Econ - Chapter 31

If S - I = NX < 0

-This is a trade deficit. -If the amount of investment demanded domestically exceeds the amount of national savings then there is a shortage of funds available. -The shortage of loanable funds is met by selling domestic assets in order to borrow from abroad. -There is net borrowing from the world financial markets and as a result net capital outflow is negative.

If S - I = NX > 0

-This is a trade surplus. -If the amount of domestic savings exceeds the amount of investment demand domestically then there are excess funds in the economy. -These excess funds are sent abroad to purchase foreign assets. -This country is a net lender to the world financial markets and as a result net capital outflow is positive.

If S - I = NX = 0

-This is called a balanced trade. -There is no borrowing or lending in the world financial markets. -The amount of investment demand domestically equals the amount of national savings. Net capital outflow is zero

principle of the law of one price

-if the costs of transportation are small and the good is easy to trade, the price of the same good in different countries should be roughly the same. In other words, the relative price of a good between the foreign and domestic country should be 1 (the real exchange rate should be 1). If the price were different there is a potential for profit

Real Exchange Rate (ε)

-shows the relative price of the goods of 2 countries (it is expressed in terms of units of foreign goods per unit of domestic goods). -An intuitive way to think of the real exchange rate is that it tells us how much foreign goods we could have purchased for the amount it took to purchase 1 unit of domestic good -think output

f purchasing power parity holds it must be the case that real exchange rate (ε = 1). Using our formula for real exchange rate we find that

1 = e x (P/P*) or e = (P*/P)

Limitations of Purchasing Power Parity

1. Most goods are not easily traded 2. Goods are not equal substitutes

Depreciation of currency

A fall in the exchange rate. The domestic currency can buy less foreign currency

appreciation of currency

An increase in the exchange rate. The domestic currency can purchase more foreign currency

National Savings =

Domestic Investment + Net Exports or Domestic Investment + Net Capital Outflow

NCO > 0

Domestic residents are purchasing more foreign assets than foreigners are purchasing domestic assets. Capital is flowing out of the country

NCO < 0

Foreigners are purchasing more domestic assets than domestic residents are purchasing foreign assets. Capital is flowing into the country. This scenario is also referred to as a capital inflow

the relationship between net exports and net capital outflow can be expressed in the following identity

NX = NCO (net exports must always equal net capital outflow)

Most goods are not easily traded

One of the big assumptions of purchasing power parity was that if the price of a good was cheaper in one country a profit opportunity existed by purchasing the good in the relatively cheaper country and reselling the good in the relatively expensive country. However, some goods (and especially services) cannot be traded.

Net capital outflow =

Purchase of foreign assets by domestic residents - Purchase of domestic assets by foreigners. -can be either positive or negative

real exchange rate equation

Real Exchange Rate = Nominal Exchange Rate x (Price of Domestic Goods/Price of Foreign Goods) ε = e x (P/P*) P = domestic price level P* = foreign price level

Goods are not equal substitutes

The second problem is that even if goods are tradable, it might be the case that they are not exactly the same. An American car is not the same as a Japanese car. Japanese cars might be worth more relative to an American car because Japanese cars are perceived to be of higher quality than their American counterparts. Purchasing power parity assumed that goods are the equivalent across countries, if that assumption does not hold then PPP does not hold.

NX < 0

This is a trade deficit. A country which is running a trade deficit is buying more goods and services abroad than it sells to foreign countries.

NX > 0

This is a trade surplus. A country which is running a trade surplus is selling more goods and services abroad than it buys from foreign countries.

NX = 0

This is called a balanced trade. The amount a country sells to foreign countries is exactly equal to the amount it buys from foreign countries

output equation

Y = C + I + G + (EX-IM) → Y = C + I + G + NX

A decrease in the money supply will lead to an

appreciation of the nominal exchange rate.

purchasing power parity

argues that it must be the case that nominal exchange rates are set in ways that make the law of one price hold. -The U.S. dollar must be able to purchase the same amount of goods in the United States as in Japan (after we exchange the dollar for Yens). -In other words, the real exchange rate must be equal to 1

An increase in the money supply will lead to a

depreciation of the nominal exchange rate.

closed economy

economy that does not engage in trade (NX=0)

open economy

economy that trades

nominal exchange rate equation

exchange rate = (foreign currency / domestic currency)

net capital outflow

measures the imbalance between financial assets that arises between countries.

In order to measure the flow of financial assets between countries we use a term called

net capital outflow (NCO) or sometimes referred to as net foreign investment.

NX

net exports trade balance

identity says that

output = domestic spending (C+I+G) + net exports.

Nominal exchange rate depends on the

price levels of the foreign county and domestic country.

When the real exchange rate is high (greater than 1), then foreign goods are

relatively cheaper than domestic goods. -There will be an increase in demand for foreign goods (imports) and less demand abroad for domestic goods (exports). -Thus net exports (X) will be lower.

When the real exchange rate is low (lower than 1), then foreign goods are

relatively more expensive than domestic goods. -There will be a decrease in demand for foreign goods (imports) and more demand abroad for domestic goods (exports). -Thus net exports (X) will be higher.

net exports measures

the imbalance between goods and services that arises between countries

Nominal Exchange rate (e)

the price at which foreign currency trades for 1 unit of domestic currency usually assume that the unit of domestic currency will be the U.S. Dollar