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EC111 Macroeconomics Chapter 18 Notes

by: Lauren Heller

EC111 Macroeconomics Chapter 18 Notes Econ 111

Marketplace > University of Alabama - Tuscaloosa > Econ 111 > EC111 Macroeconomics Chapter 18 Notes
Lauren Heller
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About this Document

These notes cover all of chapter 18 and were taken from the professors lecture. Also include aplia hints for the homework.
Kent 0. Zirlott
Class Notes
econ111, EC111, Econ, Economics, Macro, Macroeconomics, chapter 18 notes
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This 5 page Class Notes was uploaded by Lauren Heller on Tuesday April 12, 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 21 views.


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Date Created: 04/12/16
Chapter 18  Introduction:  Trade can make everyone better of  Ten principles of Economies  International macroeconomics  The trade balance (trade deficits, surpluses)  International flow of assets  Exchange rates  Closed vs. open economies  Closed economy- does not interact with other economies in the world  Open economy- interacts freely with other economies around the world  The flow of goods and services  Exports- domestically produced goods and services sold abroad  Imports- foreign produced goods and services sold domestically  Net exports (NX)- value of exports – value of imports  Aka the trade balance  Variables the influence Net Exports  Consumers preferences for foreign and domestic goods  Prices of goods at home and abroad  Incomes of consumers at home and abroad  The exchange rates at which foreign currency trades for domestic currency  Transportation costs  Government policies  Trade surpluses and deficits  Net exports 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 equal imports  NX = 0 and Y = C + I + G  The increasing openness of U.S. economy  Increasing importance of international trade and finance  1950, imports and exports 4-5% of GDP  Recent years, exports increased more than twice, imports increased more than three times  Increase in international trade  Improvements in transportation  Advances in telecommunications  Technological progress  Government trade polices – NAFTA, GATT  Net capital outflow (NCO) – domestic residents purchases of foreign assets minus foreigners’ purchases of domestic assets  NCO is also called net foreign investment  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  The flow of capital abroad takes two forms:  Foreign direct investment- domestic residents or firms set up a foreign subsidiary and actively manage the foreign investment  Such as: McDonald’s opens a fast food outlet in Moscow, Disney builds a theme park in Hong Kong  Foreign portfolio investment- domestic residents purchase foreign stocks or bonds, supply “loanable funds” to foreign firms  Such as: an American buys stock in Toyota  Variables that influence NCO  Real interest rates paid on foreign assets  Real interest rates paid on domestic assets  Perceived risks of holding foreign assets  Governments policies afecting foreign ownership of domestic assets  The equality of NX and NCO  An accounting identity: NCO = NX  An arises because every transaction that afects NX also afects NCO by the same amount  When foreigners purchase a good for the U.S.  U.S. exports and NX increase  The foreigner pays with currency or assets, so the U.S. requires some foreign assets, causing NCO to rise  Saving, Investment, and International Flow of Goods and Assets  Accounting Identity:  Y = C + I + G + NX  Rearranging terms:  Y – C – G = I + NX  Since S = Y – C – G then…  S = I + NX  Since NX = NCO then…  S = I + NCO  In an open economy  S = I + NCO  And S – I = NCO and NX  When S > I, then NCO > 0 and the excess loanable funds flow abroad in the form of positive net capital outflow (trade surplus)  When S < I, then NCO < 0 and foreigners are financing some of the country’s investments in the form of negative net capital outflow (trade deficit)  Nominal exchange rate- the rate at which one country’s currency trades from another  We express all exchange rates as foreign currency per unit of domestic currency  Appreciation- (or strengthening) an increase in the value of currency as measured by the amount of foreign currency it can buy  it takes more foreign currency to buy one US dollar  a “strong” dollar causes U.S. goods to become more expensive compared to foreign produced goods, so U.S. exports will fall and imports to the U.S. will rise  depreciation- (or weakening) 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 U.S. dollar  a “weak” dollar cause U.S. goods to become less expensive compared to foreign produced goods, so U.S. exports will rise and imports to the U.S. will fall  Real exchange rate- the rate at which the goods and services of one country trade for the good and services of another  = (e X P) / P*  where  P = domestic price  P* = foreign price (in foreign currency)  e = nominal exchange rate, foreign currency per unit of domestic currency  Purchasing-power parity (PPP)- a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries  Based on law of one price- the notion that a good should sell for the same price in all markets  Implies that the nominal exchange rates adjust to equalize the price of a basket of goods across the countries  e = P* / P  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  If the two countries have diferent inflation rates, the e will change over time  If inflation is higher in Mexico than in the U.S. then P* rises faster than P, so e rises – the dollar appreciates against the peso  If inflation is higher in the U.S. than in Japan, then P rises faster than P*, so e falls – the dollar depreciates against the yen  Limitation of the PPP theory  Two reasons why exchange rates do not always adjust to equalize prices across countries:  Many goods cannot easily be traded  Examples: haircuts, going to the movies  Price diferences on such goods cannot be arbitraged away  Foreign, domestic goods not perfect substitutes  Some U.S. consumers prefer Toyotas over Chevys, or vice verse  Price diferences reflect taste diferences  The market for loanable funds  S = I + NCO  S = savings  I = domestic investment  NCO = net capital outflow  Supply of loanable funds = savings  A dollar saving can be used to finance  The purchase of domestic capital  The purchase of a foreign asset  Demand for loanable funds = I + NCO  Remember:  S depends positively on the real interest rate r  I depends negatively on r  NCO and the real interest rate  The real interest rate, r, is the real return on domestic assets  A fall in r makes domestic assets less attractive to foreign assets  People in the U.S. purchase more foreign assets  People abroad purchase fewer U.S. assets  NCO rises  The loanable fund market diagram  R adjusts to balance supply and demand in the LF market  Both I and NCO depend negatively on r, so the D curve is down-ward sloping  The market for foreign-currency exchange  NCO = NX  NCO = net capital outflow  NX = net exports  NX is the demand for dollars  Foreigners need dollars to buy U.S. net exports  NCO is the supply of dollars  U.S. residents sell dollars to obtain the foreign currency they need to buy foreign assets  Recall:  The U.S. real exchange rate (E) measures the quantity of foreign goods and services that trade for one unit of U.S. goods and services  E is the real value of a dollar in the market for foreign-currency exchange  The market for foreign-currency exchange diagram  An increase in E makes U.S. goods more expensive to foreigners reduces foreign demand for U.S. goods – and U.S. dollar  An increase in E has no efect on saving or investment, so it does not afect NCO or the supply of dollars  Supply curve perfectly inelastic (vertical line)  Appreciation and depreciation on next test  The connection between interest rate and exchange rate  Anything that increases r will reduce NCO and supply of dollars in the foreign exchange market  Result: the real exchange rate appreciates (rises)  Help on Aplia assignment:  Domestic spending = C + I  Consumption + Imports  GDP = DS + NX  = domestic spending + net exports  number 8: one unit of foreign currency equals this of American currency  reverse of what went over in class  example on blackboard if you need help  number 11: follow example  export only if the PPP exchange rate is lower 


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