Chapter 31 - Open Economy Macroeconomics: Basic Concepts

Real exchange rate formula using price indexes:

(e x P) / P*

The two reasons why purchasing-power parity is not a perfect theory of exchange-rate determination:

-Some goods are not tradable -Some tradable goods are not perfect substitutes with their foreign counterparts

The two ways in which an open economy interacts with other economies:

1. Buys and sells goods and services in world product markets 2. Buys and sells capital assets such as stocks and bonds in world financial markets

Explain the effect of each action: 1. More people from China vacation in the U.S. 2. More people in China purchase U.S. Treasury bonds

1. Raises U.S. net exports 2. Lowers U.S. net capital outflow

Consider the identity NX = S - I = NCO, if I > S, what occurs?

A trade deficit, so the nation borrows the difference from foreigners.

Influential variables: -Tastes of consumers for domestic and foreign goods -The prices of goods at home and abroad -The exchange rates -Income of consumers at home and abroad -Cost of transporting goods -Policies on international trade

An economy's trade balance (exports, imports, net exports)

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

Appreciation ("strengthening")

The process of taking advantage of differences in prices in different markets

Arbitrage

A situation in which exports equal imports; net exports is zero

Balanced trade

Why does U.S. net capital outflow increase if Microsoft establishes a distribution center in France?

Because Microsoft makes a direct investment in capital in France.

From the equation 1 = eP / P*, if the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate (can or cannot change)

Cannot change

Records the flows of money from the purchase and sale of real and financial assets domestically and abroad (hotel building, shares of stocks)

Capital account

An international transaction that earns foreign currency

Credit (positive)

Records a nation's exports and imports of goods and services (travel to other countries, shipping), net investment income, and net transfers

Current account

An international transaction that uses foreign currency to complete a transaction

Debit (negative)

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

Depreciation ("weakening")

A nation's saving equals its. . . (S = ? + ?)

Domestic investment plus net capital outflow

Goods and services that are produced domestically and sold abroad

Exports

When an owner is actively managing the investment in another country (McDonald's opens a fast food outlet in Russia)

Foreign direct investment

What occurs if a country changes its tax laws so that domestic firms build and manage more firms overseas?

Foreign direct investment increases, which increases net capital outflow

When an owner buys stock in a corporation located in a different country

Foreign portfolio investment

The ... (higher/lower) a bond's real interest rate, the more attractive it is.

Higher

What is the real exchange rate a key determinant of?

How much a country exports or imports

Goods and services that are produced abroad and sold domestically

Imports

If a U.S. pharmacy buys drugs from a British company and pays for them with U.S. dollars, this transaction ... (inc/dec) British net exports and (inc/dec) U.S. capital outflow

Increases British net exports, decreases U.S. capital outflow

If a U.S. citizen builds a factory in Israel, how does his expenditures affect U.S. and Israeli net capital outflow?

Increases U.S. net capital outflow, but decreases Israeli net capital outflow

When a seller country transfers a good or service to a buyer country, what does the buyer country give up?

It gives up assets to pay for this good and services, which equals the value of the good or service sold

If the real exchange rate between the U.S. and Argentina is 1, does purchasing-power parity hold?

It holds and the amount of currency needed to buy goods in the U.S. is the same as the amount needed to buy enough Argentinean bolivars to buy the same good in Argentina

The law that asserts a good must sell for the same price in all locations

Law of one price

When saving is less than investment, foreigners are financing some of the country's investment, and NCO is (< or >) than zero

Less than zero

If there is a fall (depreciation) in the U.S. real exchange rate, consumers both at home and abroad are encouraged to buy . . . (more/less) goods from the U.S. and . . . (more/less) goods from other countries

More goods from the U.S., and less goods from other countries (U.S. exports rise, net exports rise)

Describe the NCO graph (x-axis, y-axis, curve)

NCO, real interest rate, downward sloping curve

Influential variables: -Real interest rates being paid on foreign and domestic assets -The perceived economic and political risk of holding assets abroad -The government policies that affect foreign ownership of domestic assets

Net capital outflow

The purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners

Net capital outflow (net foreign investment)

Why does saving equal investment in a closed economy?

Net capital outflow is zero

Net capital outflow always equals . . . (NCO = ?)

Net exports

The value of a nation's exports minus the value of its imports

Net exports / Trade balance

If a country has negative net capital outflows, what must its net exports be? How does saving compare with direct investment?

Net exports are negative, and saving is smaller than domestic investment.

The rate at which one country's currency trades for another; expressed in foreign currency per unit of domestic currency (0.97 Canadian dollars per 1 American dollar)

Nominal exchange rate

An economy that interacts freely with other economies around the world

Open economy

When saving exceeds investment, the excess loanable funds flow abroad in the form of ... (+/-) net capital outflow

Positive

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

Purchasing-power parity

What describes the forces that determine exchange rates in the long run?

Purchasing-power parity

Describe the foreign currency exchange graph (x-axis, y-axis, curve)

Quantity of domestic currency, exchange rate (foreign currency/domestic currency)

What happens to U.S. net capital outflow when a U.S. resident buys stock in a company in Mexico?

Raises U.S. net capital outflow

(Nominal exchange rate x domestic price) / foreign price

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

Real exchange rate

From the equation e = P*/P, the nominal exchange rate equals the ratio of:

The foreign price level to the domestic price level

What imbalance does net capital outflow measure?

The imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners.

When everything is added up, the net value of goods and services sold by a country (NX) must equal . . .

The net value of assets acquired (NCO)

If a U.S. company buys cotton from Egypt, how are U.S. net exports and net capital outflow affected?

They both decrease

If the dollar appreciated relative to the Peruvian peso and your building a factory in Peru, you'd find it took (more/less) dollars to build the factory. The building of the factory (inc/dec) U.S. net capital outflow.

Took less dollars, increases U.S. net capital outflow

Characteristics: -Net exports < 0 -Y < C + I + G -Saving < Investment -Net capital outflow < 0

Trade deficit

When imports are greater than exports, so a country buys more goods and services abroad than it sells to other countries.

Trade deficit

Characteristics: -Net exports > 0 -Y > C + I + G -Saving > Investment -Net capital outflow > 0

Trade surplus

When exports are greater than imports, so a country sells more goods and services abroad than it buys from other countries.

Trade surplus

If the real return from operating factories in Ghana rises relative to the real rate of return in the United States, what happens to U.S. and Ghanan net capital outflow?

U.S. net capital outflow increases, Ghanan net capital outflow decreases

Why do both foreign direct investment and foreign portfolio investment increase U.S. net capital outflow?

U.S. residents are buying assets in another country

Meaning of each variable in the real exchange rate formula (e x P)/P*

e = nominal exchange rate between country and foreign currencies P = price index for a country's basket (U.S) P* = price index for a foreign basket (Japan)