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

Harcourt Brace & Company Open or Closed Economies  CLOSED 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.

Harcourt Brace & Company An Open Economy  An 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).

Harcourt Brace & Company 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.

Harcourt Brace & Company 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.

Harcourt Brace & Company 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)

Harcourt Brace & Company 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).link

Harcourt Brace & Company 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.

Harcourt Brace & Company 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.

Harcourt Brace & Company 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.

Harcourt Brace & Company 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).

Harcourt Brace & Company 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 ).

Harcourt Brace & Company 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

Harcourt Brace & Company 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.

Harcourt Brace & Company 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.

Harcourt Brace & Company 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

Harcourt Brace & Company 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.”

Harcourt Brace & Company Calculating the Real Exchange Rate  Real exchange rates are derived from nominal rates. Computing the real exchange rate involves:

Harcourt Brace & Company Calculating the Real Exchange Rate  Real exchange rates are derived from nominal rates. Computing the real exchange rate involves: Real Exchange Rate =

Harcourt Brace & Company Calculating the Real Exchange Rate  Real exchange rates are derived from nominal rates. Computing the real exchange rate involves: Real Exchange Rate = Nominal Exchange Rate x Domestic Price

Harcourt Brace & Company Calculating the Real Exchange Rate  Real exchange rates are derived from nominal rates. Computing the real exchange rate involves: Real Exchange Rate = Nominal Exchange Rate x Domestic Price Foreign Price

Harcourt Brace & Company 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)

Harcourt Brace & Company 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.

Harcourt Brace & Company 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.

Harcourt Brace & Company 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)

Harcourt Brace & Company 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.

Harcourt Brace & Company 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 $133). What is the new dollar/mark exchange rate which will achieve parity? (Why 1.5 marks/$?)

Harcourt Brace & Company 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.