on U.S. income.
© 2007 Thomson South-Western
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Figure 2 National Saving, Domestic Investment, and Net
Foreign Investment
Figure 2 National Saving, Domestic Investment, and Net
Foreign Investment
(b) Net Capital Outflow (as a percentage of GDP)
(a) National Saving and Domestic Investment (as a percentage of GDP)
Percent
of GDP
2
Percent
of GDP
20
Net capital
outflow
1
Domestic investment
0
18
1
16
2
3
14
4
National saving
12
10
1960
1965
1970
1975
1980
1985
5
1990
1995
2000
2005
6
1960
1965
1970
1975
1980
1985
1990
© 2007 Thomson South-Western
1995
2000
2005
© 2007 Thomson South-Western
Nominal Exchange Rates
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.
• 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
Japanese yen and U.S. dollar is 80 yen to one
dollar.
© 2007 Thomson South-Western
• One U.S. dollar trades for 80 yen.
© 2007 Thomson South-Western
Nominal Exchange Rates
Real Exchange Rates
• Appreciation refers to an increase in the value
of a currency as measured by the amount of
foreign currency it can buy.
• Depreciation refers to a decrease 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.
• If it buys less there is a depreciation of the
dollar.
• 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.
• The real exchange rate compares the prices of
domestic goods and foreign goods in the
domestic economy.
© 2007 Thomson South-Western
• If a case of German beer is twice as expensive as
American beer, the real exchange rate is 1/2 case of
German beer per case of American beer.
© 2007 Thomson South-Western
5
Example With One Good
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.
• The real exchange rate is a key determinant of
how much a country exports and imports.
Real exchange rate =
Nominal exchange rate × Domestic price
Foreign price
• A Big Mac costs $2.50 in U.S., 400 yen in
Japan
• e = 120 yen per $
• e x P = price in yen of a U.S. Big Mac
= (120 yen per $) x ($2.50 per Big Mac)
= 300 yen per U.S. Big Mac
• Compute the real exchange rate:
300 yen per U.S. Big Mac
exP
=
P*
400 yen per Japanese Big Mac
= 0.75 Japanese Big Macs per US Big Mac
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Compute a real exchange rate
Interpreting the Real Exchange Rate
“The real exchange rate = 0.75 Japanese Big
Macs per U.S. Big Mac”
• This does not mean a Japanese citizen literally
exchanges Japanese burgers for American ones.
• Correct interpretation:
To buy a Big Mac in the U.S., a Japanese
citizen must sacrifice an amount that could
purchase 0.75 Big Macs in Japan.
© 2007 Thomson South-Western
Real Exchange Rates
• A depreciation (fall) in the U.S. real exchange rate
means that U.S. goods have become cheaper
relative to foreign goods.
• This 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 raise U.S. net exports.
• Conversely, 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.
© 2007 Thomson South-Western
e = 10 pesos per $
price of Tall Starbucks Latte
P = $3 in U.S., P* = 24 pesos in Mexico
A. What is the price of a US latte measured in
pesos?
e x P = (10 pesos per $) x (3 $ per US latte)
= 30 pesos per US latte
B. Calculate the real exchange rate, measured as
per U.S. latte
e x P lattes 30
Mexican
perpesos
US latte.
=
24
pesos
per
P*
= 1.25 Mexican lattes per USMexican
latte latte
© 2007 Thomson South-Western
A FIRST THEORY OF EXCHANGE-RATE
DETERMINATION: PURCHASING-POWER
PARITY
• The purchasing-power parity theory is the
simplest and most widely accepted theory
explaining the variation of currency exchange
rates.
• Purchasing-power parity is 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.
• According to the purchasing-power parity
theory, a unit of any given currency should be
© 2007 Thomson South-Western
6
The Basic Logic of Purchasing-Power
Parity
Purchasing-Power Parity (PPP)
• Example: The “basket” contains a Big Mac.
P = price of US Big Mac (in dollars)
P* = price of Japanese Big Mac (in yen)
e = exchange rate, yen per dollar
e x P = P*
• According to PPP,
price of US
Big Mac, in yen
Solve for e:
e =
price of Japanese
Big Mac, in yen
P*
P
© 2007 Thomson South-Western
The Basic Logic of Purchasing-Power
Parity
• If arbitrage occurs, eventually prices that
differed in two markets would necessarily
converge.
• According to the theory of purchasing-power
parity, a currency must have the same
purchasing power in all countries and exchange
rates move to ensure that.
© 2007 Thomson South-Western
Figure 3 Money, Prices, and the Nominal Exchange Rate During the
German Hyperinflation
• 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 locations.
• If the law of one price were not true,
unexploited profit opportunities would exist.
• The process of taking advantage of differences
in prices in different markets is called arbitrage.
© 2007 Thomson South-Western
Implications of Purchasing-Power Parity
• If the purchasing power of the dollar is always
the same at home and abroad, then the
exchange rate cannot change.
• The nominal exchange rate between the
currencies of two countries must reflect the
different price levels in those countries.
• When the central bank prints large quantities of
money, the money loses value both in terms of
the goods and services it can buy and in terms
of the amount of other currencies it can buy.
© 2007 Thomson South-Western
Limitations of Purchasing-Power Parity
Indexes
(Jan. 1921 = 100)
1,000,000,000,000,000
Money supply
10,000,000,000
Price level
100,000
• 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.
1
Exchange rate
.00001
.0000000001
1921
1922
1923
1924
1925
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© 2007 Thomson South-Western
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