Macroeconomics

Lecture 18

An Open Economy

Questions

Born to Choose Middle English chosen, from Old English ceosan; akin to Old High German kiosan

to choose, Latin gustare to taste.

Asset Value to You

Capital Value to Others

Five Ages

Hunter - GatherAgricultureIndustrial

InformationMobile

Economic Progress

Innovation

Getting something to work and think for us.

Hunter-Gatherer AgeMuscle PowerStrongest Won

Agricultural AgeAnimal Strength

PlowFurlong “furrow’s length”

220 yardsby 22 yards

4,840 square yards43,560 square feet

=1 Acre

Used to pump wateroff of potential cropland

Industrial AgeWaterWindSteam

StoreProcessTransmitNetwork

WiredTelephonesComputers

Information Age

Internet • Network • Fixed Points

Information Age LawsMoore’s Law:

Power doubles every 18 months

Segate’s LawStorage doubles every 12 months

Gilder’s LawBandwidth doubles every 6 months

Medcalf ’s LawNetwork value = members squared

Information Age LawsNine Years

2025

Computers 64 xStorage 512 x

Bandwidth 262,144 x7 billion internet users

Wireless Networks

Mobile Age

HunterGatherer Agricultural Industrial Information Mobile

Five Ages

Open Economy

An economy that interacts freely with other economies

around the world

Closed EconomyAn economy that does not

interact with other economies around the

world

Exports

Goods and services that are produced domestically and

sold abroad

Imports

Goods and services that are produced abroad and sold

domestically

Net Exports

The value of a nation’s exports minus the value of its imports; also called the trade

balance

Trade Balance

The value of a nation’s exports minus the value of its imports; also called the

net exports

Net Exports

= Exports - Imports

Trade Surplus

An excess of exports over imports

Trade Deficit

An excess of imports over exports

Balanced Trade

When imports equal exports

Net Capital Outflow

The purchase of foreign assets by domestic residents

minus the purchase of domestic assets by foreigners

Two ways to invest

Direct

Indirect

Foreign Direct Investment

FDI

Directly investing in creating a company

Foreign Portfolio Investment

FPI

Buying stock in a foreign company

StockPortfolio

Carry Stock

Certificates

FirstStock

Exchange

AmsterdamNetherlands

1602

Wall StreetNew York City

Nominal Exchange Rate

The rate at which a person can trade the currencyof one country for the currency of another

Appreciation

An increase in the value of a currency as measured by the amount of foreign currency it

can buy

Depreciation

A decrease in the value of a currency as measured by the amount of foreign currency it

can buy

Foreign Exchange Rate

The rate at which a person can trade the goods and services of one country for the goods and

services of another

Law of One Price

Identical products should sell for identical prices

(ignore transportation and transaction costs)

Arbitrage

Buy low in one market

Sell high in another market

Close the value gap

Purchasing Power Parity

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

Efficient Market

No impediments

No trade barriers

Good information

Purchasing Power Parity PPP

Identical products should sell for identical prices

(ignore transportation and transaction costs)

3.75 0.267

Always two rates

The inverse of each other

1   3.75 = 0.267

1   0.267= 3.75

Cost the same around the world?

Purchasing Power Parity

$4.27 SAR 15

$4.27x

3.75=

SAR 16

SAR 15÷

3.75=

$4.00

$4.27 x 3.75

Implied Exchange Rate 15 to 4.27 = 3.51 to 1

15

Buy Big Macs in Saudi for 15($4.00) and resell in the U.S. for 16 ($4.27) and make

6.75% profit

Currency is undervalued by 6.4% (3.75 to 3.51)

16

x 3.75$4.00