Open-Economy Macroeconomics:

Basic Concepts

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PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

Basic Concepts

• Closed economy
• Economy that does not interact with other economies in the world
• Open economy
• Economy that interacts freely with other economies around the world

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International Flow of Goods

• Exports
• Goods & services
• Produced domestically
• Sold abroad
• Imports
• Goods and services
• Produced abroad
• Sold domestically

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International Flow of Goods

• Net exports
• Value of a nation’s exports
• Minus the value of its imports
• Also called trade balance

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International Flow of Goods

• Trade surplus
• Excess of exports over imports
• Trade deficit
• Excess of imports over exports
• Balanced trade
• Exports equal imports

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International Flow of Goods

• Factors that influence a country’s exports, imports, and net exports:
• Tastes of consumers for domestic & foreign goods
• Prices of goods at home and abroad
• Exchange rates
• People use domestic currency to buy foreign currencies
• Incomes of consumers at home and abroad

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International Flow of Goods

• Factors that influence a country’s exports, imports, and net exports:
• Cost of transporting goods from country to country
• Government policies toward international trade

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Figure 1

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The Internationalization of the U.S. Economy

This figure shows exports and imports of the U.S. economy as a percentage of U.S. gross domestic product since 1950. The substantial increases over time show the increasing importance of international trade and finance.

International Flow of Capital

• Net capital outflow (NCO)
• Purchase of foreign assets by domestic residents
• Foreign direct investment
• Foreign portfolio investment
• Minus the purchase of domestic assets by foreigners

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Some Simple Algebra

• Open economy: Y = C + I + G + NX
• National saving: S = Y – C – G

• Y – C – G = I + NX

• S = I + NX

• NX = NCO

• S = I + NCO

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Figure 2

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National Saving, Domestic Investment, and Net Capital Outflow

Panel (a) shows national saving and domestic investment as a percentage of GDP. You can see from the figure that national saving has been lower since 1980 than it was before 1980. This fall in national saving has been reflected primarily in reduced net capital outflow rather than in reduced domestic investment.

Figure 2

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National Saving, Domestic Investment, and Net Capital Outflow

Panel (b) shows net capital outflow as a percentage of GDP. You can see from the figure that national saving has been lower since 1980 than it was before 1980. This fall in national saving has been reflected primarily in reduced net capital outflow rather than in reduced domestic investment.

Real & Nominal Exchange Rates

• Nominal exchange rate
• Rate at which a person can trade currency of one country for currency of another
• Appreciation (strengthen)
• Increase in the value of a currency
• Depreciation (weaken)
• Decrease in the value of a currency

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Real & Nominal Exchange Rates

• Real exchange rate
• Rate at which a person can trade goods and services of one country
• For goods and services of another

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• Real exchange rate = (E ˣ P) / P*

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Real & Nominal Exchange Rates

• Depreciation (fall) in the U.S. real exchange rate
• U.S. goods - cheaper relative to foreign goods
• Higher exports
• Lower imports
• Higher net exports
• An appreciation (rise) in the U.S. real exchange rate

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Purchasing-Power Parity

• Basic logic of purchasing-power parity
• Based on law of one price (but extends it to a basket of goods)
• A good must sell for the same price in all locations
• Arbitrage
• Take advantage of price differences for the same item in different markets

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Purchasing-Power Parity

• Parity
• Equality
• Purchasing-power
• Value of money in terms of quantity of goods it can buy
• If purchasing power of the dollar
• Is always the same at home and abroad
• Then the real exchange rate cannot change

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Implications of PPP

• (Absolute) Theory of purchasing-power parity
• Nominal exchange rate between the currencies of two countries must reflect their price levels (E=P*/P)
• Unlike absolute PPP, relative PPP predicts a relationship between changes in prices and changes in exchange rates, rather than a relationship between their levels

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Figure 3

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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 for classroom use.

Money, Prices, and the Nominal Exchange Rate during the German Hyperinflation

This figure shows the money supply, the price level, and the exchange rate (measured as U.S. cents per mark) for the German hyperinflation from January 1921 to December 1924. Notice how similarly these three variables move. When the quantity of money started growing quickly, the price level followed, and the mark depreciated relative to the dollar. When the German central bank stabilized the money supply, the price level and exchange rate stabilized as well.

Limitations of PPP

• Theory of purchasing-power parity
• Does not always hold in practice
• Many goods are not easily traded
• Even tradable goods are not always perfect substitutes
• When they are produced in different countries
• No opportunity for profitable arbitrage

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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 for classroom use.