11 THE MACROECONOMICS OF

OPEN ECONOMIES

Chapter 31
Open-Economy Macroeconomics:
Basic Concepts
 Open-Economy Macroeconomics:
Basic Concepts
Open and Closed Economies
A closed economy is one that does not interact
with other economies in the world.
There are no exports, no imports, and no
capital flows.
An open economy is one that interacts freely with
other economies around the world
Open-Economy Macroeconomics:
Basic Concepts
An Open Economy
An open economy interacts with other
countries in two ways.
It buys and sells goods and services in
world product markets.
It buys and sells capital assets in world
financial markets
 31.1 The International Flow of
Goods and Capital
An Open Economy
The United States is a very large and open
economyit imports and exports huge
quantities of goods and services.
Over the past four decades, international trade
and finance have become increasingly
important.
31.1.1 The Flow of Goods:
Exports, Imports, Net Exports
Exports are goods and services that are
produced domestically and sold abroad.
Imports are goods and services that are
produced abroad and sold domestically.
 31.1.1 The Flow of Goods:
Exports, Imports, Net Exports

Net exports (NX) are the value of a nations

exports minus the value of its imports.
Net exports are also called the trade balance.
 31.1.1 The Flow of Goods: Exports,
Imports, Net Exports
A trade deficit is a situation in which net
exports (NX) are negative.
Imports > Exports
A trade surplus is a situation in which net
exports (NX) are positive.
Exports > Imports
Balanced trade refers to when net exports
are zeroexports and imports are exactly equal.
 31.1.1 The Flow of Goods: Exports,
Imports, Net Exports
Factors That Affect Net Exports
The tastes of consumers for domestic and
foreign goods.
The prices of goods at home and abroad.
The exchange rates at which people can use
domestic currency to buy foreign currencies.
The incomes of consumers at home and abroad.
The costs of transporting goods from country to
country.
The policies of the government toward
international trade.
 Figure 1 The Internationalization of the U.S.
Economy

Percent
of GDP

15

Imports

10
Exports

0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
19

0
10
20
30
40
50
60
70
52
19
5
19 4
5
19 6
5
19 8
6
19 0
6
19 2
6
19 4
6
19 6
68
19
7
19 0
7
19 2
7
19 4
7
export/GDP

19 6
7
19 8
8
19 0
8
19 2
8
19 4
8
China Economy

19 6
8
19 8
9
19 0
9
Figure2. 1952-2005

19 2
export&import/GDP

9
19 4
9
19 6
9
20 8
Figure2. The Internationalization of the

0
20 0
0
20 2
04
 31.1.2 The Flow of Financial
Resources: Net Capital Outflow
Net capital outflow refers to the purchase
of foreign assets by domestic residents minus the
purchase of domestic assets by foreigners.
A U.S. resident buys stock in the Toyota
corporation and a Mexican buys stock in the
Ford Motor corporation.
31.1.2 The Flow of Financial
Resources: Net Capital Outflow
When a U.S. resident buys stock in Telmex,
the Mexican phone company, the purchase
raises U.S. net capital outflow.
When a Japanese residents buys a bond
issued by the U.S. government, the purchase
reduces the U.S. net capital outflow.
31.1.2 The Flow of Financial Resources:
Net Capital Outflow
Variables that Influence Net Capital Outflow.
The real interest rates being paid on foreign assets.
The real interest rates being paid on domestic
assets.
The perceived economic and political risks of
holding assets abroad.
The government policies that affect foreign
ownership of domestic assets.
 31.1.3 The Equality of Net Exports
and Net Capital Outflow
Net exports (NX) and net capital outflow (NCO)
are closely linked.
For an economy as a whole, NX and NCO must
balance each other so that:
NCO = NX
This holds true because every transaction that
affects one side must also affect the other side
by the same amount.
 31.1.3 The Equality of Net Exports
and Net Capital Outflow
To see why this accounting identity is true, consider
an example.Suppose that Boeing, the U.S.aircraft
maker, sells some planes to a Japanese airline. In
this sale, a U.S.company gives planes to a Japanese
company, and a Japanese company gives yen to a
U.S. Company. Notice that two things have occurred
simultaneously. The U.S. has sold to a foreigner
some of its output(the planes), and this sale
increases U.S. Net exports. In addition, the U.S. has
acquired some foreign assets(the yen), and this
acquisition increases U.S. Net capital outflow.
 31.1.3 The Equality of Net Exports
and Net Capital Outflow
The equality of net exports and net capital outflow
follows from the fact that every international
transaction is an exchange. When a seller country
transfers a good or service to a buyer country, the
buyer country gives up some asset to pay for this
good or service. The value of that asset equals the
value of the good or service sold. When we add
everything up, the net value of goods and services
sold by a country (NX) must equal the net value of
assets acquired(NCO). The international flow of
goods and services and the international flow of
capital are two sides of the same coin.
31.1.4 Saving, Investment, and Their
Relationship to the International Flows
Net exports is a component of GDP:
Y = C + I + G + NX
National saving is the income of the nation
that is left after paying for current
consumption and government purchases:
Y - C - G = I + NX
 31.1.4 Saving, Investment, and Their
Relationship to the International Flows
National saving (S) equals Y - C - G so:
S = I + NX
or
S = I + NCO
Saving = Domestic Investment + Net Capital Outflow
This equation shows that a nations saving must
equal its domestic investment plus its net capital
outflow. In other words, when Chinese citizens save
a dollar of their income for the future, that dollar
can be used of finance accumulation of domestic
capital or it can be used to finance the purchase of
capital abroad.
Figure 2 National Saving, Domestic Investment,
and Net Foreign Investment

(a) National Saving and Domestic Investment (as a percentage of GDP)

Percent
of GDP
20

Domestic investment
18

16

14

12 National saving

10
1960 1965 1970 1975 1980 1985 1990 1995 2000
Figure 2 National Saving, Domestic Investment,
and Net Foreign Investment
(b) Net Capital Outflow (as a percentage of GDP)

Percent
of GDP
4

2
Net capital
1 outflow

4
1960 1965 1970 1975 1980 1985 1990 1995 2000
 31.1.5 Summing Up
Consider first a country with a trade surplus. By
definition, a trade surplus means that the value of
exports exceeds the value of imports. Because net
exports are exports minus imports, net exports(NX)
are greater than zero. As a result, income(Y=C+I+G
+NX) must be greater than domestic spending
(C+I+G). But if Y is more than C+I+G, then(Y-C-G)
must be more than I. That is, saving (S=Y-C-G)
must exceed investment. Because the country is
saving more than it is investing, it must be sending
some of its saving abroad. That is, the net capital
outflow must be greater than zero.
 31.1.5 Summing Up
The converse logic applies to a country with a trade
deficit. By definition, a trade deficit means that the
value of exports are less than the value of imports.
Because net exports are exports minus imports, net
exports(NX) are negative.Thus, income(Y=C+I+G
+NX) must be less than domestic spending (C+I+G).
But if Y is less than C+I+G, then(Y-C-G) must be
less than I. That is, saving (S=Y-C-G) must less
than investment. Because the country is saving less
than it is investing, it must be attracting some of its
saving abroad. That is, the net capital outflow must
be negative.
 31.1.5 Summing Up
Table 1 International Flows of Goods and Capital: Summary
This table shows the three possible outcomes for an open economy.
(Source:Mankiw, Priciples of Economics, chapter31, p683.)
Trade Deficit Balanced Trade Trade Surplus
Exports < Imports Exports = Imports Exports > Imports
Net txports < 0 Net txports = 0 Net txports > 0
Y< C + I + G Y= C + I + G Y> C + I + G
Saving < Investment Saving = Investment Saving > Investment
Net capital outflow < 0 Net capital outflow = 0 Net capital outflow > 0
 31.2 The Prices for International
Transactions: Real and Nominal
Exchange Rates
International transactions are influenced by
international prices.
The two most important international prices are
the nominal exchange rate and the real
exchange rate.
 31.2.1 Nominal Exchange Rates

The nominal exchange rate is the rate at which a

person can trade the currency of one country for
the currency of another.
The nominal exchange rate is expressed in two
ways:
In units of foreign currency per one U.S. dollar.
And in units of U.S. dollars per one unit of the
foreign currency.
 31.2.1 Nominal Exchange Rates

Assume the exchange rate between the Japanese

yen and U.S. dollar is 80 yen to one dollar.
One U.S. dollar trades for 80 yen.
One yen trades for 1/80 (= 0.0125) of a dollar.
 31.2.1 Nominal Exchange Rates
If the exchange rate changes so that a dollar buys
more foreign currency, that change is called an
appreciation of the dollar.
Appreciation refers to an increase in the value of a
currency as measured by the amount of foreign
currency it can buy.
If the exchange rate changes so that a dollar buys
less foreign currency, that change is called an
depreciation of the dollar.
Depreciation refers to a decrease in the value of a
currency as measured by the amount of foreign
currency it can buy.
31.2.1 Nominal Exchange Rates

If a dollar buys more foreign currency, there

is an appreciation of the dollar.
If it buys less there is a depreciation of the
dollar.
 31.2.2 Real Exchange Rates

The real exchange rate is the rate at which a

person can trade the goods and services of one
country for the goods and services of another.
If a case of German beer is twice as expensive
as American beer, the real exchange rate is 1/2
case of German beer per case of American beer.
 31.2.2 Real Exchange Rates

The real exchange rate compares the prices of

domestic goods and foreign goods in the domestic
economy.
The real exchange rate depends on the nominal
exchange rate and the prices of goods in the two
countries measured in local currencies.
 31.2.2 Real Exchange Rates

Suppose that a bushel of American rice sells for

$100, and a bushel of Japanese rice sell $16,000
yen. What is the real exchange rate between
American and Japanese rice?

Bushel: measure for grain and fruit (8 gallons

or about 36.4 litres)
 31.2.2 Real Exchange Rates
The real exchange rate is a key determinant of how
much a country exports and imports.
Nominal exchange rate Domestic price
Real exchange rate=
Foreign Price
(80 yen per dollar)
($100per bushel of American rice)
Real exchange rate= 16,000 yen per bushel of Japanese rice
8000 yen per bushel of American rice
=
16,000 yen per bushel of Japanese rice
= 1/2 bushel of Japanese rice
per bushel of American rice.
31.2.2 Real Exchange Rates

A depreciation (fall) in the U.S. real

exchange rate means that U.S. goods have
become cheaper relative to foreign goods.
This encourages consumers both at home
and abroad to buy more U.S. goods and
fewer goods from other countries.
31.2.2 Real Exchange Rates

As a result, U.S. exports rise, and U.S.

imports fall, and both of these changes raise
U.S. net exports.
Conversely, an appreciation in the U.S. real
exchange rate means that U.S. goods have
become more expensive compared to
foreign goods, so U.S. net exports fall.
 Foreign
Foreign exchange Currency in Money
exchange rates (Yuan circulation Money(M1), & Quasi
reserves per US (M0), (Unit:100 money(M2),
(100 million Dollar) , ( (Unit:100 M illion (Unit:100
USD) Period Million Yuan) M illion
Average) Yuan) Yuan)
2003.12 4032.51 8.277 19746.23 84118.81 219226.81
2004.12 6099.32 8.2765 21468.3 95970.82 253207.7
2005.1 6236.46 8.2765 24015.41 97079.03 257708.47
2005.12 8188.72 8.0759 24031.67 107278.57 298755.48
2006.1 8451.8 8.0668 29310.37 107250.68 303571.65
2006.12 10663.44 7.8238 27072.62 126028.05 345577.91
2007.1 11046.92 7.7898 27949.13 128484.06 351498.77
2007.12 15282.49 7.3676 30334.32 152519.17 403401.3
2008.1 15898.1 7.2478 36673.15 154872.59 417846.17
2008.3 16821.77 7.0752 30433.07 150867.47 423054.53

Source:
(www.pbc.gov.cn/diaochatongji/tongjishuju/gofile.asp?file=2008S08.htm)
 Table1: (:)


3 6 1 2 3 5
1990.04.15 2.88 6.3 7.74 10.08 10.98 11.88 13.68
1990.08.21 2.16 4.32 6.48 8.64 9.36 10.08 11.52
1991.04.21 1.8 3.24 5.4 7.56 7.92 8.28 9
1993.05.15 2.16 4.86 7.2 9.18 9.9 10.8 12.06
1993.07.11 3.15 6.66 9 10.98 11.7 12.24 13.86
1996.05.01 2.97 4.86 7.2 9.18 9.9 10.8 12.06
1996.08.23 1.98 3.33 5.4 7.47 7.92 8.28 9
1997.10.23 1.71 2.88 4.14 5.67 5.94 6.21 6.66
1998.03.25 1.71 2.88 4.14 5.22 5.58 6.21 6.66
1998.07.01 1.44 2.79 3.96 4.77 4.86 4.95 5.22
1998.12.07 1.44 2.79 3.33 3.78 3.96 4.14 4.5
1999.06.10 0.99 1.98 2.16 2.25 2.43 2.7 2.88
2002.02.21 0.72 1.71 1.89 1.98 2.25 2.52 2.79
2004.10.29 0.72 1.71 2.07 2.25 2.7 3.24 3.6
2006.08.19 0.72 1.8 2.25 2.52 3.06 3.69 4.14
2007.03.18 0.72 1.98 2.43 2.79 3.33 3.96 4.41
2007.05.19 0.72 2.07 2.61 3.06 3.69 4.41 4.95
2007.07.21 0.81 2.34 2.88 3.33 3.96 4.68 5.22
2007.08.22 0.81 2.61 3.15 3.6 4.23 4.95 5.49
2007.09.15 0.81 2.88 3.42 3.87 4.5 5.22 5.76
2007.12.21 0.72 3.33 3.78 4.14 4.68 5.4 5.85
source: http://www.pbc.gov.cn/detail.asp?col=462&ID=1902
 Table2: ( : )
6 1 13() 35() 5
1991.04.21 8.1 8.64 9 9.54 9.72
1993.05.15 8.82 9.36 10.8 12.06 12.24
1993.07.11 9 10.98 12.24 13.86 14.04
1995.01.01 9 10.98 12.96 14.58 14.76
1995.07.01 10.08 12.06 13.5 15.12 15.3
1996.05.01 9.72 10.98 13.14 14.94 15.12
1996.08.23 9.18 10.08 10.98 11.7 12.42
1997.10.23 7.65 8.64 9.36 9.9 10.53
1998.03.25 7.02 7.92 9 9.72 10.35
1998.07.01 6.57 6.93 7.11 7.65 8.01
1998.12.07 6.12 6.39 6.66 7.2 7.56
1999.06.10 5.58 5.85 5.94 6.03 6.21
2002.02.21 5.04 5.31 5.49 5.58 5.76
2004.10.29 5.22 5.58 5.76 5.85 6.12
2006.04.28 5.4 5.85 6.03 6.12 6.39
2006.08.19 5.58 6.12 6.3 6.48 6.84
2007.03.18 5.67 6.39 6.57 6.75 7.11
2007.05.19 5.85 6.57 6.75 6.93 7.2
2007.07.21 6.03 6.84 7.02 7.2 7.38
2007.07.21 6.03 6.84 7.02 7.2 7.38
2007.07.21 6.03 6.84 7.02 7.2 7.38
2007.08.22 6.21 7.02 7.2 7.38 7.56
2007.09.15 6.48 7.29 7.47 7.65 7.83
2007.12.21 6.57 7.47 7.56 7.74 7.83
Source: http ://www.p bc.gov.cn/detail.asp ?col=462&ID=1903
1985 10%
1987 10%12%
1988 12%13%
1998321 12%8%
19991121 8%6%
2003921 6%7%
2004425 7%7.5%
200675 7.5%8%
2006815 8%8.5%
20061115 8.5%9%
2007115 9%9.5%
2007225 9.510
2007416 1010.5
2007515 10.511
200765 1111.5
 31.3 A FIRST THEORY OF
EXCHANGE-RATE DETERMINATION:
PURCHASING-POWER PARITY
The purchasing-power parity theory is the
simplest and most widely accepted theory
explaining the variation of currency exchange
rates.
Purchasing-power parity is 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.
 31.3.1 The Basic Logic of
Purchasing-Power Parity
The theory of purchasing-power parity is based on
a principle called the law of one price. This law
asserts that a good must sell for the same price in
all locations.
31.3.1 The Basic Logic of
Purchasing-Power Parity
If the law of one price were not true,
unexploited profit opportunities would exist.
The process of taking advantage of
differences in prices in different markets is
called arbitrage .
 31.3.1 The Basic Logic of
Purchasing-Power Parity
If arbitrage occurs, eventually prices that differed
in two markets would necessarily converge.
According to the theory of purchasing-power
parity, a currency must have the same purchasing
power in all countries and exchange rates move to
ensure that.
31.3.2 Implications of Purchasing-Power Parity
Suppose that P is the price of a basket of goods in
the US. (measured in dollars), P* is the price of a
basket of goods in Japan (measured in yen), and e is
the nominal exchange rate (the number of yen a
dollar can buy). Now consider the quantity of goods
a dollar can buy at home and abroad. At home, the
price level is P, so the purchasing power of $1 at
home is 1/P. Abroad, a dollar can be exchanged
into e units of foreign currency, which in turn
have purchasing power e/P*. For the purchasing
power of a dollar to be the same in the two
countries, it must be the case that
1/ P = e / P*
31.3.2 Implications of Purchasing-Power Parity
1/ P = e /P*
With rearrangement, this equation becomes
1 = eP / P*
Notice that the left-hand side of this equation is a
constant, and the right-hand side is the real
exchange rate. Thus, If the purchasing power of
the dollar is always the same at home and abroad,
then the exchange rate----the relative price of
domestic and foreign goods---- cannot change.
31.3.2 Implications of Purchasing-Power Parity
1 = eP / P*
We can rearrange the equation to solve for the
nominal exchange rate:
e = P* / P
That is, the nominal exchange rate equals the ratio
of the foreign price level (measured in units of the
foreign currency) to the domestic price level
(measured in units of the domestic currency).
According to the theory of purchasing-power parity,
the nominal exchange rate between the currencies
of two countries must reflect the different price
levels in those countries.
 31.3.2 Implications of Purchasing-
Power Parity
A key implication of this theory is that nominal
exchange rates change when price levels change.
The price level in any country adjusts to bring the
quantity of money supplied and the quantity of
money demanded into balance.
When the central bank prints large quantities of
money, the money loses value both in terms of the
goods and services it can buy and in terms of the
amount of other currencies it can buy.
 Figure 3 Money, Prices, and the Nominal Exchange
Rate During the German Hyperinflation
Indexes
(Jan. 1921 5 100)

1,000,000,000,000,000

Money supply
10,000,000,000

Price level
100,000

Exchange rate
.00001

.0000000001
1921 1922 1923 1924 1925
 31.3.3 Limitations of Purchasing-
Power Parity
Purchasing power provides a simple model of
how exchange rates are determined.
Yet the theory of purchasing-power parity is not
completely accurate. That is, exchange rates do
not always move to ensure that a dollar has the
same real value in all countries all the time.There
are two reasons why the theory of purchasing-
power parity does not always hold in practice.
 31.3.3 Limitations of Purchasing-
Power Parity
1) The first reason is that many goods are not easily
traded or shipped from one country to another.
2) The second reason that purchasing-power parity
does not always hold is that even tradable goods
are not always perfect substitutes when they are
produced in different countries.
Eg. some consumers prefer German cars, and
others prefer American cars. Moreover,
consumer tastes can change over time.
 Summary

Net exports are the value of domestic goods

and services sold abroad minus the value of
foreign goods and services sold
domestically.
Net capital outflow is the acquisition of
foreign assets by domestic residents minus
the acquisition of domestic assets by
foreigners
 Summary

An economys net capital outflow always

equals its net exports.
An economys saving can be used to either
finance investment at home or to buy assets
abroad.
 Summary

The nominal exchange rate is the relative

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

When the nominal exchange rate changes so

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

According to the theory of purchasing-

power parity, a unit of currency should buy
the same quantity of goods in all countries.
The nominal exchange rate between the
currencies of two countries should reflect
the countries price levels in those countries.
 Mankiw - ch31

Questions for Review

1.Define net exports and net capital outflow. Explain
how and why they are related. (Mankiw,3rd edition,
p676,678,680)
2. Explain the relationship among saving, investment,
and net capital outflow.(Mankiw,3rd edition, p681-682.)
3.What are nominal exchange rate and real exchange
rates?
3. 50
l1
lO0
4. Describe the economic logic behind the theory of
purchasing-powering parity.(Mankiw,3rd edition, p689)
5. 1