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298
WHAT’S NEW IN THE SEVENTH EDITION:
There is a new
In the News
feature on "The Changing Nature of U.S. Exports" and an updated
presentation of the U.S. trade deficit.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ how net exports measure the international flow of goods and services.
➢ how net capital outflow measures the international flow of capital.
➢ why net exports must always equal net foreign investment.
➢ how saving, domestic investment, and net capital outflow are related.
➢ 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 18 is the first chapter in a two-chapter sequence dealing with open-economy macroeconomics.
Chapter 18 develops the basic concepts and vocabulary associated with macroeconomics in an
international setting: net exports, net capital outflow, real and nominal exchange rates, and purchasing-
power parity. The next chapter, Chapter 19, builds an open-economy macroeconomic model that shows
18
OPEN-ECONOMY
MACROECONOMICS: BASIC
CONCEPTS
Chapter 18/Open-Economy Macroeconomics: Basic Concepts ❖ 299
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 outflow is the acquisition of
foreign assets by domestic residents (capital outflow) minus the acquisition of domestic assets by
foreigners (capital inflow). 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.
• 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.
• 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 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
.
CHAPTER OUTLINE:
I. We will no longer be assuming that the economy is a closed economy.
A. Definition of closed economy: an economy that does not interact with other economies
in the world.
B. Definition 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
3. Definition of net exports: the value of a nation’s exports minus the value of its
imports, also called the trade balance.
Point out foreign products that students are likely to buy.
300 ❖ Chapter 18/Open-Economy Macroeconomics: Basic Concepts
4. Definition of trade balance: the value of a nation’s exports minus the value of its
imports, also called net exports.
8. There are several factors that influence 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.
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.
10.
In the News: The Changing Nature of U.S. Exports
a. Growing U.S. exports include entertainment royalties, tourism, travel, and services.
b. This article from
The
Wall Street Journal
describes the growth in "New Exports."
B. The Flow of Financial Resources: Net Capital Outflow
= Exports Imports
NX
−
Point out to students that a trade surplus implies a positive level of net exports, a
trade deficit 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 benefit if you review this.
Figure 1
Chapter 18/Open-Economy Macroeconomics: Basic Concepts ❖ 301
1. Definition of net capital outflow (NCO): the purchase of foreign assets by domestic
residents minus the purchase of domestic assets by foreigners.
2. The flow 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 financed with foreign money
but operated by domestic residents.
3. Net capital outflow can be positive or negative.
a. When net capital outflow is positive, domestic residents are buying more foreign assets
4. There are several factors that influence a country’s net capital outflow:
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 affect foreign ownership of domestic assets.
C. The Equality of Net Exports and Net Capital Outflow
1. Net exports and net capital outflow 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.
2. For an economy, net exports must be equal to net capital outflow.
3. Example: You are a computer programmer who sells some software to a Japanese consumer
for 10,000 yen.
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 net capital outflow.
purchases of foreign assets purchases of domestic assets
by domestic residents by foreigners
NCO
=−
302 ❖ Chapter 18/Open-Economy Macroeconomics: Basic Concepts
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
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 flowing out of 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 outflow).
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
).
Y C I G NX
= + + +
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. firm (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 States.
This leads to negative net exports for the United States. The extra dollars spent by U.S.
residents on foreign-produced goods and services would be used to purchase the stock in
Microsoft.
Chapter 18/Open-Economy Macroeconomics: Basic Concepts ❖ 303
2. Recall that national saving is equal to the income of the nation after paying for current
consumption and government purchases.
4. Because net exports and net capital outflow are equal, we can rewrite this as:
5. This implies that saving is equal to the sum of domestic investment (
I
) and net capital
outflow (
NCO
).
6. 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.
7. Note that, in a closed economy such as the one we assumed earlier, net capital outflow
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
deficit, a country with balanced trade, or a country with a trade surplus.
2.
Case Study: Is the U.S. Trade Deficit 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 outflow for the United States as a percentage of
GDP for the same time period.
S Y C G
= − −
Figure 2
S I NCO
=+
Table 1
304 ❖ Chapter 18/Open-Economy Macroeconomics: Basic Concepts
f.
Investment boom:
From 1991 to 2000, the capital flow into the United States increased
as the government's budget switched from deficit to surplus, but investment went from
13.4% to 17.8% of GDP. The economy enjoyed a boom in information technology and
firms invested heavily.
i. On the other hand, a trade deficit 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.
III. The Prices for International Transactions: Real and Nominal Exchange Rates
A. Nominal Exchange Rates
1. Definition 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.
3. Definition of appreciation: an increase in the value of a currency as measured by
the amount of foreign currency it can buy.
4. Definition of depreciation: a decrease in the value of a currency as measured by the
amount of foreign currency it can buy.
5. When a currency appreciates, it is said to
strengthen;
when a currency depreciates, it is said
to
weaken
.
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 foreign currencies if they have them.
ALTERNATIVE CLASSROOM EXAMPLE:
$1 10 pesos
1 peso $0.10
=
=
Chapter 18/Open-Economy Macroeconomics: Basic Concepts ❖ 305
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.
f. From 2010 to 2012, 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. 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.
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.
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
=
Nominal exchange rate Domestic price
real exchange rate Foreign price
=
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.
306 ❖ Chapter 18/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.
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.
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. Definition 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.
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 corn)
50 pesos per bushel of Mexican corn
real exchange rate = 120 pesos per bushel of American corn
50 pesos per bushel of Mexican corn
real exchange rate = 2.4 bushels of Mexican corn per bushel of American corn
Chapter 18/Open-Economy Macroeconomics: Basic Concepts ❖ 307
c. 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.
2. The same logic should apply to currency.
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.
308 ❖ Chapter 18/Open-Economy Macroeconomics: Basic Concepts
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 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.
Activity 1—A Profitable 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
profit 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.
How much profit could you expect on a six-pack?
Common Answers and Points for Discussion
1. How much would it cost in U.S. currency to buy the beer in Ontario?
$12.95 0.90 = $11.66 U.S.
2. How much would it cost in Canadian currency to buy the beer in Michigan?
$6.99/0.90 = $7.77 Canadian
3. Is there an arbitrage opportunity?
Yes. A price differential exists. The beer is more expensive in Canada, cheaper in the
United States.
4. If there is an arbitrage opportunity, where would you buy and where would you sell?
How much profit could you expect on a six-pack?
Chapter 18/Open-Economy Macroeconomics: Basic Concepts ❖ 309
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
.
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.
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.
5.
Case Study: The Nominal Exchange Rate during a Hyperinflation
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
hyperinflation 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 ( )/ *
eP P
=
Figure 3
P/*Pe =
310 ❖ Chapter 18/Open-Economy Macroeconomics: Basic Concepts
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.
a. Many goods are not easily traded (haircuts in Paris versus haircuts in New York). Thus,
arbitrage would be too limited to eliminate the difference in prices between the locations.
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 an article from January 2013, it was shown that 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.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. Net exports are the value of a nation’s exports minus the value of its imports, also called the
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 the implications of each.
Point out to students that, even with its flaws, purchasing-power parity does tell us
about exchange rates. Large and persistent movements in nominal exchange rates
typically reflect changes in price level at home and abroad.
Chapter 18/Open-Economy Macroeconomics: Basic Concepts ❖ 311
Questions for Review
1. The net exports of a country are the value of its exports minus the value of its imports. Net
Quick Check Multiple Choice
1. a
Problems and Applications
1. a. When an American art professor spends the summer touring museums in Europe, she
312 ❖ Chapter 18/Open-Economy Macroeconomics: Basic Concepts
2. a. When an American buys a Sony TV, there is a decrease in net exports.
3. Foreign direct investment requires actively managing an investment, for example, by opening
4. a. When an American cellular phone company establishes an office in the Czech Republic,
5. a. Dutch pension funds holding U.S. government bonds would be happy if the U.S. dollar
Chapter 18/Open-Economy Macroeconomics: Basic Concepts ❖ 313
8. a. To make a profit, you would want to buy rice where it is cheap and sell it where it is
9. If you take
X
units of foreign currency per Big Mac divided by 3.57 dollars per Big Mac, you
get
X
/3.57 units of the foreign currency per dollar; that is the predicted exchange rate.
314 ❖ Chapter 18/Open-Economy Macroeconomics: Basic Concepts
10. a. The exchange rate is 1 Ecterian dollar is equal to 3 Wiknamian pesos.
