Harcourt Brace & Company Chapter 29 Open-Market Macroeconomics: Basic Concepts.

Harcourt Brace & Company

Chapter 29

Open-Market Macroeconomics:

Basic Concepts


Open or Closed EconomiesCLOSED ECONOMY:

There are few economic relations with other countries. Exports, imports, and capital flows are restricted.

OPEN ECONOMY:

Exports, imports and capital flow in and out of the country with few restrictions.


An Open EconomyAn open economy interacts with other

countries in two important ways:1. It buys and sells goods and services in

world product markets.

2. It buys and sells capital assets in world financial markets (e.g foreign exchange is traded, foreign investment is allowed).


The Flow of Goods

U.S. Exports:Are domestically (U.S.) produced goods

that are sold abroad.

Example: U.S. aircraft manufacturer, Boeing, building planes in Seattle and selling them to Air France.


The Flow of Goods

U.S. Imports:Are foreign produced goods and services

that are sold to U.S. residents.

Examples: Computer monitors made in Korea and wine produced in France but shipped for consumption in U.S.


The Flow of Goods

• Net Exports (NX) or Trade Balance:– The value of exports minus the value of

imports. • Trade Deficit:

– A situation when net exports (NX) are negative. (i.e. Exports < Imports)

• Trade Surplus:– A situation when net exports (NX) are

positive. (i.e. Exports > Imports)


U.S. Economy

• The U.S. is a very large, open economy. It imports and exports huge quantities of goods and services.

• Capital flows freely in and out of the U.S.

• U.S. trade has been increasing; the U.S. has a persistent trade deficit (see Figure 29-1 and link).


Factors That Influence a Country’s Exports, Imports, and Net Exports

• The tastes of consumers for domestic and foreign goods.

• The prices of goods at home and abroad (impacted by transportation costs).

• Exchange rates.• Government policies toward international

trade.• Economic conditions.


Net Foreign Investment (the flow of capital)

Net Foreign Investment (NFI): difference between foreign assets purchased by residents and domestic assets purchased by foreigners. – Example: U.S. company invests in a

plant in Mexico. A Mexican citizen buys stock in the Ford Motor Corporation.


Net Foreign Investment (NFI)

• When U.S.residents purchase more financial assets in foreign economies than foreigners purchase in the U.S., there is a net capital outflow to other countries.

• If foreigners purchase more U.S. financial assets than U.S. residents spend on foreign financial assets, then there will be a net capital inflow into the U.S.


U.S. Net Foreign Investment

• Negative net foreign investment for U.S. indicates that we are attracting foreign savings (net capital inflow).

• Domestic Investment in the U.S. exceeds U.S. Savings (see Figure 29-2).


The Equality of NX, NFI and S-I

• NX = NFI=S-I• For the U.S., we have a trade deficit

(NX<0), our investment exceeds our

savings (S-I<0 ) and we have a net

capital inflow (NFI<0 ).


Real and Nominal Exchange Rates

International transactions are influenced by international prices. The two most important international prices are:

–Nominal Exchange rate

–Real Exchange Rate


The Nominal Exchange Rate

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– Exchange rate table (see handout). An

exchange rate is expressed in two ways:

1. In units of foreign currency per one U.S. dollar,

2. In units of U.S. dollars per one unit of the foreign currency.


Changing Exchange Rates

– If the exchange rate changes so that a dollar buys more foreign currency, that change is called an appreciation of the dollar. The opposite is called a depreciation of the dollar.

– The yen appreciated vs. the dollar from 1970 to 1995

– The dollar depreciated vs. the pound from 1976 to 1980


The Real Exchange Rate

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. Also “the Terms of Trade.”


Calculating the Real Exchange Rate

Real exchange rates are derived from nominal rates. Computing the real exchange rate involves:




RealExchange

Rate=




RealExchange

Rate=

Nominal Exchange Ratex Domestic Price




RealExchange

Rate=

Nominal Exchange Ratex Domestic Price

Foreign Price


The Real Exchange Rate: Sample Calculation

• American Car $10,000• Japanese Car (imported) 2,400,000

Yen• Nominal Exchange Rate 120 yen=$1• Real Exchange Rate=.5 Japanese car

per American car• Implication: Buy the American Car (it

cost 1/2 the Japanese import)


The Real Exchange Rate

• The real exchange rate is a key determinant of how much a country exports and imports.

• When a country’s real exchange rate is low, its goods are cheap relative to foreign goods, so consumers both at home and abroad tend to buy more of that country’s goods and fewer foreign produced goods.


Purchasing-Power Parity (PPP)• The variation of currency exchange

rates has different sources. An increase in demand will cause a currency to appreciate. A decrease in demand will cause a currency to depreciate.

• The simplest and most widely accepted theory (about long run changes) is called Purchasing-Power Parity Theory.


Purchasing Power Parity

– Purchasing-Power Parity Theory states that “a unit of any given currency should be able to buy the same quantity of goods in all countries.”

– Based upon “The Law of One Price” (i.e. A good must sell for the same price in all locations)


The Law of One Price and Exchange Rates

• This “Law of One Price” applies in the international market.

• The nominal exchange rate between the currencies of two countries will adjust in the long run to achieve parity in prices between countries.


PPP Example

• Assume 2 Marks=1$; Ton of steel costs $100 in U.S.; Ton of steel costs 200 marks in Germany. Do we have parity? (Why “yes”?)

• U.S. experiences inflation (steel price in U.S. rises to $133). What is the new dollar/mark exchange rate which will achieve parity? (Why 1.5 marks/$?)


Limitations of The Purchasing-Power Parity

Two things may keep nominal exchange rates from exactly equalizing purchasing power:

1. Many goods are not easily traded or shipped from one country to another.

2. Traded goods are not always perfect substitutes.

Harcourt Brace & Company Chapter 29 Open-Market Macroeconomics: Basic Concepts.

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