CH 13 and 14 OPEN ECONOMY (MACRO)

There are several factors that influence a country's net capital outflow (NCO): (4)

+ The real interest rates being paid on foreign assets. • The real interest rates being paid on domestic assets. ( Bc they determine how much is gained from the investment. So higher interest rates are favorable. ) • The perceived economic and political risks of holding assets abroad. • The government policies that affect foreign ownership of domestic assets.

Limitations of Purchasing-Power Parity: (3)

- Exchange rates do not always move to ensure that a dollar has the same real value in all countries all of the time. - There are two reasons why the theory of purchasing-power parity does not always hold in practice. o Many goods are not easily traded (haircuts in Paris vs. haircuts in New York). Thus, arbitrage would be too limited to eliminate the difference in prices between the locations. o Tradable goods are not always perfect substitutes when they are produced in different countries (American cars versus German cars). There is no opportunity for arbitrage here, because the price difference reflects the different values the consumer places on the two products.

When a nation is running a trade surplus (NX > 0), it must be using the ________ currency to purchase foreign assets. Thus, capital is flowing _____ of the country (NCO > 0). When a nation is running a trade deficit (NX < 0), it must be financing the net purchase of these goods by______ _____ _______. Thus, capital is flowing into the country (NCO < 0).

- Foreign, Out - Selling Assets Abroad To sum up: Every international transaction involves exchange. When a seller country transfers a good or service to a buyer country, the buyer country gives up some asset to pay for the good or service. -Because every international transaction involves an exchange of an asset for a good or service, an economy's net capital outflow always equals its net exports. -Thus, the net value of the goods and services sold by a country (net exports) must equal the net value of the assets acquired (net capital outflow):

Net capital outflow (NCO) can be positive, negative, or zero:

- When net capital outflow is positive, domestic residents are buying more foreign assets than foreigners are buying domestic assets. Capital is flowing out of the country. - When net capital outflow is negative, domestic residents are buying fewer foreign assets than foreigners are buying domestic assets. The country is experiencing a capital inflow.

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. (IMPLIES THE REAL EXCHANGE RATE HAS TO BE ONE, AND THE NOMINAL EXCHANGE RATE MUST BE 1USD=$1 USD EQUIVALENT IN FOREIGN CURRENCY) - means that the nominal exchange rate between the currencies of two countries will depend on the price levels in those countries. If a dollar buys the same amount of goods and services in the United States (where prices are measured in dollars) as it does in Japan (where prices are measured in yen), then the nominal exchange rate (the number of yen per dollar) must reflect the prices of goods and services in the two countries.

Foreign portfolio investment

- involves an investment that is financed with foreign money but operated by domestic residents. - Examples include stocks, bonds, and mutual funds...

There are several factors that influence a country's exports (X), imports (M), and net exports (NX): (6)

1. Tastes and Preferences of Consumers for Domestic and Foreign Goods 2. Prices at Home and Abroad 3. Exchange Rates +The exchange rates at which people can use the domestic currency to buy foreign currencies. 4. Consumer Incomes at Home and Abroad 5. Transportation Costs +The cost of transporting goods from country to country 6. International Government Trade Policies

The Equality of Net Exports and Net Capital Outflow

For an economy, net exports (NX) must be equal to net capital outflow NX = NCO

Saving formula

S=Y-C-G Saving (Income not spent) = (Income) - (Consumption of Goods of Services) - (Government Purchases) OR Saving Y - C - G = I + NX S = I + NCO (because NX=NCO) Explanation: - An economy's saving can be used to finance investment at home or buy assets abroad. Thus, national saving equals domestic investment plus net capital outflow. When a U.S. citizen saves $1 of her income, that dollar can be used to finance the accumulation of domestic capital or it can be used to finance the purchase of foreign capital.

Nominal Exchange Rates

The nominal exchange rate is the relative price of the currency of two countries, and the real exchange rate is the relative price of the goods and services of two countries.

Arbitrage

The process of taking advantage of differences in prices for the same item in different markets

depreciate or weaken of exchange rates

When the nominal exchange rate changes so that each dollar buys less foreign currency, the dollar is said to depreciate or weaken.

when exchange rates appreciate or strengthen

When the nominal exchange rate changes so that each dollar buys more foreign currency, the dollar is said to appreciate or strengthen.

Trade Deficit Formula (with Savings)

X < M NX<0 and NCO<0 Y<C+I+G S<I (you are purchasing more capital/goods than you are selling/saving.)

Balanced Trade (w/saving)

X=M NX=0 and NCO=0 Y=C+I+G S=I (Selling and Buying constant. Income not spent = purchase of new capital)

Trade Surplus Formula (with Savings)

X>M or NX >0 NCO>0 bc NX>0 Y (income) > C + I + G S > I (amount saving is greater than personal consumption, purchase of new capital by people and government. Selling (exporting) more than you are buying)

GDP formula (expenditure approach)

Y=C+I+G+NX

Foreign direct investment

a (physical) capital investment that is owned and operated by a foreign entity. Ex: Building, Equipment, a Business

Definition of balanced trade

a situation in which exports equal imports. NX = X − M = 0

Definition of closed economy:

an economy that does not interact with other economies in the world.

Definition of open economy:

an economy that interacts freely with other economies around the world.

What is a trade surplus?

an excess of exports over imports: NX = X − M > 0

What is a Trade Deficit?

an excess of imports over exports: NX = X − M < 0

Even with its flaws, purchasing-power parity describes the forces that determine __________ rates in the _____ run. Large and persistent movements in nominal exchange rates typically reflect changes in price level at home and abroad.

exchange, long

The flow of capital abroad takes two forms:

foreign direct investment and foreign portfolio investment

Definition of imports (M):

goods and services that are produced abroad and sold domestically.

Definition of exports (X)

goods and services that are produced domestically and sold abroad.

Implications of Purchasing Power Parity:

o Purchasing-power parity means that the nominal exchange rate between the currencies of two countries will depend on the price levels in those countries. O SO THE REAL EXCHANGE RATE HAS TO BE ONE. o If a dollar buys the same amount of goods and services in the United States (where prices are measured in dollars) as it does in Japan (where prices are measured in yen), then the nominal exchange rate (the number of yen per dollar) must reflect the prices of goods and services in the two countries. Purchasing-power parity implies that the two must be equal: 1/P (purchasing power [price of a basket of goods in the US measured in dollars] of $1) = e/P* (nominal exchange rate; $1 can be exchanged for e units of yen/ purchasing power of yen [ price of a basket of goods in japan measured in yen]) 1 = (eP)/(P* 1 (CONSTANT) = REAL EXCHANGE RATE SO IF THIS WERE TRUE THE REAL EXCHANGE RATE WOULD HAVE TO BE 1 We can rearrange again to see that: e = P* / P The nominal exchange rate is determined by the ratio of the foreign price level to the domestic price level. Nominal exchange rates will change when price levels change

The Basic Logic of Purchasing Power Parity:

o The law of one price suggests that a good must sell for the same price in all locations. o If a good sold for less in one location than another, a person could make a profit by buying the good in the location where it is cheaper and selling it in the location where it is more expensive (arbitrage). o Note what will happen as people take advantage of the differences in prices. The price in the location where the good is cheaper will rise (because the demand is now higher) and the price in the location where the good was more expensive will fall (because the supply is greater). This will continue until the two prices are equal. The same logic should apply to currency. o A U.S. dollar should buy the same quantity of goods and services in the United States and Japan; a Japanese yen should buy the same quantity of goods and services in the United States and Japan. o Purchasing power parity suggests that a unit of all currencies must have the same purchasing power in every country. o If this was not the case, people would take advantage of the profit-making opportunity and this arbitrage would then push the real values of the currencies to equality.

The real exchange rate is a key determinant of

of how much a country exports and imports.

Net Capital Outflow (NCO)

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

Definition of nominal exchange rate:

the rate at which a person can trade the currency of one country for the currency of another. Example: $1 = 20 pesos, or 1 peso = $0.05.

Definition of 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 = Nominal Exchange Rate x Domestic Price/Foreign Price Example: A bag of American avocados sells for $10 and a bag of Mexican avocados sells for 80 pesos. The nominal exchange rate is 20 pesos per dollar. Real exchange rate = (20 pesos per dollar)($10 per bag of American avocados) 80 pesos per bag of Mexican avocados = 2.5 bags of Mexican avocados per bag of American avocados

Definition of Net Exports (NX) aka Trade Balance

the value of a nation's exports minus the value of its import also called the trade balance. NX = X - M