Chapter 18

When NCO < 0

"capital inflow" Foreign purchases of domestic assets exceed domestic purchases of foreign assets

When NCO > 0

"capital outflow" Domestic purchases of foreign assets exceed foreign purchases of domestic assets

Real exchange rate formula

(e x P)/P*

Variables that Influence Net Exports

-Consumers' preferences -Prices of goods at home/abroad -Incomes of consumers at home/abroad -The exchange rates at which foreign currency trades for domestic currency -Transportation costs -Gov. policies

Two reasons why exchange rates do not always adjust to equalize prices across countries

-Many goods cannot easily be traded ex:haircuts, going to the movies -price differences on such goods cannot be arbitraged away Foreign domestic goods not perfect subsitures -ex some us consumers prefer toyotas over chevys vice verse price differences reflect taste differences

When a foreigner purchases a good from the US

-U.S. exports and NX increase -the foreigner pays with currency or assets, so the U.S. acquires some foreign assets, causing NCO to rise.

When a U.S. citizen buys foreign goods

-U.S. imports rise, NX falls -the U.S. buyer pays with U.S. dollars or assets, so the other country acquires U.S. assets, causing U.S. NCO to fall.

Real exchange rate = 2

1 us good for 2 foreign goods

Real exchange rate = 3

1 us good for 3 foreign goods

Variables that Influence NCO

1. Real interest rates paid on foreign assets 2. Real interest rates paid on domestic assets 3. Perceived risks of holding foreign assets 4. Govt policies affecting foreign ownership of domestic assets

If a country had a trade surplus of $100 billion and then its exports rose by $40 billion and its imports rose by $30 billion, its net exports would now be

110 billion NX = 100 40-30= 10 100 + 10

trade deficit

An excess of imports over exports

Foreign direct investment

Domestic residents actively manage the foreign investment ex: Mcdonalds opens a fast-food outlet in Moscow Apple opens up a shop in China

Trade deficits

EX < IM NX < 0 Y < C + I + G S < I NCO < 0

The flow of capital takes two forms

Foreign direct investment Foreign portfolio investment

NCO =

NX

(e x P)/P*

P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate, ex: foreign currency per unit of domestic currency

P =

U.S. price level, e.g., Consumer Price Index, measures the price of a basket of goods

Canada experiences a recession (falling incomes, rising unemployment) on NX = EX - IM

US exports would go down US net exports would go down Imports remained unchanged

If the U.S. real exchange rate appreciates,

US goods become more expensive relative to foreign goods

US consumers decide to be patriotic and buy more products "Made in the USA" on NX = EX - IM

US imports would go down US net exports goes up

Prices of goods produced in Mexico rise faster than prices of goods produces in the US on NX = EX - IM

Us imports would go down US exports would go up

Depreciation (weakening)

a decrease in the value of a currency as measured by the amount of foreign currency it can buy

Purchasing Power Parity

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

Trade surplus

an excess of exports over imports

Appreciation (strengthening)

an increase in the value of a currency as measured by the amount of foreign currency it can buy

Closed economy

does not interact with other economies in the world

foreign portfolio investment

domestic residents purchase foreign stocks or bonds, supplying "loanable funds" to a foreign firm -Buy a bond of UK u are lending money to UK -not actively managed

Net capital outflow (NCO):

domestic residents' purchases of foreign assets ( money flows out of the country) minus foreigners' purchases of domestic assets (money flows into the country) -talking about financial assets (bonds, stocks, foreign currency, bank account, property)

Exports

domestically produced goods and services sold in other countries

If PPP holds

e = P*/P

Net Exports (NX, Trade Balance)

exports - imports

Balanced trade

exports = imports

P* =

foreign price level

Imports

foreign produced goods and services sold domestically

Open economy

interacts freely with other economies around the world

arbitrage

making a quick profit by buying coffee in Seattle and selling it in Boston

NCO also called

net foreign investment measures in imbalance in country's trade in assets

if PPP holds then RER = 1 then

one home good can be traded for one foreign goods

S = I + NX S = I + NCO or S - I = NCO

since S = Y - C - G since NX = NCO

Y = C + I + G + NX is an accounting identity because

the equality holds due to the way the variables are defined

When S > I

the excess loanable funds flow abroad in the form of positive net capital outflow

When S<I

the excess loanable funds flow abroad in the form of positive net capital outflow NCO < 0

NX measures

the imbalance in a country trade in goods and services

Law of one price

the notion that a good should sell for the same price in all markets

nominal exchange rate

the rate at which a person can trade the currency of one country for the currency of another we express all exchange rates as foreign currency per unit of domestic currency

Real exchange rate

the rate at which a person can trade the goods and services of one country for the goods and services of another