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The Macroeconomics of Open Economies

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Omar Bani Khalef
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0% found this document useful (0 votes)
27 views25 pages

The Macroeconomics of Open Economies

Uploaded by

Omar Bani Khalef
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Part 13

THE MACROECONOMICS OF OPEN ECONOMIES


29
OPEN-ECONOMY MACROECONOMICS: BASIC
CONCEPTS

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH


EDITION 9781473725331 © CENGAGE EMEA 2017
Introduction
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.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
The International Flows of Goods
And Capital
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.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
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.

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9781473725331 © CENGAGE EMEA 2017
The Flow of Goods: Exports, Imports,
Net Exports
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.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
The Flow of Goods: Exports, Imports,
Net Exports
Factors That Affect Net Exports
◦ Consumer tastes 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.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
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.

◦ A UK resident buys shares in the BMW and a


Japanese resident buys a bond issued by the UK
government.
◦ When a UK resident buys shares in BMW, the German car
company, the purchase raises UK net capital outflow.
◦ When a Japanese resident buys a bond issued by the UK
government, the purchase reduces the UK net capital outflow.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
The Flow of Financial Resources: 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.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
The Equality of Net Exports and Net
Capital Outflow
Net exports (NX) and net capital outflow (NCO) are
closely linked.
For an economy as a whole, NX and 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.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
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
or
Saving = Domestic Investment + Net Capital Outflow
S = I + NCO

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
Table 1 International Flows of Goods and Capital: Summary

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
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.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
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 euro.
◦ In euros per unit of the foreign currency.

◦ Assume the exchange rate between the Japanese yen and the euro is
80 yen to one euro.
◦ One euro trades for 80 yen.

◦ One yen trades for 1/80 (= 0.0125) of a euro .

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
Nominal 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 euro buys:
◦ More foreign currency, there is an appreciation of the
euro.
◦ Less foreign currency, there is a depreciation of the
euro.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
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.
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.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
Real Exchange Rates

N o m in a l e x c h a n g e ra te  D o m e s tic p ric e
R e a l e x c h a n g e ra te =
F o re ig n p ric e

The real exchange rate compares the prices of domestic goods


and foreign goods in the domestic economy.
◦ If a kilo of British wheat sells for £1 and a kilo of European
wheat sells for €3.
◦ If the nominal exchange rate is 2 euros per £, then….
◦ The price of British wheat in euros is €2.
◦ So the real exchange rate is 2/3 kilo of European wheat per kilo
of British wheat.
FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION
9781473725331 © CENGAGE EMEA 2017
Real Exchange Rates
A depreciation (fall) in the UK real exchange rate:
◦ Means that UK goods have become cheaper relative to
foreign goods.
◦ This encourages consumers both at home and abroad to
buy more UK goods and fewer goods from other countries.
◦ As a result, UK exports rise, and UK imports fall, and both of
these changes raise UK net exports.
An appreciation in the UK real exchange rate:
◦ Means that UK goods have become more expensive
compared to foreign goods.
◦ UK net exports fall.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
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.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
A First Theory Of Exchange Rate
Determination: Purchasing Power Parity
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.
◦ It is based on a principle called 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.
◦ Exchange rates move to ensure PPP.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
Implications of Purchasing Power
Parity
The nominal exchange rate between the currencies of
two countries must reflect the different price levels in
those countries.
Because the nominal exchange rate depends on the
price levels, it must also depend on the money supply
and money demand in each country.
◦ If a 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.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
Limitations of Purchasing Power
Parity
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.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
Summary
① Net exports are the value of domestic goods and
services sold abroad minus the value of foreign
goods and services sold domestically.
② Net capital outflow is the acquisition of foreign
assets by domestic residents minus the acquisition
of domestic assets by foreigners.
③ An economy’s net capital outflow always equals its
net exports.
④ An economy’s saving can be used to either finance
investment at home or to buy assets abroad.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
Summary
⑤ The nominal exchange rate is the relative price
of the currency of two countries.
⑥ The real exchange rate is the relative price of
the goods and services of two countries.
⑦ When the nominal exchange rate changes so
that each euro buys more foreign currency, the
euro is said to appreciate or strengthen.
⑧ When the nominal exchange rate changes so
that each euro buys less foreign currency, the
euro is said to depreciate or weaken.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017
Summary
⑨ According to the theory of purchasing power parity,
a unit of currency should buy the same quantity of
goods in all countries.
⑩ The nominal exchange rate between the currencies
of two countries should reflect the countries’ price
levels in those countries.

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION


9781473725331 © CENGAGE EMEA 2017

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