Tuesday, June 18, 2019 1

Presented To: Prof. Bushra Anwar

Group Members:
• Muhammad Shabbir Ali (Roll No. 17)
• Shahryar Abbasi (Roll No. 13)
• Rana Usama (Roll No. 49)
• Malik Haseeb (Roll No. 47)
• Murawat Sultan (Roll No. 17)
Tuesday, June 18, 2019 2
 Open-Economy Macroeconomics:
Basic Concepts
Tuesday, June 18, 2019 3
Open and Closed Economy

Closed Economy:
• 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.

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

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 The International Flows of Goods
and Capital
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The Flow of Goods: Exports, Imports, and Net Exports

Exports:
Exports are domestically produced goods
and services that are sold abroad.

Imports:
Imports are foreign-produced goods and
services that are sold domestically.

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 Net Exports:
• Net Exports of any country are the
difference between the value of its exports
and the value of its imports:
Net Exports = Value of country’s exports − Value of country’s imports

• Net exports are also called the

trade balance.

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Trade Deficit:
• It is a situation in which net exports are negative.
Imports > Exports
Trade Surplus:
• It is a situation in which net exports are positive.
Exports > Imports
Balanced Trade:
• Refers to when net exports are zero.
• Exports and Imports are exactly equal.
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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.

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The Internationalization of the U.S. Economy

15

Imports
This figure shows
10
exports and imports of
Exports
the U.S. economy as a
percentage of U.S.
5 GDP since 1950.

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

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The Flow of Financial Resources: Net Capital Outflow

Net Capital Outflow:

• It 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.

Net capital outflow = Purchasing of foreign assets by domestic residents

− Purchase of domestic assets by foreigners.

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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.

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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.

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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.

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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.

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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.

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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

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Saving, Investment, and Their Relationship to the
International Flows
National saving (S) equals Y - C - G so:

S = I + NX

This equation shows that a nation’s 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.

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Summing Up

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.

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Summing Up (Cont.)

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.

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Summing Up (Cont.)

International Flows of Goods and Capital: Summary

Trade Deficit Balanced Trade Trade Surplus

Exports < Imports Exports = Imports Exports > Imports
Net Exports < 0 Net Exports = 0 Net Exports > 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
This table shows the three possible outcomes for an open economy

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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
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 (b) Net Capital Outflow (as a percentage of GDP)

Percent of GDP

2
Net capital
1 outflow

–1

–2

–3

–4
1960 1965 1970 1975 1980 1985 1990 1995 2000

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

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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.

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Nominal Exchange Rates (Cont.)

• 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.

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Nominal Exchange Rates (Cont.)
Appreciation:
• If the exchange rate changes so that a dollar buys more foreign
currency, that change is called an appreciation of the dollar.
• It refers to an increase in the value of a currency as measured by
the amount of foreign currency it can buy.

Depreciation:
• If the exchange rate changes so that a dollar buys less foreign
currency, that change is called an depreciation of the dollar.
• It refers to a decrease in the value of a currency as measured by the
amount of foreign currency it can buy.

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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.

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Real Exchange Rates (Cont.)
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?

Nominal exchange rate Domestic price

Real exchange rate =
Foreign Price
(80 yen per dollar)  ($100 per bushel of American rice)
Real exchange rate =
16,000 yen per bushel of Japanese rice

(8000 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.
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Real Exchange Rates (Cont.)
Appreciation:
• 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.
Depreciation:
• A depreciation 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.
• As a result, U.S. exports rise, and U.S. imports fall, and both of these
changes raise U.S. net exports.

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

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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.
• 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.

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The Basic Logic of Purchasing-Power Parity (Cont.)

• 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.

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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).
• 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*

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Implications of Purchasing-Power Parity (Cont.)

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.

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Implications of Purchasing-Power Parity (Cont.)
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.

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Implications of Purchasing-Power Parity (Cont.)

• 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.
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 Indexes
(Jan. 1921 = 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

Money, Prices, and the Nominal Exchange Rate During the German Hyperinflation
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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.

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Limitations of Purchasing-Power Parity (Cont.)

• The first reason is that many goods are not easily traded or
shipped from one country to another.
• 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.
• some consumers prefer German cars, and others prefer
American cars. Moreover, consumer tastes can change over
time.

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Conclusion

• The purpose of this chapter has been to develop basic

concepts that macroeconomics use to study open economies.
• You should now understand how a nation’s trade balance is
related to the international flow of capital and how national
saving can differ from domestic investment in open economy.
• You should understand that when a nation is running a trade
surplus, it must be sending capital abroad, and that when it is
running a trade deficit, it must be experiencing a capital
inflow.

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