2007 Thomson South-Western
Open-Economy Macroeconomics:
Basic Concepts
Open and Closed Economies
A closed economy is one that does not interact with
other economies in the world.
There are no exports, no imports, and no capital flows.
An open economy is one that interacts freely with
other economies around the world.
2007 Thomson South-Western
Open-Economy Macroeconomics: Basic
Concepts
An open economy interacts with other
countries in two ways.
It buys and sells goods and services in world
product markets.
It buys and sells capital assets in world financial
markets.
2007 Thomson South-Western
THE INTERNATIONAL FLOW OF
GOODS AND CAPITAL
The Flow of Goods: Exports, Imports, and Net
Exports
The United States is a very large and open
economyit imports and exports huge quantities
of goods and services.
Malaysia is a small but open economy.
Over the past four decades, international trade and
finance have become increasingly important.
2007 Thomson South-Western
The Flow of Goods: Exports, Imports, Net
Exports
Exports are goods and services that are
produced domestically and sold abroad.
Imports are goods and services that are
produced abroad and sold domestically.
2007 Thomson South-Western
The Flow of Goods: Exports, Imports, Net
Exports
Net exports (NX) are the value of a nations
exports minus the value of its imports.
Net exports are also called the trade balance.
2007 Thomson South-Western
The Flow of Goods: Exports, Imports, Net
Exports
A trade deficit is a situation in which net
exports (NX) are negative.
Imports > Exports
A trade surplus is a situation in which net
exports (NX) are positive.
Exports > Imports
Balanced trade refers to when net exports are
zeroexports and imports are exactly equal.
2007 Thomson South-Western
The Flow of Goods: Exports, Imports, Net
Exports
Factors That Affect Net Exports
The tastes of consumers for domestic and foreign
goods.
The prices of goods at home and abroad.
The exchange rates at which people can use
domestic currency to buy foreign currencies.
2007 Thomson South-Western
The Flow of Goods: Exports, Imports, Net
Exports
Factors That Affect Net Exports
The incomes of consumers at home and abroad.
The costs of transporting goods from country to
country.
The policies of the government toward international
trade.
2007 Thomson South-Western
Figure 1 The Internationalization of the Malaysian Economy
140.00
120.00
Percentage
100.00
80.00
X/Y
M/Y
60.00
40.00
20.00
0.00
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Year
2007 Thomson South-Western
The Flow of Financial Resources: Net
Capital Outflow
Net capital outflow refers to the purchase of
foreign assets by domestic residents minus the
purchase of domestic assets by foreigners.
A Malaysian resident buys stock in the Toyota
corporation (capital outflow) and a Mexican buys
stock in TM corporation (capital inflow).
2007 Thomson South-Western
The Flow of Financial Resources: Net
Capital Outflow
When a Malaysian resident buys stock in
Telmex, the Mexican phone company, the
purchase raises Malaysias net capital outflow.
When a Japanese residents buys a bond issued
by the Malaysian government, the purchase
reduces Malaysias net capital outflow.
2007 Thomson South-Western
The Flow of Financial Resources: Net
Capital Outflow
Variables that Influence Net Capital
Outflow
The real interest rates being paid on foreign assets.
The real interest rates being paid on domestic
assets.
The perceived economic and political risks of
holding assets abroad.
The government policies that affect foreign
ownership of domestic assets.
2007 Thomson South-Western
The Equality of Net Exports and Net
Capital Outflow
For an economy as a whole, NX and NCO must
balance each other so that:
NCO = NX
This holds true because every transaction that
affects one side must also affect the other side
by the same amount.
2007 Thomson South-Western
Saving, Investment, and Their
Relationship to the International Flows
Net exports is a component of GDP:
Y = C + I + G + NX
National saving is the income of the nation that
is left after paying for current consumption and
government purchases:
Y C G = I + NX
2007 Thomson South-Western
Saving, Investment, and Their
Relationship to the International Flows
National saving (S) equals Y C G so:
S = I + NX
or
Saving
Domestic + Net Capital
Investment
Outflow
I
NCO
2007 Thomson South-Western
Table 1 International Flows of Goods and Capital: Summary
2007 Thomson South-Western
THE PRICES FOR INTERNATIONAL
TRANSACTIONS: REAL AND NOMINAL
EXCHANGE RATES
International transactions are influenced by
international prices.
The two most important international prices
are the nominal exchange rate and the real
exchange rate.
2007 Thomson South-Western
Nominal Exchange Rates
The nominal exchange rate is the rate at which a
person can trade the currency of one country for the
currency of another.
2007 Thomson South-Western
Nominal Exchange Rates
The nominal exchange rate is expressed in two
ways:
In units of foreign currency per one ringgit.
And in units of ringgit per one unit of the foreign
currency.
2007 Thomson South-Western
Nominal Exchange Rates
Assume the exchange rate between the
Japanese yen and RM is 80 yen to one ringgit.
One ringgit trades for 80 yen.
One yen trades for 1/80 (= 0.0125) of a ringgit.
2007 Thomson South-Western
Nominal Exchange Rates
Appreciation refers to an increase in the value
of a currency as measured by the amount of
foreign currency it can buy.
Depreciation refers to a decrease in the value of
a currency as measured by the amount of
foreign currency it can buy.
2007 Thomson South-Western
Nominal Exchange Rates
If a dollar buys more foreign currency, there is
an appreciation of the ringgit.
If it buys less there is a depreciation of the
ringgit.
2007 Thomson South-Western
Real Exchange Rates
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.
2007 Thomson South-Western
Real Exchange Rates
The real exchange rate compares the prices of
domestic goods and foreign goods in the
domestic economy.
If a case of German beer is twice as expensive as
American beer, the real exchange rate is 1/2 case of
German beer per case of American beer.
2007 Thomson South-Western
Real Exchange Rates
The real exchange rate depends on the nominal
exchange rate and the prices of goods in the
two countries measured in local currencies.
2007 Thomson South-Western
Real Exchange Rates
The real exchange rate is a key determinant of
how much a country exports and imports.
Nominal exchange rate Domestic price
Real exchange rate =
Foreign price
2007 Thomson South-Western
Real Exchange Rates
A depreciation (fall) in Malaysias real
exchange rate means that Malaysian goods
have become cheaper relative to foreign goods.
This encourages consumers both at home and
abroad to buy more Malaysian goods and fewer
goods from other countries.
2007 Thomson South-Western
Real Exchange Rates
As a result, Malaysias exports rise, and
Malaysias imports fall, and both of these
changes raise Malaysias net exports.
Conversely, an appreciation in Malaysias real
exchange rate means that Malaysian goods
have become more expensive compared to
foreign goods, so Malaysias net exports fall.
2007 Thomson South-Western
A FIRST THEORY OF
EXCHANGE-RATE DETERMINATION:
PURCHASING-POWER PARITY
The purchasing-power parity theory is the
simplest and most widely accepted theory
explaining the variation of currency exchange
rates.
2007 Thomson South-Western
The Basic Logic of Purchasing-Power
Parity
Purchasing-power parity is 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.
According to the purchasing-power parity
theory, a unit of any given currency should be
able to buy the same quantity of goods in all
countries.
2007 Thomson South-Western
The Basic Logic of Purchasing-Power
Parity
The theory of purchasing-power parity is based
on a principle called the law of one price.
According to the law of one price, a good must
sell for the same price in all locations.
If the law of one price were not true,
unexploited profit opportunities would exist.
The process of taking advantage of differences
in prices in different markets is called arbitrage.
2007 Thomson South-Western
The Basic Logic of Purchasing-Power
Parity
If arbitrage occurs, eventually prices that
differed in two markets would necessarily
converge.
According to the theory of purchasing-power
parity, a currency must have the same
purchasing power in all countries and exchange
rates move to ensure that.
2007 Thomson South-Western
Implications of Purchasing-Power Parity
If the purchasing power of the dollar is always
the same at home and abroad, then the
exchange rate cannot change.
The nominal exchange rate between the
currencies of two countries must reflect the
different price levels in those countries.
2007 Thomson South-Western
Implications of Purchasing-Power Parity
When the central bank prints large quantities of
money, the money loses value both in terms of
the goods and services it can buy and in terms
of the amount of other currencies it can buy.
2007 Thomson South-Western
Figure 3 Money, Prices, and the Nominal Exchange Rate During the
German Hyperinflation
Indexes
(Jan. 1921 = 100)
1,000,000,000,000,000
Money supply
10,000,000,000
Price level
100,000
Exchange rate
.00001
.0000000001
1921
1922
1923
1924
1925
2007 Thomson South-Western
Limitations of Purchasing-Power Parity
Many goods are not easily traded or shipped
from one country to another.
Tradable goods are not always perfect
substitutes when they are produced in different
countries.
2007 Thomson South-Western
Example With One Good
A Big Mac costs $2.50 in U.S., 400 yen in Japan
e = 120 yen per $
e x P = price in yen of a U.S. Big Mac
= (120 yen per $) x ($2.50 per Big Mac)
= 300 yen per U.S. Big Mac
Compute the real exchange rate:
300 yen per U.S. Big Mac
exP
=
P*
400 yen per Japanese Big Mac
= 0.75 Japanese Big Macs per US Big Mac
Interpreting the Real Exchange Rate
The real exchange rate =
0.75 Japanese Big Macs per U.S. Big Mac
This does not mean a Japanese citizen
literally exchanges Japanese burgers for American
ones.
Correct interpretation:
To buy a Big Mac in the U.S.,
a Japanese citizen must sacrifice
an amount that could purchase
0.75 Big Macs in Japan.
Summary
Net exports are the value of domestic goods
and services sold abroad minus the value of
foreign goods and services sold domestically.
Net capital outflow is the acquisition of
foreign assets by domestic residents minus the
acquisition of domestic assets by foreigners.
2007 Thomson South-Western
Summary
An economys net capital outflow always
equals its net exports.
An economys saving can be used to either
finance investment at home or to buy assets
abroad.
2007 Thomson South-Western
Summary
The nominal exchange rate is the relative price
of the currency of two countries.
The real exchange rate is the relative price of
the goods and services of two countries.
2007 Thomson South-Western
Summary
When the nominal exchange rate changes so
that each ringgit buys more foreign currency,
the ringgit is said to appreciate or strengthen.
When the nominal exchange rate changes so
that each ringgit buys less foreign currency,
the ringgit is said to depreciate or weaken.
2007 Thomson South-Western
Summary
According to the theory of purchasing-power
parity, a unit of currency should buy the same
quantity of goods in all countries.
The nominal exchange rate between the
currencies of two countries should reflect the
countries price levels in those countries.
2007 Thomson South-Western
