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Chapter 4 Open-Economy Basic Concepts

Macro economics (Học viện Ngân hàng)

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BUI DUY HUNG

MACROECONOMICS

CHAPTER

4 Open-Economy: Basic Concepts

Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University

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IN THIS TOPIC
• How are international flows of goods and assets
related?
• 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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IN THIS TOPIC

1.The International Flows of Goods and Capital

2.The Prices for International Transactions: Real and Nominal
Exchange Rates
3.A First Theory of Exchange-Rate Determination: Purchasing-Power
Parity

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

Introduction
Trade can make everyone better off.
• This topic introduces basic concepts of international macroeconomics:
– The trade balance (trade deficits, surpluses)
– International flows of assets
– Exchange rates

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

• Closed economy
– Economy that does not interact with other economies in the world
• Open economy
– Economy that interacts freely with other economies around the world
– Buys and sells goods and services in world product markets
– Buys and sells capital assets such as stocks and bonds in world financial
markets

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

The Flow of Goods

• Exports
– Goods and services that are produced domestically and sold abroad
• Imports
– Goods and services that are produced abroad and sold domestically
• Net exports, NX (Trade balance)
= Value of exports – value of imports

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Active Learning 1: Variables that affect NX

What do you think would happen to Vietnam net exports if:

A. EU experiences a recession (falling incomes, rising unemployment)
B. Vietnamese consumers decide to be patriotic and buy more products “Made in
Vietnam.”
C. Prices of goods produced in China rise faster than prices of goods produced in
Vietnam.

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Active Learning 1: Answers A, B

A. EU experiences a recession (falling incomes, rising unemployment)

Vietnam net exports would fall
due to a fall in EU consumers’ purchases of VN’s exports
B. Vietnamese consumers decide to be patriotic and buy more products “Made in
Vietnam”
Vietnam’s net exports would rise due to a fall in imports

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Active Learning 1: Answers, C

C. Prices of goods produced in China rise faster than prices of goods produced in
Vietnam.

This makes Vietnamese goods more attractive relative to Chinese goods.

Exports to China increase, imports from Vietnam decrease, so Vietnam’s net
exports increase.

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

Factors that Influence NX

• Factors that might influence a country’s exports, imports, and net

exports:
– Consumers’ tastes for foreign and domestic goods
– Prices of goods at home and abroad
– Exchange rates at which foreign currency trades for domestic currency
– Incomes of consumers at home and abroad
– Transportation costs
– Government policies

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

Trade Surpluses & Deficits

• Trade surplus, NX > 0
– Exports are greater than imports
• The country sells more goods and services abroad than it buys from other
countries
• Trade deficit, NX < 0
– Imports are greater than exports
• The country sells fewer goods and services abroad than it buys from other
countries
• Balanced trade: Exports = Imports

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Vietnamese economy’s increasing openness

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

The Flow of Financial Resources

• Net capital outflow, NCO (net foreign investment)

– Purchase of foreign assets by domestic residents
• Foreign direct investment
• Foreign portfolio investment
– Minus the purchase of domestic assets by foreigners

Purchase of foreign Purchase of domestic

NCO = assets by domestic assets by foreigners
residents

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

Net Capital Outflow, NCO

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

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

Variables that Influence NCO

– Real interest rates paid on foreign assets
– Real interest rates paid on domestic assets
– Perceived economic and political risks of holding foreign assets
– Government policies affecting foreign ownership of domestic assets

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

The Equality of NX and NCO – 1

• An accounting identity: NCO = NX
– Every transaction that affects NX also affects NCO by the same amount
(and vice versa)
• When a foreigner purchases a good from Vietnam
– Vietnam’s exports and NX increase
– The foreigner pays with currency or assets, so Vietnam acquires some foreign
assets, causing NCO to rise.

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

The Equality of NX and NCO – 2

• When a Vietnamese buys foreign goods,
– Vietnam’s imports rise, NX falls
– Vietnamese buyer pays with VND or assets, so the other country acquires
Vietnamese assets, causing Vietnam’s NCO to fall.

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EXAMPLE 1: Exporting to Korea

Nam is a web designer living in Hanoi. He creates and sells a website to Lee who
is living in Korea. Lee pays Nam 5,000 won for the website.
• What is the effect on Vietnam’s net exports and net capital outflows if:
A. Nam keeps the 5,000 won at home
B. Nam buys 5,000 won worth of stocks in a Korean company
C. Nam spends the 5,000 won on shoes made in Korea
D. Nam exchanges the 5,000 won into VND

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EXAMPLE 1: Solution, exporting to Korea

Nam (Vietnam) sells a website to Lee (Korea) for 5,000.

• NX = Exports – Imports
• NCO = Purchases of foreign assets by domestic resident – Purchases of
domestic assets by foreigners
• The website sold to Lee is an export for Vietnam, so Vietnam’s exports and net
exports increase.

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EXAMPLE 1: Solutions, A and B

• Vietnam’s exports and net exports increase.

A. Nam keeps the 5,000 won at home
Nam (a domestic resident) acquired a foreign asset (5,000 won from Korea), so
Vietnam’s NCO increases
B. Nam buys 5,000 won worth of stocks in a Korean company
Nam (a domestic resident) acquired a foreign asset (5,000 won worth of stocks in
a Korean company), so Vietnam’s NCO increases

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EXAMPLE 1: Answers, C and D

C. Nam spends the 5,000 won on Korean shoes

Nam purchase of shoes made in Korea: overall, exports increase by 5,000 won
(website sale to Korea), and imports increase by 5,000 won (shoes bought from
Korea), so Vietnam’s Net exports do not change; NCO do not change.
D. Nam exchanges the 5,000 won into VND
Now the bank has to use the 5,000 won (keep in the vault, or purchase Korean
assets, or sell the won to a Vietnamese that wants to purchase a good or service
for won) The change in NX is matched by the change in NCO.

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EXAMPLE 2: Importing from China

VNU purchases VND10,000,000 worth of goods from China (to sell to
the Vietnamese customers).
• What is the effect on the Vietnam’s net exports and net capital
outflows if:
A. China buys VND10 million worth of Vietnamese government bonds
B. China buys VND10 million worth of goods from Vietnam.
C. China buys $10 million worth of stocks in Vietnam’s companies

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EXAMPLE 2: Solutions, importing from China

• The VND10 million worth of goods bought from China are imports for Vietnam
Imports increase, NX decrease.
A. and C. China buys VND10 million worth of the Vietnamese government bonds
or stocks in Vietnam’s companies
Purchase of domestic assets by foreigners increase, so Vietnam’s NCO decrease
B. China buys VND10 million worth of goods from Vietnam.
Vietnam’s imports increase (VNU buys goods from China) and Vietnam’s exports
increase (Vietnam sells goods to China). NX do not change. NCO do not change.

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

Trade Surplus and NCO

• A country running a trade surplus, NX > 0

– Selling more goods and services to foreigners than it is buying from them.
– Use the foreign currency it receives from the net sale of goods and services
abroad to buy foreign assets.
– Capital is flowing out of the country, NCO > 0

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

Trade Deficit and NCO

• A country is running a trade deficit, NX < 0
– Buying more goods and services from foreigners than it is selling to them.
– Financing the net purchase of these goods and services in world markets by
selling assets abroad.
– Capital is flowing into the country, NCO < 0

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I THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

Saving and Investment

• Open economy: Y = C + I + G + NX
• National saving: S = Y – C – G
• Y – C – G = I + NX
• S = I + NX
• NX = NCO
• S = I + NCO
• Saving = Domestic investment + Net capital outflow

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International flows of goods and capital

• Trade surplus:
• Exports > Imports and Net exports > 0
• Y > Domestic spending (C+I+G)
• S > I and NCO > 0
• Trade deficit:
• Exports < Imports and Net exports < 0
• Y < Domestic spending (C+I+G)
• S < I and NCO < 0

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II THE EXCHANGE RATE

The Nominal Exchange Rate

• Nominal exchange rate: The price of one currency in terms of another
- Price of foreign currency in term of domestic currency (E): Domestic
currency (VND) per unit of foreign currency (USD)
- Price of domestic currency in term of foreign currency (e): Foreign currency
(USSD) per unit of domestic currency (VND)

We express all exchange rates as domestic currency

per unit of foreign currency (E)

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II THE EXCHANGE RATE

The Nominal Exchange Rate

• Some exchange rates, 31 July 2022
Code Currency name Buying Selling
AUD AUSTRALIAN DOLLAR 15,835.29 16,510.66
CAD CANADIAN DOLLAR 17,746.78 18,503.68
CHF SWISS FRANC 23,597.97 24,604.42
CNY YUAN RENMINBI 3,387.18 3,532.17
EUR EURO 23,267.12 24,570.16
GBP POUND STERLING 27,449.51 28,620.22
JPY YEN 166.18 175.93
KRW KOREAN WON 15.44 18.82
USD US DOLLAR 23,185.00 23,495.00
Source: VCB
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II THE EXCHANGE RATE

Prices for International Transactions

• Appreciation (or “strengthening”)
– Increase in the value of a currency as measured by the amount of foreign
currency it can buy
• Depreciation (or “weakening”)
– Decrease in the value of a currency
– As measured by the amount of foreign currency it can buy

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EXAMPLE 3: Appreciation or depreciation?

What is the exchange rate? Did the VND appreciated or depreciated?

A. Last year, Nam exchanged 22,980 VND for $1, but this year he exchanged $1
for 23,495VND.
B. Last year, Bac exchanged 15.44VND for 1KRW, but this year he exchanged
15.00VND for 1KRW.

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EXAMPLE 3: Solutions
A. Last year’s exchange rate = 22,980 VND per dollar. This year’s exchange rate =
23,495 VND per dollar
– US dollar appreciation : $1 now can buy more VND than last year (VND
depreciation)
B. Last year’s exchange rate = 15.44 VND per KRW
• This year’s exchange rate = 15.00 VND per KRW
– VND appreciation: 1KRW now can buy less VND than last year (VND
appreciation)

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II THE EXCHANGE RATE

The Real Exchange Rate

• Real exchange rate:
– Rate at which the goods and services of one country trade for the goods and
services of another
• Real exchange rate = E x P*/P
– Where
• P = domestic price
• P* = foreign price (in foreign currency)
• E = nominal exchange rate (domestic currency per unit of foreign currency)

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EXAMPLE 4: Calculating real exchange rate

A Big Mac costs $4 in U.S., 69.000VND in Japan. The exchange rate is 23.500 VND
per dollar.
• Compute the real exchange rate.

E x P* = price in VND of a U.S. Big Mac

= (23500 VND per $) x ($4 per Big Mac)
= 94.000 VND per U.S. Big Mac
Real exchange rate = E x P* / P
= 94.000 VND per U.S. Big Mac / 69.000 VND per Vietnamese Big Mac
= 1.36 Vietnamese Big Macs per U.S. Big Mac

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Active Learning 2: Compute a real exchange rate

The exchange rate is E = 19 VND per KRW

The price of a tall Starbucks Latte is:
P = 80.000 in VN and P* = 5 KRW in South Korea
A. What is the price of a Korean latte measured in VN?
B. Calculate the real exchange rate, measured as Vietnamese lattes per Korean
latte.

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Active Learning 2: Answers

E = 19 VND per $; P = 80.000 in VN., P* = 5 KRW in Korea

A. What is the price of a Korean latte measured in VND?
E x P* = (19 VND per KRW) x (5 KRW per Korean latte)
= 95.000 VND per Korean latte
B. Calculate the real exchange rate, measured as Vietnamese lattes per Korean
latte.
E x P* / P = 95.000 VND per Korean latte / 80.000 VND per Vietnamese latte
= 1.18 Vietnamese lattes per Korean latte.

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II THE EXCHANGE RATE

For the Economy as a Whole

• Real exchange rate = (E x P*)/P
= price of a domestic basket of goods relative to price of a foreign basket of
goods
• P = Vietnamese price level, e.g., Consumer Price Index, measures the price of
a basket of goods
• P* = U.S. price level
– If Vietnamese real exchange rate decrease (appreciates), Vietnamese goods
become more expensive relative to foreign goods.

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III THEORY OF EXCHANGE RATE DETERMINATION

Purchasing-Power Parity – 1
• 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
• Based on the law of one price:
– A good should sell for the same price in all locations
• Arbitrage
– Take advantage of price differences for the same item in different markets

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EXAMPLE 5: The law of one price

If coffee beans sell for 600.000 VND/kg in Hanoi and 500.000/kg in HCM; and
coffee beans can be costlessly transported, how will the two markets reach
equilibrium?

• Opportunity for arbitrage: making a quick profit by buying coffee in Hanoi and
selling it in HCM.
• HCM: increase demand drives up the price
• Hanoi: increase supply drives the price down
• Until the two prices are equal.

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III THEORY OF EXCHANGE RATE DETERMINATION

Purchasing-Power Parity – 2
• PPP: a currency must have the same purchasing power in all countries
– A U.S. dollar must buy the same quantity of goods in the United States and
Vietnam
– And a Korean won must buy the same quantity of goods in Korea and the
United States
– A unit of a currency must have the same real value in every country.

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EXAMPLE 6: Applying PPP

Using the theory of purchasing-power parity, find the exchange rate if a bushel of
apples sells for $30 in the U.S. and 300 krona in Sweden.

• PPP: a dollar buys the same quantity of goods in the United States (prices in
$) as in Sweden (prices in krona)
• The number of krona per dollar must reflect the prices of goods in the U.S. and
Sweden.
• Nominal exchange rate = 300 krona / 30 dollars = 10 krona per dollar

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III THEORY OF EXCHANGE RATE DETERMINATION

Implications of PPP – 1
• If purchasing power of the dollar is always the same at home and
abroad
– Then the real exchange rate cannot change
• Theory of purchasing-power parity, E= P*/P
– Nominal exchange rate between the currencies of two countries must reflect
the price levels in those countries
• P = domestic price level
• P* = foreign price level
• And E = exchange rate (domestic currency per $)

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III THEORY OF EXCHANGE RATE DETERMINATION

Implications of PPP – 2
• Implications:
– Nominal exchange rates change when price levels change
– When a central bank in any country increases the money supply
• And causes the price level to rise
• It also causes that country’s currency to depreciate relative to other
currencies in the world

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III THEORY OF EXCHANGE RATE DETERMINATION

Limitations of PPP – 1

• Theory of purchasing-power parity does not always hold in practice

1. Many goods are not easily traded
• Price differences on such goods cannot be arbitraged away
2. Even tradable goods are not always perfect substitutes when they are
produced in different countries
• Price differences reflect taste differences

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III THEORY OF EXCHANGE RATE DETERMINATION

Limitations of PPP – 2
• Purchasing-power parity
– Not a perfect theory of exchange-rate determination
– Real exchange rates fluctuate over time
• Large and persistent movements in nominal exchange rates
– Typically reflect changes in price levels at home and abroad

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Active Learning 3: Topic review questions

A. Which of the following statements about a country with a trade deficit is not
true?
a) Exports < imports
b) Net capital outflow < 0
c) Investment < saving
d) Y < C + I + G
B. A Hyundai Santa Fer SUV sells for 49,9 mil won in Korea and 1.5 bil VND in
Vietnam. If purchasing-power parity holds, what is the nominal exchange rate
(VND per KRW)?

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Active Learning 3: Answers, A

A. Which of the following statements about a country with a trade deficit is not
true?
a) Exports < imports
b) Net capital outflow < 0
c) Investment < saving
d) Y < C + I + G
• A trade deficit means: NX < 0; exports < imports;
• Y < domestic spending (C + I + G);
• and NCO < 0.
• Since NX = S – I, a trade deficit implies I > S.

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Active Learning 3: Answers, B

B. A Hyundai Santa Fer SUV sells for 49,9 mil won in Korea and 1.5 bil VND in
Vietnam. If purchasing-power parity holds, what is the nominal exchange rate
(VND per KRW)?

• P* = 49.900.000
• P = 1.500.000.000
• E = P/P* = 1.500.000.000/49.900.000 = 30,06 VND per won

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CHAPTER IN A NUTSHELL
• Net exports are exports minus imports.
• Net capital outflow is the acquisition of foreign assets by domestic
residents minus the acquisition of domestic assets by foreigners.
• An economy’s net capital outflow always equals its net exports.
• An economy’s saving can be used either to finance investment at
home or to buy assets abroad. Thus, national saving equals
domestic investment plus net capital outflow.

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CHAPTER IN A NUTSHELL
• 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.
• 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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CHAPTER IN A NUTSHELL
• According to the theory of purchasing-power parity, a dollar (or a unit
of any other currency) should be able to buy the same quantity of
goods in all countries.
• This theory implies that the nominal exchange rate between the
currencies of two countries should reflect the price levels in those
countries. As a result, countries with relatively high inflation should
have depreciating currencies, and countries with relatively low
inflation should have appreciating currencies.

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