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Chapter 13 Open Economy Macroeconomics: Basic Concepts

by: Roger D.

Chapter 13 Open Economy Macroeconomics: Basic Concepts Econ 202 - 01

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These are notes which cover class material from and for chapter 13 of Basic Principles of Macroeconomics by N. Gregory Mankiw. This is my very first upload and is totally free for you to download ...
Principles Of Macroeconomics
Kwan Yong Lee
Class Notes
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Date Created: 04/08/16
Econ 202 ~ Chapter 13 ~ Open-Economy Macroeconomics: Basic Concepts The International Flows of Goods and Capital Some Definitions: A Closed Economy ~ is an economy which doesn’t interact (trade) with other economies in the world. An Open Economy ~ is an economy which interacts (trades) freely with other economies in the world. 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) ~ is the value of a nation’s exports minus the value of its imports; which is also referred to as the trade balance.  Net Exports = Exports – Imports  Measures the imbalance between a country’s exports and imports Trade Balance ~ is the value of a nation’s exports minus the value of its imports; which is also referred back to as net exports. Trade Surplus ~ is an excess of exports over imports. NX > 0. Trade Deficit ~ is an excess of imports over exports. NX < 0. Balanced Trade ~ is a situation in which exports equal imports. NX =0. 6 Factors (variables) which influence imports, exports and net exports: 1. The tastes of consumers for domestic and foreign goods. (NX = Exports – Imports) a. US imports will ↓ if US consumers start buying more cars from Detroit than Japan, then NX ↑ 2. The prices of goods at home and abroad. (NX = Exports – Imports) a. If prices of German Porsches rise faster than Chevy Corvettes; US Imports ↓ then the NX ↑ and US exports to Germany ↑ then NX ↑. 3. The exchange rates at which people can use domestic currency to buy foreign currencies. 4. The incomes of consumers at home and abroad. (NX = Exports – Imports) a. US exports will ↓ if a foreign country experiences economic hardships, then NX ↓ 5. The cost of transporting goods from country to country. 6. Government policies towards international trade. When imports and exports increase overtime relative to the percentage of the rGDP, this represents an increase (growth) of trade amongst countries. (See graph on page 269)  This is because of improvements of transportation ~ bigger and faster steamships   Technological progress changed the kinds of goods countries produced ~ computer parts. The Flow of Financial Resources: Net Capital Outflow (NCO) Net Capital Outflow ~ is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners: These transactions include the flow of goods & services and the flow of capital. Net Capital Outflow is sometimes called Net Foreign Investment, and it measures the imbalance between the amounts of foreign assets bought by domestic residents against the amounts of domestic assets bought by foreign entities.  A flow of goods or services is the purchase of a Samsung smart-phone  A flow of capital is the purchase of stock in Samsung or purchase of Korean government bonds o This would be considered a Foreign Portfolio Investment o Domestic (US) residents purchase foreign stocks or bonds, thusly supplying “loanable funds” to a foreign firm or government  Foreign Direct Investment ~ would be a plant made by General Motors in Mexico o Domestic (US) residents actively manage the foreign investment and firm  Net Capital Outflow (NCO) = DPFA – FPDA o DPFA > FPDA ~ Domestic Purchase of Foreign Investment ~ NCO > 0 ~ “Capital Outflow” o FPDA > DPFA ~ Foreign Purchase of Domestic Asset ~ NCO < 0 ~ “Capital Inflow” 4 Variables which influence Net Capital Outflow (NCO) 1. The real interest rate paid on foreign assets 2. The real interest rates paid on domestic assets 3. The perceived economic and political risks of holding assets abroad 4. The government policies that affect foreign ownership of domestic assets The identity equation: NCO = NX  Identity ~ is an equation which must hold because of how the variables in the equation are defined and measured: o You sell a home-made software program to someone in Germany. This increases net exports. Your sale was so profitable that you used all of your earnings and bought a Porsche 911 GTX which is made in Germany. This increases US imports by the same amount. This exchange of assets balances the NX and doesn’t impact the NCO. o You sell a home-made software program to someone in Canada. This increases net exports. Since you are a saver and an online trader and believe Canada’s economy will improve, you go out and buy Canadian bonds. The increase (outflow) in NCO exactly equals the NX of the sale of your software and you acquired a foreign asset. o You sell a home-made software program to someone in the United Kingdom. After getting paid for your software, you do nothing with your earnings. In this case the increase in the (outflow) of NCO is gained by holding English pounds which equals NX. o You sell a home-made software program to someone in the Australia. You decide that you want US currency instead and trade the Australian dollars for US dollars at the bank. The bank has 3 options: It can re-sell the currency to another user, it can use the proceeds to buy financial assets or buy something from Australia like boomerangs. The net exports still equals the net capital outflow. In summary of this: When you sell something to someone overseas or out-of-country, domestic capital is flowing out of the US, thusly that earned foreign payment goes to work by buying foreign assets. When you are buying a good or service from a foreign country, their capital is flowing into the US, in essence you are financing your purchase by selling an asset abroad. The Accounting Identities: GDP (Income) (Y) = C + I + G + NX National Saving (S) = Y – C – G S = I + NX (NX = S – I) NX = S – I = NCO = NX S = I + NCO (Saving = Domestic Investment + Net Capital Outflow) NX = Exports – Imports Income = Y = rGDP Spending = C + I + G When a sale of a good or service is made, the seller acquires an asset (payment) from the foreigner and the US acquires some assets:  ↑Exports → ↑NX → ↑NCO → ↑DPFA When a purchase of a foreign good or service occurs, the US citizen pays with assets or dollars and the foreign entity acquires US assets:  ↑Imports → ↓NX → ↓NCO → ↑FPDA When S > I, the excess “loanable funds” flow abroad in the form of positive NCO (NCO > 0). When S < I, foreigners are financing some of the US’s (country’s) investment and NCO < 0. In an open economy:  The supply of “loanable funds” comes from National Saving (Y – C – G).  The demand (borrowing) for “loanable funds” comes from Domestic Investment and Net Capital Outflow (I + NCO). Trade Deficit (NCO < 0) Balanced Trade (NCO = 0) Trade Surplus (NC0 > 0) Imports > Exports Exports = Imports Exports > Imports Inflow of Capital Flow of Capital is Equal Outflow of Capital Net Exports (NX) < 0 Net Exports (NX) = 0 Net Exports (NX) > 0 C + I + G > Y (Spending > Income) Y = C + I + G (Income = Spending) Y > C + I + G (Income > Spending) Saving < Domestic Investment Saving = Investment (S = I) Saving > Domestic Investment Assets are sold abroad No changes in assets Assets are purchased abroad FPDA > DPFA DPFA = FPDA DPFA > FPDA ↓ Acquired Foreign Assets No changes in acquired assets ↑ Acquired Foreign Assets Net Capital Outflow < 0 Net Capital Outflow = 0 Net Capital Outflow > 0 Putting it all together with the “identities”: (See the graphs on page 277) Remember: S (National Saving) = I + NX, then S = I + NCO which transforms to: NCO = S – I  Net Capital Outflow (NCO) = National Saving (S) – Domestic Investment (I) Unbalanced Fiscal Policy  ↓ National Saving (Y – C – G) → ↓ Public Saving (T – G) → ↑ Trade and Government Deficits  If no budget deficit occurred when savings ↓, then domestic investment would have ↓ too An Investment Boom  ↑ Domestic Investment (I) → I > S → ↓ NCO → ↑ Trade Deficit  What is happening here is the US is borrowing from abroad to finance its domestic investment In An Economic Down-Turn  ↓ National Saving & ↓ Domestic Investment → ↓ NCO → ↑ Government & Trade Deficits  From 2000 to 2012, national saving ↓ because of government spending and additional capital became less profitable because of a poor investment climate. The ↓ in national saving was greater than the ↓ in domestic investment which then ↓ NCO and ↑ deficits. Part of national saving (Y – C – G) was financing 2/3 of domestic investment and flows of capital from abroad by the selling of assets abroad financed the other 1/3 of domestic investment. The Prices for International Transactions: Real and Nominal Exchange Rates The nominal exchange rate ~ is that rate at which a person can trade the currency of one country for the currency of another country.  Here, we’ll express all exchange rates as foreign currency per $ unit of US domestic currency Appreciation ~ is an increase in the value (1/P) of a currency as measured by the amount of foreign currency it can buy.  US $ strengthens against a foreign currency Depreciation ~ is a decrease in the value (1/P) of a currency as measured by the amount of foreign currency it can buy.  US $ weakens against a foreign currency Let’s now use the Canadian dollar (CAD) in some “nominal” terms as an example: Canadian dollar (CAD): The exchange rate is 25% or 0.25. Then, 1 + 0.25 = 1.25 CAD/$ (Only if the US dollar is “stronger” than the Canadian dollar: The opposite would happen with a strong CAD)  1.25 CAD/$ is the same as 1/1.25 = 0.80 $/CAD (1 US $ buys 1.25 CAD and CAD buys 0.80 US $) The exchange rate of the Canadian dollar ↑ to 43% or 0.43. Then, 1 + 0.43 = 1.43 CAD/$  1.43 CAD/$ is the same as 1/1.43 = 0.70 $/CAD (1 US $ buys 1.43 CAD and CAD buys 0.70 US $)  The US dollar is said to have “appreciated” against the CAD and buys more CAD/$ The exchange rate of the Canadian dollar ↓ to 15% or 0.15. Then, 1 + 0.15 = 1.15 CAD/$  1.15 CAD/$ is the same as 1/1.15 = 0.87 $/CAD (1 US $ buys 1.15 CAD and CAD buys 0.87 US $)  The US dollar is said to have “depreciated” against the CAD and buys less CAD/$. The exchange rate of the Canadian dollar ↓ to –10% or –0.10. Then, 1 – 0.10 = 0.90 CAD/$  0.90 CAD/$ is the same as 1/0.90 = 1.11 $/CAD (1 US $ buys 0.90 CAD and CAD buys 1.11 US $)  The CAD dollar is said to have “appreciated” against the US $ and buys more US $ per CAD. Economists and financial institutions frequently refer back to an “Exchange Rate Index” in calculating international exchange rates. The CPI (consumer price index) for each country is used in these calculations.  Remember this fact: Nominal values are expressed in $ “signs,” so that an “exchange rate index” is also expressed in $ “signs.” A Real Exchange Rate (RER) or simply (E) ~ is the rate at which a person can trade the goods and services of one country for the goods and services of another country:  RER or E = Foreign goods and services ÷ Unit of domestic goods and service  It is the price of a domestic basket of goods relative to the price basket of a foreign basket of goods.  If the RER appreciates, US goods become more expensive relative to foreign goods & NX ↓  IF the RER depreciates, US goods become less expensive relative to foreign goods & NX ↑ ∗ e = nominal exchange rate P = US price or price index ???? = foreign price or price index ???????????????????????????? ????????????ℎ???????????????? ???????????????? ×???????????????????????????????? ???????????????????? ???? × ???? ????????????× $ 1.25 × 4.50 1 Real Exchange Rate = = ∗ = $ ???????????? ????????????ℎ????= = = 0.5 ???????????????????????????? ???????????????????? ???? ???????????? ????????????ℎ???????? 11.25 2 So, ½ bushel of Canadian wheat = 1 bushel of US wheat ~ ½ bushel of Canadian wheat buys 1 bushel of US wheat and is more costly and inflated in price by 2X. Note that the “$” signs cancel out in the numerator. And then the “CAD dollar” signs cancel too and leaving us with CAD Bushels/US Bushels. Big Mac Index: A “Mac” costs $2.50 in US and ¥400 in Japan. e = ¥120 / $. e × P = ¥300/US Big Mac ???????????????????????????? ????????????ℎ???????????????? ???????????????? ×???????????????????????????????? ???????????????????? ¥300/US Big Mac 3 ???????????????????????????????? ???????????? Real Exchange Rate = = = = 0.75 ???????????????????????????? ???????????????????? ¥400/???????????????????????????????? ???????????? ???????????? 4 ???????? ???????????? ???????????? A Big Mac is more costly in Japan. To buy a Big Mac in the US, a Japanese citizen would forfeit only ¥300; the price of only ¾ of a Big Mac in Japan. In other words, 400 ¥ would get him/her (4/3) 1.33 of a Big Mac in the US, or 1 extra-large fries and a Coke with his/her Big Mac order!!! Score  ∗ A Starbucks latte costs $3 (P) in the US. It costs 24 pesos (???? ) in Mexico. e = 10 pesos / $. The price of a US latte in pesos = e × P = 10 × 3 = 30 pesos / US latte ???????????????????????????? ????????????ℎ???????????????? ???????????????? ×???????????????????????????????? ???????????????????? 30 pesos / US latte 30 ???????????????????????????? ???????????????????? Real Exchange Rate = ???????????????????????????? ???????????????????? = 24 pesos / Mexican latt24= 1.25 ???????? ???????????????????? A US latte would be equivalent to 1.25 latte in Mexico and is more expensive than a Mexican latte. Let’s assume: That, 10 years ago 2 Japanese cars = 1 US car. And today; ½ Japanese car = 1 US car. So, (in 2006) 2 Japanese-cars/1 US car and then (in 2016) ½ Japanese-car/1 US car means that Japanese cars appreciated in price relative to US cars. In other words, in 2016, a Japanese citizen gives up less of-a-car in order to purchase 1 US car today, or gets 2 US cars for 1 Japanese car. Inversely, there is a depreciation of US made cars 10 years later in 2016 as compared to Japanese cars, and US cars are much cheaper; relatively to the price of Japanese made cars. Exports of US cars ↑ and imports of Japanese cars ↓ then NX ↑ All of these prior problems and examples tells us 6 things: 1. When a foreign good is (< 1), it is more expensive than the US good; the US good is cheaper 2. When a foreign good is (> 1), it is less expensive than the US good; the US good is costlier 3. The real exchange rate is determined by nominal exchange rates 4. The real exchange rate is determined by the prices of goods and services in each country’s currency 5. The real exchange rate is a key determinate of exports and imports 6. The real exchange rate uses consumer price indexes (CPI) for calculations A First Theory of Exchange-Rate Determinations: 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.  PPP ~ implies that the nominal exchange rates adjust to equalize the price of a basket of goods across countries.  The Law-Of-One asserts that a good must sell for the same price in all locations.  It is subject to long-run macroeconomics  Parity ~ refers to and means equality  Arbitrage is an implication of the disparity of prices in different locations: o Arbitrage takes advantage of price differences in different locations by buying a commodity at a given price and re-selling it at a higher price in a different location. Through this process supply and demand for that commodity will shift around until a final and settled price occurs where equilibrium is established in price and quantity.  Let’s suppose coffee is $4/lb. in Grand Forks and $5/lb. in Winnipeg. This represents an opportunity in arbitrage in order to make a quick profit by buying coffee in the Grand Forks market and selling it to retailers in Winnipeg. Remember that: P = US price level, CPI measures the price in a basket of goods, and that 1/P = value (purchasing power). The US dollar can be changed into a different currency and have purchasing ∗ power in a foreign currency e/???? so then: ∗  1 = ???? transforms to 1 = ???? × ????then with some algebraic manipulation e = ???? ???? ????∗ ????∗ ???? A Corvette Z06 sells for $110,000 in the US at Rydell’s Chevrolet and for 3,330,000 rubles in Russia. If PPP holds, what is the nominal exchange rate (e)? e = 3,330,000/110,000 = 30 rubles/$. Whoa!! This tells us a few (5) things about PPP and its Implications: 1. If the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate – the relative price of domestic and foreign goods – cannot change. 2. The nominal exchange rate between the currencies of two countries must reflect the ratio of the price levels in those countries. In other words, the nominal exchange rate (e) equals the ratio of the foreign price level (measured in units of the foreign currency) to the domestic price level (measured in units of the domestic currency). 3. When the central bank prints large quantities of money, that money loses value both in terms of the goods and services it can buy and in terms of the amount of other currency’s it can buy. 4. A key implication to this theory is the fact that when nominal exchange rates change so do prices. a. The nominal exchange rate is also depend upon money supply and money demand in each country. 5. Inflation rates may vary between countries and that the greater the inflation rate, the faster that country’s currency depreciates (devalues) against the other country’s currency: a. The nominal exchange rate between two countries should equal the ratio of price levels i. e = ???? /P whereas E = 1 (“E” aka “RER” ~ the real exchange rate) b. Inflation in another country grows faster than the US’s inflation rate ∗ i. ∆???? > ∆P > 0 then e↑ and domestic currency appreciates against foreign currency, in other words, that foreign country’s currency depreciates faster. c. Inflation in the US grows faster than the inflation rate in a foreign country i. ∆P > ∆???? > 0 then e↓ and domestic currency depreciates faster against foreign currency, in other words, foreign currency appreciates against US currency. 2 Limitations of the PPP (Purchasing-Power Parity) Theory  Many goods and services are not easily traded; such as, haircuts, mowing someone’s lawn and going to the movies which can’t be arbitraged away.  Sometimes tradable goods aren’t good (perfect) substitutes and are dependent upon consumer preferences; such as, a German Volkswagen versus a US Tesla electric car o This fact also limits arbiters from gaining profits from price differences The bottom line is: As the real exchange rate drifts from the level predicted by PPP (purchasing- power parity), people have greater incentive to move goods across national boundaries.  Purchasing-power parity is not a precise theory of exchange rates; however, it often provides a reasonable first approximation and explains long-run trends. Summary and Review of Notes Net exports are the value of domestic goods and services sold abroad (exports) minus the value of foreign goods and services sold domestically (imports). Net capital outflow is the acquisition of foreign assets by domestic residents (outflow) minus the acquisition of domestic assets by foreigners (capital inflow). Because every international transaction involves an exchange of an asset for a good or service, an economy’s net capital outflow always equals its net exports (NCO = NX). An economy’s saving can be used either to finance investment at home or to buy assets abroad. Thusly, national saving equals domestic investment plus net capital outflow (S = I + NCO). The nominal exchange rate (e) is the relative price of the currency of two countries, and the real exchange rate (E) 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.” 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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