CH 13 - Open-Economy Macroeconomics Basic Concepts PDF

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Instructor: Dr. Derek Stimel...

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MAY 18, 23 CH 13 - Open-Economy Macroeconomics: Basic Concepts Trade Surpluses & Deficits NX measures the imbalance in a country’s trade in goods and services NX = Exports - Imports Trade deficit (NX < 0): an excess of imports over exports Trade surplus (NX > 0): an excess of exports over imports Balanced trade (NX = 0): when exports = imports Variables that 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 Govt policies Ex. tariffs: taxes on imported goods The Flow of Capital

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Net capital outflow / Net foreign investment (NCO): (domestic residents’ purchases of foreign assets) - (foreigners’ purchases of domestic assets) NX = Exports Imports NCO = (Capital Outflow) - (Capital Inflow) From the POV of the US Capital outflow = when we export domestic assets (when the US obtains foreign assets) Capital inflow = when we import domestic assets (when a foreign country obtains US assets) We’re assuming that the US is the “domestic” country The flow of money 1 way has to equal the flow of money the other way Bc goods & services always flow 1 way, and assets flow the other way Takes 2 forms Foreign direct investment: domestic residents actively manage the foreign investment Ex. McDonalds opens a fast-food outlet in Moscow Foreign portfolio investment: domestic residents purchase foreign stocks or bonds Supplying “loanable funds” to a foreign firm Measures the imbalance in a country’s trade in assets When NCO > 0 (+), (domestic purchases of foreign assets) > (foreign purchases of domestic assets) The US is getting more foreign assets than foreigners are getting of our assets When NCO < 0 (-), (domestic purchases of foreign assets) < (foreign purchases of domestic assets) Deficit Foreigners are getting more US assets than the US is getting in foreign assets

Variables that influence NCO Real interest rates paid on foreign assets Real interest rates paid on domestic assets Perceived risks of holding foreign assets Govt policies affecting foreign ownership of domestic assets The Equality of NX and NCO An accounting identity: NCO = NX arises bc every transaction that affects NX also affects NCO by the same amount (and vice versa) Net Capital Outflow has to equal Net Exports Closed Economy assumption: S = I When a foreigner purchases a good from the US US exports and NX increase The foreigner pays w/currency or other assets, so the US acquires some foreign assets → NCO will rise When a US citizen buys foreign goods US imports rise, NX falls The US buyer pays w/US dollars or other assets, so the other country acquires US assets → US NCO will fall

Saving, Investment, and International Flows of Goods & Assets Y = C + I + G + NX accounting identity → Y - C - G = I + NX rearranging items → S = I + NX since S = Y - C - G → S = I + NCO since NX = NCO National savings = Investment (in own country) + Investments (overseas on net) ^ NCO Public saving + National saving = I + NX = I + NCO When (we save more) S > I, the excess loanable funds flow abroad in the form of positive net capital outflow When (we save less) S < I, foreigners are financing some of the country’s investment, and NCO < 0 What the US has (US is financed by a lot of foreign investment)

The Nominal Exchange Rate (e) Nominal exchange rate (e): the rate at which one country’s currency trades for another We express all exchange rates as foreign currency per unit of domestic currency For this class, we will always express it as “foreign dollar per US dollar” (foreign currency) / (US dollar) Appreciation and Depreciation Appreciation (“strengthening”): an increase in the value of a currency as measured by the amount of foreign currency it can buy Depreciation (“weakening”): a decrease in the value of a currency as measured by the amount of foreign currency it can buy Ex. exchange rate right now = (18.84 mexican pesos) / $1 US I can buy 18.84 mexican pesos with $1 US next year's exchange rate = (20.23 mexican pesos) / $1 US The US dollar can buy more mexican pesos The US dollar appreciates relative to the peso The peso is depreciating relative to the dollar The Real Exchange Rate Real exchange rate =

the rate at which the goods & services of one country trade for the goods & services of another

nominal exchange rate → real exchange rate P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate Ex. foreign currency per unit of domestic currency If US real exchange rate (US $$) Appreciates against the euro US Imports ↑ Euro products is going to start to look cheaper for those that hold US dollars US NX ↓ Bc Europeans will see things as more expensive and buy less US NCO ↓ **NX = NCO Depreciates against the euro US dollar is losing value / purchasing power against the Euro Euro is appreciated against the US dollar US Imports ↓ Anything that is priced in Euros is going to start to look expensive for those that hold US dollars US NX ↑ Bc Europeans will see things as cheaper US NCO ↑ **NX = NCO -

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Example w/1 good A Big Mac costs $2.50 in the US, 400 yen in Japan e = 120 yen per $ e x P = price in yen of a US Big Mac = (120 yen per $) x ($2.50 per Big Mac) = 300 yen per US Big Mac

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Real exchange rate: (e x P) / P* = 300 yen per U.S. Big Mac / 400 yen per Japanese Big Mac = 0.75 Japanese Big Macs per US Big Mac

The Real Exchange Rate w/Many Goods P = US price level Ex. Consumer Price Index measures the price of a basket of goods P* = foreign price level Real exchange rate = (e x P) / P* = price of a dometic basket of goods relative to price of a foreign basket of goods If US real exchange rate depreciates, US goods become more expensive relative to foreign goods The Law of One Price Law of one price: the notion that a good should sell for the same price in all markets (as long as trade is allowed) Suppose coffee sells for $4/pound in Seattle and $5/pound in Boston, and can be costlessly transported → There is an opportunity of arbitrage: making a quick profit by buying coffee in Seattle and selling it in Boston → Drives up the price in Seattle and drives down the price in Boston, until the 2 prices are equal Should apply to everything, including currency Purchasing-Power Parity (PPP) Purchasing-power parity: a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries (unit of currency should be the same in all markets) Supersized version of the Law of One Price Purchasing power is measured by the price level (CPI) When price level (CPI) goes up, then we know the value of the dollar is going down “ “ down, “ “ up Implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries Real exchange rate should always = 1 Ex. The “basket” contains a Big Mac P = price of US Big Mac (in dollars) P* = price of Japanese Big Mac (in yen) e = exchange rate, yen per dollar According to PPP P* = e x P P* = price of Japanese Big Mac, in yen e x P = price of US Big Mac, in yen → Solve for e Implies that the nominal exchange rates (e) between 2 countries should equal the ratio of price levels Goods should be tradeable If 2 countries have different inflation rates, then e will change over time If inflation is higher in Mexico than in the US, P* rises faster than P, so e rises (the dollar appreciates against the peso) Prices on avg are rising faster in Mexico than it is in the US The peso is losing value faster If inflation is higher in the US than in Japan, P rises faster than P*, so e falls (the dollar depreciates against the yen) Limits of PPP Theory 2 reasons why exchange rates do not always adjust to equalize prices across countries 1. Many goods cannot easily be traded Ex. haircuts, going to the movies Price differences on such goods cannot be arbitraged away 2. Foreign, domestic goods are not perfect substitutes Ex. some US consumer prefers Toyotas over Chevys, or vice versa Price differences reflect taste differences...