ECO - Ch.18 - Open-Economy Macroeconomics: Basic Concepts
Interpreting the Real Exchange Rate
"The real exchange rate = 0.75 Japanese Big Macs per U.S. Big Mac" 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.
During some year a country had exports of $50 billion, imports of $35 billion, and purchased $30 billion of foreign assets. What was the value of domestic assets purchased by foreigners?
$15 billion
The price of a basket of goods is $2000 in the U.S. If purchasing power parity holds, and the dollar buys two units of some country's currency, then how many units of foreign currency does the same basket of goods cost in that country?
4000
The nominal exchange rate is about 2 Aruban florin per dollar. If a basket of goods in the United States costs $40, how many florins must a basket of goods in Aruba cost for purchasing power parity to hold?
80 florin
If the Fed purchases bonds in the open market, then the money supply curve shifts right.
A change in the price level does not shift the money supply curve.
Suppose a Starbucks tall latte cost $4.00 in the United States, 5.00 euros in the euro area and $2.50 Australian dollars in Australia. Nominal exchange rates are .80 euros per dollar and 1.4 Australian dollars per U.S. dollar. Where does purchasing power parity hold?
Neither the euro area or Australia.
The Real Exchange Rate With Many Goods
P = U.S. price level, e.g., 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 domestic basket of goods relative to price of a foreign basket of goods - If U.S. real exchange rate appreciates, U.S. goods become more expensive relative to foreign goods.
Real exchange rate: (e x P) / P*
P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate, i.e., foreign currency per unit of domestic currency
since NX = NCO
S = I + NCO - Nation Saving must equal its domestic investment plus its net capital outflow
since S = Y - C - G
S = I + NX
nation saving
S = Y-C-G
rearranging terms
Y - C - G = I + NX
gdp - accounting identity
Y = C + I + G + NX
Appreciation (or "strengthening")
an increase in the value of a currency as measured by the amount of foreign currency it can buy
The U.S. Trade Deficit
as of 6-30-2016 •People abroad owned $31.6 trillion in U.S. assets. •U.S. residents owned $24.1 trillion in foreign assets. •U.S.' net indebtedness to other countries = $7.5 trillion. -Higher than every other country's -Hence, U.S. is "world's biggest debtor nation."
A Swiss company sells chocolates to a retailer in the United States. These sales by themselves
decrease U.S. net exports and increase Swiss net exports.
purchase of a foreigner belonged to america
decrease us net capital outflow
If P = domestic prices, P* = foreign prices, and e is the nominal exchange rate, which of the following is implied by purchasing-power parity?
e = P*/P
Example: The "basket" contains a Big Mac. P = price of U.S. Big Mac (in dollars) P* = price of Japanese Big Mac (in yen) e = exchange rate, yen per dollar
e x P = P* - e x P = price of U.S. Big Mac, in yen - P* = price of Japanese Big Mac, in yen e = P*/ P
If PPP holds, the real exchange rate should be
equal to 1
An appreciation of the U.S. real exchange rate induces U.S. consumers to buy
fewer domestic goods and more foreign goods.
We express all exchange rates as
foreign currency per unit of domestic currency.
trade deficit
imports are more than exports - net export is positive
purchase of a us resident outside of america
increase us net capital outflow
When the price level rises, the number of dollars needed to buy a representative basket of goods
increases, and so the value of money falls.
One year a country has positive net exports. The next year it still has positive but larger net exports
its trade surplus rose.
Suppose that U.S. citizens purchase more cars made in Korea, and Koreans purchase more bonds issued by U.S. corporations. Other things the same, these actions
lower both U.S. net exports and U.S. net capital outflows.
trade surplus (NX >0) and (NCO >0)
sell more goods and services to foreigner than it is buying from them
the higher the bond real interest rate
the more attractive -> ppl will buy it - but have to take in account other factors
The Law of One Price
the notion that a good should sell for the same price in all markets - Suppose coffee sells for $4/pound in Seattle and $5/pound in Boston, and can be costlessly transported. - There is an opportunity for arbitrage, making a quick profit by buying coffee in Seattle and selling it in Boston. - Such ARBITRAGE drives up the price in Seattle and drives down the price in Boston, until the two prices are equal.
Nominal exchange rate
the rate at which one country's currency trades for another
Real exchange rate
the rate at which the g&s of one country trade for the g&s of another
nominal exchange rate is the relative price of the currency of two countries,
the real exchange rate is the relative price of the goods and services of two countries
net export also called
trade balance (exports - imports)
trade surplus
when a country exports more than it imports - net export is positive
Some exchange rates,12 July 2016, per US$
•Canadian dollar: 1.31 •Euro: 0.90 •Japanese yen: 104.13 •Mexican peso: 18.39
The nominal exchange rate is 30 Thai baht for one U.S. dollar. A sub sandwich combo deal in the U.S. costs $6 dollars in the U.S. and 120 bhat in Thailand. The real exchange rate is
3/2
Suppose that a country imports $75 million of goods and services and exports $100 million of goods and services. What is the value of net exports?
$25 million
If a country had a trade surplus of $50 billion and then its exports rose by $30 billion and its imports rose by $20 billion, its net exports would now be
$60 billion.
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
Limitations of PPP Theory
- Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends. - For example, PPP implies: the greater a country's inflation rate, the faster its currency should depreciate (relative to a low-inflation country like the US). - The data support this prediction...
PPP and Its Implications
- PPP implies that the nominal exchange rate between two countries should equal the ratio of price levels. - If the two countries have different inflation rates, then e will change over time: - If inflation is higher in Mexico than in the U.S., then P* rises faster than P, so e rises— the dollar appreciates against the peso. - If inflation is higher in the U.S. than in Japan, then P rises faster than P*, so e falls— the dollar depreciates against the yen.
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
Saving, Investment, and International Flows of Goods & Assets
- When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow. - When S < I, foreigners are financing some of the country's investment, and NCO < 0.
An accounting identity: NCO = NX
- arises because every transaction that affects NX also affects NCO by the same amount (and vice versa) - When a foreigner purchases a good from the U.S., + U.S. exports and NX increase + The foreigner pays with currency or assets + The U.S. acquires some foreign assets, causing NCO to rise.
Net capital outflow (NCO):
- domestic residents' purchases of foreign assets minus foreigners' purchases of domestic assets - NCO is also called net foreign investment.
Suppose the real exchange rate is 1/2 gallon of Canadian gasoline per gallon of U.S. gasoline, a gallon of U.S. gasoline costs $5.00 U.S., and a gallon of Canadian gas costs 8 Canadian dollars. What is the nominal exchange rate?
.80 Canadian dollars per U.S. dollar
The flow of capital abroad takes two forms:
1. foreign direct investment 2. foreign portfolio investment
The nominal exchange rate is 2 Barbados dollars per U.S. dollar. If the price of a good in Barbados is 3 Barbados dollars and the price in the U.S. is 2 U.S. dollars, what is the real exchange rate to the nearest 100th?
1.33 Barbados goods per U.S. good
Theory of purchasing-power parity does not always hold in practice
1.Many goods are not easily traded •Price differences on such goods cannot be arbitraged away 2.Even tradable goods are not always perfect substitutes •Price differences reflect taste differences
A country has net capital outflow of -10 billion euros and domestic investment of 20 billion euros. What is its national saving?
10 billion euros
If the exchange rate is 3 units of Peruvian currency per dollar and a hotel room in Lima costs 300 units of Peruvian currency, then how many dollars do you need to get a room?
100 and your purchase will increase Peru's net exports.
e = 10 pesos per $ price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico A. What is the price of a U.S. latte measured in pesos? B. Calculate the real exchange rate, measured as Mexican lattes per U.S. latte.
A. What is the price of a U.S. latte measured in pesos? e x P = (10 pesos per $) x (3 $ per U.S. latte) = 30 pesos per U.S. latte B. Calculate the real exchange rate. (e x P) / P* 30 pesos per U.S. latte / 24 pesos per Mexican latte = 1.25 Mexican lattes per U.S. latte
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: (e x P) / P* = 300 yen per U.S. Big Mac / 400 yen per Japanese Big Mac = 0.75 Japanese Big Macs per U.S. Big Mac
When NCO > 0, "capital outflow"
Domestic purchases of foreign assets exceed foreign purchases of domestic assets - purchase out of the country more than foreigner buy in the us - EXPERIENCE A CAPITAL OUTFLOW
Foreign portfolio investment
Domestic purchases of foreign stocks or bonds that supply "loanable funds" to foreign firms. - Foreign portfolio investment involves an investment that is financed with foreign money but operated by domestic residents + American buy Russian bonds
Foreign direct investment - increase net capital outflow
Domestic residents actively manage the foreign investment - Foreign direct investment occurs when a capital investment is owned and operated by a foreign entity. + open a McDonalds in Moscow.
Appreciation and Depreciation
Examples: During 2007, the U.S. dollar... - depreciated 9.5% against the Euro - appreciated 1.5% against the S. Korean This theory implies that the nominal exchange rate between the currencies of two countries should reflect the price levels in those countries. As a result, countries with relatively high inflation should have depreciating currencies, and countries with relatively low inflation should have appreciating currencies
When NCO < 0, "capital inflow"
Foreign purchases of domestic assets exceed domestic purchases of foreign assets. - foreigner buy more in us than American buy out of country - EXPERIENCE A CAPITAL INFLOW
The country of Wiknam has net capital outflow of $1,000, government purchases of $5,000 and consumption of $20,000. Which of the following is correct?
If its domestic investment is $2,000, its GDP is $28,000.
balanced trade
Imports equal exports - net exports are zero
C. Prices of Mexican goods rise faster than prices of U.S. goods
This makes U.S. goods more attractive relative to Mexico's goods. Exports to Mexico increase, imports from Mexico decrease, so U.S. net exports increase.
A. Canada experiences a recession (falling incomes, rising unemployment)
U.S. net exports would fall due to a fall in Canadian consumers' purchases of U.S. exports
B. U.S. consumers decide to be patriotic and buy more products "Made in the U.S.A."
U.S. net exports would rise due to a fall in imports
NCO measures the imbalance in a country's trade in assets:
When NCO > 0, "capital outflow" When NCO < 0, "capital inflow"
Depreciation (or "weakening")
a decrease in the value of a currency as measured by the amount of foreign currency it can buy
Purchasing-Power Parity (PPP)
a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries - PPP is based on the law of one price - implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries
14. Other things remaining equal, if real interest rates increase abroad, our:
b. net capital outflow will increase.
Julie and John are American residents. Julie buys stock issued by a Japanese company. John opens a sporting goods store in Mexico. Whose purchase, by itself, increases the U.S.'s net capital outflow?
both Julie's and John's
trade deficit (NX<0) and (NCO<0)
buy more goods and services from foreigners than it is selling to them
