978-1305971509 Chapter 31_18 Lecture Notes

WHAT’S NEW IN THE EIGHTH EDITION:

There is a new In the News feature on “The Complicated Politics of Trade Agreements,” and a

new Ask the Experts feature on “Trade Balances.”

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

 how net exports measure the international ow of goods and services.

 how net capital out ow measures the international ow of capital.

 why net exports must always equal net foreign investment.

 how saving, domestic investment, and net capital out ow are related.

502

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on a password-protected website or school-approved learning management system for classroom use.

31 OPEN-ECONOMY

MACROECONOMICS:

BASIC CONCEPTS

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 the meaning of the nominal exchange rate and the real exchange rate.

 purchasing-power parity as a theory of how exchange rates are determined.

CONTEXT AND PURPOSE:

Chapter 31 is the ;rst chapter in a two-chapter sequence dealing with open-economy

macroeconomics. Chapter 31 develops the basic concepts and vocabulary associated with

macroeconomics in an international setting: net exports, net capital out ow, real and

nominal exchange rates, and purchasing-power parity. The next chapter, Chapter 32, builds

an open-economy macroeconomic model that shows how these variables are determined

simultaneously.

The purpose of Chapter 31 is to develop the basic concepts macroeconomists use to

study open economies. It addresses why a nation’s net exports must equal its net capital

out ow. It also addresses the concepts of the real and nominal exchange rate and develops

a theory of exchange rate determination known as purchasing-power parity.

KEY POINTS:

 Net exports are the value of domestic goods and services sold abroad (exports) minus

the value of foreign goods and services sold domestically (imports). Net capital out ow is

the acquisition of foreign assets by domestic residents (capital out ow) minus the

acquisition of domestic assets by foreigners (capital in ow). Because every international

transaction involves an exchange of an asset for a good or service, an economy’s net

capital out ow always equals its net exports.

 An economy’s saving can be used to ;nance investment at home or buy assets abroad.

Thus, national saving equals domestic investment plus net capital out ow.

 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. When

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on a password-protected website or school-approved learning management system for classroom use.

Chapter 31/Open-Economy Macroeconomics: Basic Concepts ❖ 504

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.

 According to the theory of purchasing-power parity, a dollar (or a unit of any other

currency) should be able to buy the same quantity of goods in all countries. This theory

implies that the nominal exchange rate between the currencies of two countries should

re ect the price levels in those countries. As a result, countries with relatively high

in ation should have depreciating currencies, and countries with relatively low in ation

should have appreciating currencies.

CHAPTER OUTLINE:

I. We will no longer be assuming that the economy is a closed economy.

A. De;nition of closed economy: an economy that does not interact with other

economies in the world.

B. De;nition of open economy: an economy that interacts freely with other

economies around the world.

II. The International Flows of Goods and Capital

A. The Flow of Goods: Exports, Imports, and Net Exports

1. De;nition of exports: goods and services that are produced domestically

and sold abroad.

2. De;nition of imports: goods and services that are produced abroad and

sold domestically.

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Point out foreign products that students are likely to buy.

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3. De;nition of net exports: the value of a nation’s exports minus the value

of its imports, also called the trade balance.

4. De;nition of trade balance: the value of a nation’s exports minus the

value of its imports, also called net exports.

5. De;nition of trade surplus: an excess of exports over imports.

6. De;nition of trade de1cit: an excess of imports over exports.

7. De;nition of balanced trade: a situation in which exports equal imports.

8. There are several factors that in uence a country’s exports, imports, and net

exports:

a. The tastes of consumers for domestic and foreign goods.

b. The prices of goods at home and abroad.

c. The exchange rates at which people can use domestic currency to buy foreign

currencies.

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= Exports ImportsNX –

Point out to students that a trade surplus implies a positive level of net

exports, a trade de;cit means that net exports are negative, and balanced

trade occurs when net exports are equal to zero. While this will likely be

obvious to most students, some will bene;t if you review this.

Chapter 31/Open-Economy Macroeconomics: Basic Concepts ❖ 506

d. The incomes of consumers at home and abroad.

e. The cost of transporting goods from country to country.

f. Government policies toward international trade.

9. Case Study: The Increasing Openness of the U.S. Economy

a. Figure 1 shows the total value of exports and imports (expressed as a

percentage of GDP) for the United States since 1950.

b. Advances in transportation, telecommunications, and technological progress

are some of the reasons why international trade has increased over time.

c. Policymakers around the world have also become more accepting of free trade

over time.

10. In the News: The Complicated Politics of Trade Agreements

a. Trade agreements create winners and losers so achieving consensus among

decision-makers is challenging.

b. This Los Angeles Times article describes diKerent perspectives on the Trans

Paci;c Partnership exemplifying the challenges of ratifying a trade agreement.

B. The Flow of Financial Resources: Net Capital Out ow

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Figure 1

507 ❖ Chapter 31/Open-Economy Macroeconomics: Basic Concepts

1. De;nition of net capital out3ow (NCO): the purchase of foreign assets by

domestic residents minus the purchase of domestic assets by

foreigners.

2. The ow of capital abroad takes two forms.

a. Foreign direct investment occurs when a capital investment is owned and

operated by a foreign entity.

b. Foreign portfolio investment involves an investment that is ;nanced with

foreign money but operated by domestic residents.

3. Net capital out ow can be positive or negative.

a. When net capital out ow is positive, domestic residents are buying more

foreign assets than foreigners are buying domestic assets. Capital is owing

out of the country.

b. When net capital out ow is negative, domestic residents are buying fewer

foreign assets than foreigners are buying domestic assets. The country is

experiencing a capital in ow.

4. There are several factors that in uence a country’s net capital out ow:

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purchases of foreign assets purchases of domestic assets

by domestic residents by foreigners

NCO = –

You will likely have to write this equation several times on the board for

students when discussing this chapter and the next. Students can grasp

the concept of net exports more easily than they can grasp the concept of

Chapter 31/Open-Economy Macroeconomics: Basic Concepts ❖ 508

a. The real interest rates being paid on foreign assets.

b. The real interest rates being paid on domestic assets.

c. The perceived economic and political risks of holding assets abroad.

d. The government policies that aKect foreign ownership of domestic assets.

C. The Equality of Net Exports and Net Capital Out ow

1. Net exports and net capital out ow each measure a type of imbalance in a world

market.

a. Net exports measure the imbalance between a country’s exports and imports

in world markets for goods and services.

b. Net capital out ow measures the imbalance between the amount of foreign

assets bought by domestic residents and the amount of domestic assets

bought by foreigners in world ;nancial markets.

2. For an economy, net exports must be equal to net capital out ow.

3. Example: You are a computer programmer who sells some software to a Japanese

consumer for 10,000 yen.

a. The sale is an export of the United States so U.S. net exports increase.

b. There are several things you could do with the 10,000 yen.

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509 ❖ Chapter 31/Open-Economy Macroeconomics: Basic Concepts

c. You could hold the yen (which is a Japanese asset) or use it to purchase

another Japanese asset. Either way, U.S. net capital out ow rises.

d. Alternatively, you could use the yen to purchase a Japanese good. Thus, U.S.

imports will rise so the net eKect on net exports will be zero.

e. One ;nal possibility is that you could exchange the yen for dollars at a bank.

This does not change the situation though, because the bank then must use

the yen for something.

4. This example can be generalized to the economy as a whole.

a. When a nation is running a trade surplus (NX > 0), it must be using the

foreign currency to purchase foreign assets. Thus, capital is owing out of the

country (NCO > 0).

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ALTERNATIVE CLASSROOM EXAMPLE:

Assume that U.S. residents do not want to buy any foreign assets, but foreign

residents want to purchase some stock in a U.S. ;rm (such as Microsoft).

How are the foreigners going to get the dollars to purchase the stock?

They would do it the same way U.S. residents would purchase the stock—they

would have to earn more than they spend. In other words, foreigners must sell

the United States more goods and services than they purchase from the United

Chapter 31/Open-Economy Macroeconomics: Basic Concepts ❖ 510

b. When a nation is running a trade de;cit (NX < 0), it must be ;nancing the net

purchase of these goods by selling assets abroad. Thus, capital is owing into

the country (NCO < 0).

5. 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.

6. 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 out ow).

D. Saving, Investment, and Their Relationship to the International Flows

1. Recall that GDP (Y ) is the sum of four components: consumption (C ), investment

(I ), government purchases (G ) and net exports (NX ).

2. Recall that national saving is equal to the income of the nation after paying for

current consumption and government purchases.

3. We can rearrange the equation for GDP to get:

Substituting for the left-hand side, we get:

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Y C I G NX= + + +

S Y C G= – –

Y C G I NX– – = +

S I NX= +

511 ❖ Chapter 31/Open-Economy Macroeconomics: Basic Concepts

4. Because net exports and net capital out ow are equal, we can rewrite this as:

5. This implies that saving is equal to the sum of domestic investment (I ) and net

capital out ow (NCO ).

6. When a U.S. citizen saves $1 of her income, that dollar can be used to ;nance the

accumulation of domestic capital or it can be used to ;nance the purchase of

foreign capital.

7. Note that, in a closed economy such as the one we assumed earlier, net capital

out ow would equal zero and saving would simply be equal to domestic

investment.

E. Summing Up

1. Table 1 describes three possible outcomes for an open economy: a country with a

trade de;cit, a country with balanced trade, or a country with a trade surplus.

2. Case Study: Is the U.S. Trade De(cit a National Problem?

a. Panel (a) of Figure 2 shows national saving and domestic investment for the

United States as a percentage of GDP since 1960.

b. Panel (b) of Figure 2 shows net capital out ow for the United States as a

percentage of GDP for the same time period.

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S I NCO= +

Table 1

Figure 2

Chapter 31/Open-Economy Macroeconomics: Basic Concepts ❖ 512

c. Before 1980, domestic investment and national saving tended to uctuate

together, so net capital out ow was typically small.

d. Trade de;cits can arise under a variety of circumstances.

e. Unbalanced (scal policy: From 1980 to 1987, national saving fell due to an

increase in the government budget de;cit.

f. Investment boom: From 1991 to 2000, the capital ow into the United States

increased as the government’s budget switched from de;cit to surplus, but

investment went from 15.3% to 19.8% of GDP. The economy enjoyed a boom

in information technology and ;rms invested heavily.

g. Economic downturn and recovery: From 2000 to 2015, the capital ow into the

United States remained large. From 2000 to 2009, both saving and investment

fell by about 6%. Tough economic times made additional capital less pro;table

and national saving fell due to extraordinarily large budget de;cits. From 2009

to 2015, as the economy recovered both saving and investment increased by

about 3%.

h. When national saving falls, either investment will have to fall or net capital

out ow will have to fall.

i. On the other hand, a trade de;cit led by an increase in investment will not

pose a large problem for the United States if the increased investment leads

to a higher production of goods and services.

3. Ask the Experts: Trade Balances

a. When asked if a typical country can increase its’ citizens welfare by enacting

policies that would increase its trade surplus, 66 percent of economic experts

disagreed, while 6 percent agreed and 28 percent were uncertain.

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513 ❖ Chapter 31/Open-Economy Macroeconomics: Basic Concepts

III. The Prices for International Transactions: Real and Nominal Exchange Rates

A. Nominal Exchange Rates

1. De;nition of nominal exchange rate: the rate at which a person can trade

the currency of one country for the currency of another.

2. An exchange rate can be expressed in two ways.

a. Example: 80 yen per dollar.

b. This can also be written as 1/80 dollar (or 0.0125 dollar) per yen.

3. De;nition of appreciation: an increase in the value of a currency as

measured by the amount of foreign currency it can buy.

4. De;nition of depreciation: a decrease in the value of a currency as

measured by the amount of foreign currency it can buy.

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on a password-protected website or school-approved learning management system for classroom use.

ALTERNATIVE CLASSROOM EXAMPLE:

$1 10 pesos

1 peso $0.10

=

Students are curious about the currencies of other countries. Bring in a

current list of nominal exchange rates between several currencies and the

U.S. dollar. Quiz the students to see if they can match up the currencies

with the countries where they are used. Encourage students to bring in

Chapter 31/Open-Economy Macroeconomics: Basic Concepts ❖ 514

5. When a currency appreciates, it is said to strengthen; when a currency

depreciates, it is said to weaken.

6. When economists study nominal exchange rates, they often use an exchange rate

index, which converts the many nominal exchange rates into a single measure.

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515 ❖ Chapter 31/Open-Economy Macroeconomics: Basic Concepts

7. FYI: The Euro

a. During the 1990s, many European nations decided to give up their national

currencies and use a new common currency called the euro.

b. The euro started circulating on January 1, 2002.

c. Monetary policy is now set by the European Central Bank (ECB), which

controls the supply of euros in the economy.

d. Bene;ts of a common currency include easier trading ability and increased

unity.

e. However, because there is only one currency, there can be only one monetary

policy.

f. From 2010 to 2015, worries about having a common currency came to the

forefront when Greece faced a possible default of its government debt.

B. Real Exchange Rates

1. De;nition 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.

2. Example: A bushel of American rice sells for $100 and a bushel of Japanese rice

sells for 16,000 yen. The nominal exchange rate is 80 yen per dollar.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Make sure that you emphasize that when the dollar appreciates against a

particular currency that currency must depreciate against the dollar. Use

an example to illustrate this point.

Chapter 31/Open-Economy Macroeconomics: Basic Concepts ❖ 516

3. The real exchange rate depends on the nominal exchange rate and on the prices

of goods in the two countries measured in the local currencies.

4. In our example:

(80 yen per dollar)($100 per bushel of American rice)

real exchange rate 16,000 yen per bushel of Japanese rice

=

8,000 yen per bushel of American rice

real exchange rate 16,000 yen per bushel of Japanese rice

=

real exchange rate = 1/2 bushel of Japanese rice per bushel of American rice

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Nominal exchange rate Domestic price

real exchange rate Foreign price

´

=

517 ❖ Chapter 31/Open-Economy Macroeconomics: Basic Concepts

5. The real exchange rate is a key determinant of how much a country exports and

imports.

6. When studying an economy as a whole, macroeconomists focus on overall prices

instead of the prices of individual goods and services.

a. Price indexes are used to measure the level of overall prices.

b. Assume that P is the price index for the United States, P* is a price index for

prices abroad, and e is the nominal exchange rate between the U.S. dollar and

foreign currencies.

real exchange rate = *

e P

P

´

7. The real exchange rate measures the price of a basket of goods and services

available domestically relative to the price of a basket of goods and services

available abroad.

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ALTERNATIVE CLASSROOM EXAMPLE:

Price of Mexican corn = 50 pesos/bushel

Price of American corn = $10/bushel

Nominal exchange rate: $1 = 12 pesos

real exchange rate = (12 pesos per dollar)($10 per bushel of American

Chapter 31/Open-Economy Macroeconomics: Basic Concepts ❖ 518

8. A depreciation in the U.S. real exchange rate means that U.S. goods have become

cheaper relative to foreign goods. U.S. exports will rise, imports will fall, and net

exports will increase.

9. Likewise, an appreciation in the U.S. real exchange rate means that U.S. goods

have become more expensive relative to foreign goods. U.S. exports will fall,

imports will rise, and net exports will decline.

IV. A First Theory of Exchange-Rate Determination: Purchasing-Power Parity

A. De;nition of 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.

B. The Basic Logic of Purchasing-Power Parity

1. The law of one price suggests that a good must sell for the same price in all

locations.

a. If a good sold for less in one location than another, a person could make a

pro;t by buying the good in the location where it is cheaper and selling it in

the location where it is more expensive.

b. The process of taking advantage of diKerences in prices for the same item in

diKerent markets is called arbitrage.

c. Note what will happen as people take advantage of the diKerences 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.

2. The same logic should apply to currency.

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519 ❖ Chapter 31/Open-Economy Macroeconomics: Basic Concepts

a. 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.

b. Purchasing-power parity suggests that a unit of all currencies must have the

same purchasing power in every country.

c. If this was not the case, people would take advantage of the pro;t-making

opportunity and this arbitrage would then push the real values of the

currencies to equality.

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Chapter 31/Open-Economy Macroeconomics: Basic Concepts ❖ 520

Activity 1—A Pro1table Opportunity

Type: In-class assignment

Topics: Exchange rates, arbitrage

Materials needed: None

Time: 20 minutes

Class limitations: Works in any size class

Purpose:

This assignment lets students practice calculating prices with exchange rates and

looking for pro;t opportunities.

Instructions:

Explain the following: Molson’s Beer is produced in Canada and sold in many countries.

In the province of Ontario, a six-pack of Molson’s beer sells for $12.95 Canadian. Across

the border in Michigan, a six pack of the same beer sells for $6.99 U.S. Suppose that the

exchange rate is $0.90 U.S. = $1.00 Canadian.

Ask the class to make the following calculations:

1. How much would it cost in U.S. currency to buy the beer in Ontario?

2. How much would it cost in Canadian currency to buy the beer in Michigan?

3. Is there an arbitrage opportunity?

4. If there is an arbitrage opportunity, where would you buy and where would you sell?

How much pro;t could you expect on a six-pack?

C. Implications of Purchasing-Power Parity

1. Purchasing-power parity means that the nominal exchange rate between the

currencies of two countries will depend on the price levels in those countries.

2. 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

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521 ❖ Chapter 31/Open-Economy Macroeconomics: Basic Concepts

measured in yen), then the nominal exchange rate (the number of yen per dollar)

must re ect the prices of goods and services in the two countries.

3. Suppose that P is the price of a basket of goods in the United States (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 each dollar can buy).

a. In the United States, the purchasing power of $1 is 1/P.

b. In Japan, $1 can be exchanged for e units of yen, which in turn have the

purchasing power of e/P*.

c. Purchasing-power parity implies that the two must be equal:

d. Rearranging, we get:

Note that the left-hand side is a constant and the right-hand

side is the real exchange rate. This implies that if the

purchasing power of a dollar is always the same at home and

abroad, then the real exchange rate cannot change.

e. We can rearrange again to see that:

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.

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P/*Pe 

1/ / *P e P=

1 ( )/ *eP P=

Chapter 31/Open-Economy Macroeconomics: Basic Concepts ❖ 522

4. Because the nominal exchange rate depends on the price levels, it must also

depend on the money supply and money demand in each country.

a. If the central bank increases the supply of money in a country and raises the

price level, it also causes the country’s currency to depreciate relative to other

currencies in the world.

b. When a central bank prints large quantities of money, that 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.

5. Case Study: The Nominal Exchange Rate during a Hyperin2ation

a. Figure 3 shows the German money supply, the German price level, and the

nominal exchange rate (measured as U.S. cents per German mark) during

Germany’s hyperin ation in the early 1920s.

b. When the supply of money begins growing, the price level also increases and

the German mark depreciates.

D. Limitations of Purchasing-Power Parity

1. Exchange rates do not always move to ensure that a dollar has the same real

value in all countries all of the time.

2. There are two reasons why the theory of purchasing-power parity does not always

hold in practice.

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Figure 3

523 ❖ Chapter 31/Open-Economy Macroeconomics: Basic Concepts

a. Many goods are not easily traded (haircuts in Paris versus haircuts in New

York). Thus, arbitrage would be too limited to eliminate the diKerence in prices

between the locations.

b. Tradable goods are not always perfect substitutes when they are produced in

diKerent countries (American cars versus German cars). There is no

opportunity for arbitrage here, because the price diKerence re ects the

diKerent values the consumer places on the two products.

3. Case Study: The Hamburger Standard

a. The Economist, an international newsmagazine, occasionally compares the

cost of a Big Mac in various countries all around the world.

b. Once we have the prices of Big Macs in two countries, we can compute the

nominal exchange rate predicted by the theory of purchasing-power parity

and compare it with the actual exchange rate.

c. In 2016, the exchange rates predicted by the theory were not exactly equal to

the actual rates. However, the predicted rates were fairly close to the actual

rates.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Point out to students that, even with its aws, purchasing-power parity

does tell us about exchange rates. Large and persistent movements in

nominal exchange rates typically re ect changes in price level at home

Students who have lived or traveled overseas will often point out that

many American products (such as blue jeans) are much more expensive

overseas than they are in the United States. Point out to students that this

could be the result of trade restrictions or price discrimination. Examine