Chapter 28 - Open-Economy Macroeconomics: Basic Concepts
Real exchange rate equation
(nominal exchange rate x domestic price)/foreign price
Factors that affect net capital outflow (NCO)
- Real interest rates being paid on foreign assets. - Real interest rates being paid on domestic assets. - Perceived economic and political risks of holding assets abroad. - Government policies that affect foreign ownership of domestic assets.
Factors that affect net exports (NX)
- Tastes of consumers for domestic and foreign goods. - Prices of goods at home and abroad. - The exchange rates at which people can use domestic currency to buy foreign currencies. - Incomes of consumers at home and abroad. - Cost of transporting goods from country to country. - Policies of government towards international trade.
The nominal exchange rate is expressed in two ways
1. In units of foreign currency per euro. 2. In euros per unit of the foreign currency.
Depreciation
A decrease in the value of a currency as measured by the amount of foreign currency it can by. If a euro buys less foreign currency.
PPP is based on the principle: the law of one price
A good must sell for the same price in all locations. If the law were not true, unexploited profit opportunities would exist.
Purchasing Power Parity (PPP)
A theory of exchange rates where by a unit of any given currency should be able to buy the same quantity of goods in all countries.
Closed economy
An economy that does not interact with other countries in the world. No exports, no imports and no capital flows.
Open economy
An economy that interacts freely with other economies around the world. It buys and sells goods and services in world product markets. It buys and sells capital assets in world financial markets.
Appreciation
An increase in the value of a currency as measured by the amount of foreign currency it can buy. If a euro buys more foreign currency.
Trade deficits
Exports are greater than imports, it is a situation in which net exports are negative.
Trade surplus
Exports are greater than imports, it is a situation in which net exports are positive.
Imports
Goods and services that are produced abroad and sold domestically.
Exports
Goods and services that are produced domestically and sold abroad.
Foreign portfolio investment (FPI)
Invest in a company by buying stocks and bonds (passive role).
Balanced trade
Net exports are zero, exports and imports are exactly equal.
Foreign direct investment (FDI)
Opening a subsidiary in another country (active role).
Net capital outflow
Refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Also called net foreign investment.
National savings
The income of the nation that is left after paying for current consumption and government purchases. Y - C - G : S = I + NX : savings = domestic investment + net capital outflow.
Arbitrage
The process of taking advantages of differences in prices in different markets in order to make profit.
The nominal exchange rate
The rate at which a person can trade the currency of one country for the currency of another.
The 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 country. It compares the prices of domestic goods and foreign goods in the domestic economy.
Net exports (NX)
The value of a nation's exports minus the value of its imports. Also called the trade balance.
Limitations on PPP
− Many goods are not easily traded or shipped form one country to another. − Tradable goods are not always perfect substitutes when they are produced in different countries.
Implications of PPP
− The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries. − Because the nominal exchange rate depends on the price levels, it must also depend on the money supply and money demand in each country. (printing money > money loses its value).