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Macroeconomics- Week 11 Notes

by: Matt Cutler

Macroeconomics- Week 11 Notes Econ 111

Marketplace > University of Alabama - Tuscaloosa > Econ 111 > Macroeconomics Week 11 Notes
Matt Cutler
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About this Document

These notes cover chapter 18- The Open Economy
Kent 0. Zirlott
Class Notes
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This 4 page Class Notes was uploaded by Matt Cutler on Friday April 8, 2016. The Class Notes belongs to Econ 111 at University of Alabama - Tuscaloosa taught by Kent 0. Zirlott in Fall 2016. Since its upload, it has received 24 views.

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Date Created: 04/08/16
Chapter 18- Open Economy Monday, April 4, 2016 5:00 PM 1. Intro a. Trade can make everyone better off b. This chapter introduces basic concepts of international macroeconomics i. The trade balance (trade deficits, surpluses) ii. International flows of assets iii. Exchange rates 2. Closed vs. Open Economies a. A closed economy does not interact with other economies in the world b. An open economy interacts freely with other economies around the world 3. The flow of goods and services a. Exports: i. Domestically-produced g&s sold abroad b. Imports: i. Foreign-produced g&s sold domestically c. Net Exports (NX), aka the trade balance i. =value of exports - value of imports 4. Examples: a. Canada experiences a recession i. U.S. net exports would fall 1) 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" i. U.S. net exports rise 1) Due to a fall in imports c. Prices of Mexican goods rise faster than prices of U.S. goods i. U.S. net exports rise 1) Exports to Mexico increase, Imports from Mexico decrease 5. Variables that influence Net Exports a. Consumer preferences for foreign and domestic goods b. Prices of goods at home and abroad c. Incomes of consumers at home and abroad d. The exchange rates at which foreign currency trades for domestic currency e. Transportation costs f. Government policies 6. Trade surpluses and Deficits ○ NX measures the imbalance in a country's trade in goods and services  Trade deficit: □ An excess of imports over exports, NX<0 and Y<C+I+G  Trade Surplus: □ An excess of exports over imports, NX>0 and Y>C+I+G  Balanced trade: □ When exports= imports, NX=0 and Y= C+I+G  Table 1, page 380 (KNOW THIS STUFF!!) 7. The Increasing openness of the U.S. Economy a. Increasing importance of international trade and finance i. 1950s, imports and exports: 4-5% of GDP ii. Recent years: 1) Exports- increased more than twice 2) Imports- increased more than three times b. Increase in international trade i. Improvements in transportation i. Improvements in transportation ii. Advances in telecommunications iii. Technological progress iv. Government's trade policies 1) NAFTA 2) GATT 8. The Flow of Capital a. Net capital Outflow (NCO): i. Domestic residents' purchases of foreign assets minus foreigners' purchases of domestic assets b. NCO is also called net foreign investment c. Flow of capital abroad takes two forms: i. Foreign direct investment: 1) Domestic residents or firms set up a foreign subsidiary and actively manage the foreign investment, such as, McDonalds opens a fast-food outlet in Moscow, Disney builds a theme park in Hong Kong ii. Foreign Portfolio investment: 1) Domestic residents purchase foreign stocks or bonds, supplying "loanable funds" to a foreign firm, such as, an American buys stock in Toyota ○ 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 d. Variables that influence NCO i. Real interest rates paid on foreign assets ii. Real interest rates paid on domestic assets iii. Perceived risks of holding foreign assets iv. Govt policies affecting foreign ownership of domestic assets 9. The Equality of NX and NCO a. An Accounting identity: NCO=NX i. Arises because every transaction that affects NX also affects NCO by the same amount (and vice versa) 10. When a foreigner purchases a good from the U.S. a. The us exports and NX increases b. The foreigner pays with currency or assets, so the U.S. acquires some foreign assets, causing NCO to rise. 11. Saving, Investment, and International Flows of Goods & Assets a. Accounting Identity i. Y=C+I+G+NX b. Rearranging terms i. Y-C-G=I+NX c. Since S=Y-C-G i. S=I+NX d. Since NX=NCO i. S=I+NCO S=National Savings 1) Thus, in an open economy, S=I+NCO I= Domestic Investment 2) Then S-I=NCO and NX 3) When S>I, Then NCO>0 and the excess loanable funds flow abroad in the form of positive net capital outflow. (Trade Surplus) 4) When S<I, then NCO<0 and foreigners are financing some of the country's investment in the form of negative capital outflow. (Trade Deficit) Flowing into the country (PAGE 380!) 12. Nominal exchange rate a. Nominal exchange rate i. The rate at which one country's currency trades for another ii. We express all exchange rates as foreign currency per unit of domestic currency 13. Appreciation and Depreciation 13. Appreciation and Depreciation a. Appreciate- "Strengthening" i. An increase in the value of a currency as measure by the amount of foreign currency it can buy (it takes more foreign currency to buy one US dollar) ii. A "strong" dollar causes US goods to become more expensive compared to foreign produced goods, so US exports will fall and imports will rise b. Depreciation "Weakening" i. A decrease in the value of a currency as measured by the amount of foreign currency it can buy (it takes less foreign currency to buy one US dollar) ii. A "weak" dollar causes US goods to become less expensive compared to foreign produced goods, so US exports rise and imports fall. 14. The Real Exchange Rate a. Real Exchange Rate i. The rate at which the G&S of one country trade for the G&S of another ii. Real exchange rate = (e x P)/P* iii. Ex: e=nominal exchange rate, i.e., foreign currency per unit of domestic currency 1) Big mac= $2.50 in US P= domestic price 2) Big mac= 400 yen P*= foreign price (in foreign currency) 3) e=120 yen per $ 4) E x P= price in yen of a US Big mac 1) =120yen per $ X $2.50 per big mac 2) =300 yen per US Big Mac 5) Real Exchange rate 1) = 300 yen/ 400 yen 2) =0.75 Japanese Big Macs per US Big Mac 15. Purchasing-Power Parity (PPP) a. Purchasing-power parity i. A Theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries ii. Based on the Law of One Price: the notion that a good should sell for the same price in all markets iii. Implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries b. PPP and its Implications (PPP shows us how inflation affects nominal exchange rates) i. e=P*/P (will not have to calculate PPP on Exam 3) ii. PPP implies that the nominal exchange rate e between two countries should equal the ratio of price levels, P* is the foreign price level and P is the domestic Price level. iii. If two countries have different inflation rates, then e will change over time: 1) If inflation is higher in Mexico than in the US., then P* rises faster than P, so e rises- the dollar appreciates against the peso 2) Vice versa c. Limitations i. Two reasons why exchange rates do not always adjust to equalize prices across countries: 1) Many goods cannot easily be traded 1) Ex: haircuts, going to the movies 2) Price differences on such goods cannot be arbitraged away 2) Foreign, domestic goods not perfect substitutes 1) E.g., some US consumers prefer Toyotas over Chevys, or vice versa 2) Price differences reflect taste differences 16. Review: a. Which of the following statements about a country with a trade deficit is not true? i. A) exports< imports ii. B) NCO<0 iii. C)Investment<Saving iv. D) Y<C+I+G


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