Principles of Macroeconomics Ch. 18 Open-Economy Basic Concepts

Closed vs. Open Economies

1. A closed economy does not interact with other economies in the world. 2. An open economy interacts freely with other economies around the world.

The Equality of NX and NCO

1. An accounting identity: NCO = NX 2. When a foreigner purchases a good from the U.S.,

Variables that Influence Net Exports

1. Consumers' preferences for foreign and domestic goods 2. Prices of goods at home and abroad 3. Incomes of consumers at home and abroad 4. The exchange rates at which foreign currency trades for domestic currency 5. Transportation costs 6. Govt policies

The Flow of Goods & Services

1. Exports 2. Imports 3. Net exports (NX), aka the trade balance

The flow of capital abroad takes two forms

1. Foreign direct investment 2. Foreign portfolio investment

Why U.S. saving has been less than investment

1. In the 1980s and early 2000s, huge govt budget deficits and low private saving depressed national saving. 2. In the 1990s, national saving increased as the economy grew, but domestic investment increased even faster due to the information technology boom.

The Nominal Exchange Rate

1. Nominal exchange rate: the rate at which one country's currency trades for another 2. We express all exchange rates as foreign currency per unit of domestic currency.

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

Case Study: The U.S. Trade Deficit

1. The U.S. trade deficit reached record levels in 2006 and remained high in 2007-2008. 2. Recall, NX = S - I = NCO. A trade deficit means I > S, so the nation borrows the difference from foreigners. 3. In 2007, foreign purchases of U.S. assets exceeded U.S. purchases of foreign assets by $775 million. 4. Such deficits have been the norm since 1980.

Is the U.S. trade deficit a problem?

1. The extra capital stock from the '90s investment boom may well yield large returns. 2. The fall in saving of the '80s and '00s, while not desirable, at least did not depress domestic investment, since firms could borrow from abroad.

When a foreigner purchases a good from the U.S.,

1. U.S. exports and NX increase 2. the foreigner pays with currency or assets, so the U.S. acquires some foreign assets, causing NCO to rise.

NCO measures the imbalance in a country's trade in assets

1. When NCO > 0, "capital outflow" 2. When NCO < 0, "capital inflow"

Saving, Investment, and International Flows of Goods & Assets continued.

1. When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow. 2. When S < I, foreigners are financing some of the country's investment, and NCO < 0.

Saving, Investment, and International Flows of Goods & Assets

1. Y = C + I + G + NX accounting identity 2. Y - C - G = I + NX rearranging terms 3. S = I + NX since S = Y - C - 4. S = I + NCO since NX = NCO

Net exports (NX), aka the trade balance

= value of exports - value of imports

A country, like a person, can go into debt for good reasons or bad ones.

A trade deficit is not necessarily a problem, but might be a symptom of a problem.

Some exchange rates as of 20 May 2011, all per US$

Canadian dollar: 0.97 Euro: 0.71 Japanese yen: 81.67 Mexican peso: 11.65

When NCO > 0, "capital outflow"

Domestic purchases of foreign assets exceed foreign purchases of domestic assets.

Foreign direct investment

Domestic residents actively manage the foreign investment, e.g., McDonalds opens a fast-food outlet in Moscow.

Foreign portfolio investment

Domestic residents purchase foreign stocks or bonds, supplying "loanable funds" to a foreign firm.

Appreciation and Depreciation Examples

During 2007, the U.S. dollar. depreciated 9.5% against the Euro appreciated 1.5% against the S. Korean Won

When NCO < 0, "capital inflow"

Foreign purchases of domestic assets exceed domestic purchases of foreign assets.

Trade Surpluses & Deficits

NX measures the imbalance in a country's trade in goods and services. 1. Trade deficit 2. Trade surplus 3. Balanced trade

The Flow of Capital

Net capital outflow (NCO): domestic residents' purchases of foreign assets minus foreigners' purchases of domestic assets. NCO is also called net foreign investment.

The Real Exchange Rate

Real exchange rate: the rate at which the g&s of one country trade for the g&s of another

One of the Ten Principles of Economics

Trade can make everyone better off.

People abroad owned $21.1 trillion in U.S. assets. U.S. residents owned $18.4 trillion in foreign assets. U.S.' net indebtedness to other countries = $2.7 trillion. Higher than every other country's net indebtedness

U.S. is "the world's biggest debtor nation." So far, the U.S. earns higher interest rates on foreign assets than it pays on its debts to foreigners. But if U.S. debt continues to grow, foreigners may demand higher interest rates, and servicing the debt would become a drain on U.S. income.

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

a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries

Trade surplus

an excess of exports over imports

Trade deficit

an excess of imports over exports

Appreciation or "strengthening"

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

An accounting identity: NCO = NX

arises because every transaction that affects NX also affects NCO by the same amount and vice versa

Exports

domestically-produced g&s sold abroad

Imports

foreign-produced g&s sold domestically

The Law of One Price

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

Balanced trade

when exports = imports

e x P/p*

where P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate, i.e., foreign currency per unit of domestic currency