MACROECONOMICS I
Open-Economy Macroeconomics:
Basic Concepts
Lecture 8
April 22, 2022
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1
LOOK FOR THE ANSWERS TO THESE
QUESTIONS:
• How are international flows of goods and assets
related?
• What’s the difference between the real and
nominal exchange rate?
• What is “purchasing-power parity,” and how does
it explain nominal exchange rates?
2
INTRODUCTION
Trade can make everyone better off.
This chapter introduces basic concepts of
international macroeconomics:
 The trade balance (trade deficits, surpluses)
 International flows of assets
 Exchange rates
3
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
➢ It buys and sells goods and services in world
product markets
➢ It buys and sells capital assets such as stocks
and bonds in world financial markets 4
THE FLOW OF GOODS
Exports
 Goods and services that are produced
domestically and sold abroad
Imports
 Goods and services that are produced abroad
and sold domestically
Net exports (Trade balance)
= Value of exports – value of imports
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6
ACTIVE LEARNING 1 VARIABLES THAT AFFECT NX
What do you think would happen to Czech net exports
if:
A. Germany experiences a recession (falling incomes,
rising unemployment)
B. Czech consumers decide to be patriotic and
buy more products “Made in the ČR”
C. Prices of goods produced in Slovakia rise faster than
prices of goods produced in the ČR.
ACTIVE LEARNING 1 ANSWERS
A. Germany experiences a recession (falling
incomes, rising unemployment)
Czech net exports would fall
due to a fall in German consumers’ purchases of
Czech exports
B. Czech consumers decide to be patriotic and
buy more products “Made in the ČR”
Czech net exports would rise
due to a fall in imports 7
ACTIVE LEARNING 1 ANSWERS
C. Prices of goods produced in Slovakia rise faster
than prices of goods produced in the ČR
This makes Czech goods more attractive relative
to Slovakia’s goods.
Exports to Slovakia increases,
imports from Slovakia decreases,
so Czech net exports increases.
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VARIABLES THAT INFLUENCE NX
Factors that might influence a country’s exports,
imports, and net exports:
 Consumers’ preferences for foreign and domestic
goods
 Prices of goods at home and abroad
 Exchange rates at which foreign currency trades
for domestic currency
 Incomes of consumers at home and abroad
 Transportation costs
 Government policies 9
TRADE SURPLUSES & DEFICITS
Trade surplus (Positive net exports)
 Exports are greater than imports
➢ The country sells more goods and services
abroad than it buys from other countries
Trade deficit (Negative net exports)
 Imports are greater than exports
➢ The country sells fewer goods and services
abroad than it buys from other countries
Balanced trade: Exports equal imports
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13
THE U.S. ECONOMY’S INCREASING OPENNESS
PercentofGDP
4
6
8
10
12
14
16
18
20
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
Exports
Imports
THE INCREASING OPENNESS OF THE ECONOMY
 cheaper cost of transportation
 better communication
 devices, high value per weight
 lower tariffs
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THE FLOW OF FINANCIAL RESOURCES
Net capital outflow, NCO (net foreign investment)
The flow of capital abroad takes two forms.
➢ Foreign direct investment
(a capital investment is owned and operated by a foreign entity)
➢ Foreign portfolio investment
(an investment that is financed with foreign money but operated by
domestic residents) 15
purchases of foreign assets purchases of domestic assets
by domestic residents by foreigners
NCO = −
THE FLOW OF CAPITAL
NCO measures the imbalance in a country’s trade in
assets:
When NCO > 0, “capital outflow”
 Domestic purchases of foreign assets exceed foreign
purchases of domestic assets
When NCO < 0, “capital inflow”
 Foreign purchases of domestic assets exceed domestic
purchases of foreign assets
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VARIABLES THAT INFLUENCE NCO
 Real interest rates paid on foreign assets
 Real interest rates paid on domestic assets
 Perceived risks of holding foreign assets
 Government policies affecting foreign
ownership of domestic assets
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THE EQUALITY OF NX AND NCO
An accounting identity: NCO = NX
 Every transaction that affects NX also affects NCO
by the same amount (and vice versa)
18
When a foreigner purchases a good from the U.S.,
 U.S. exports and NX increase
 The foreigner pays with currency or assets,
so the U.S. acquires some foreign assets,
causing NCO to rise.
THE EQUALITY OF NX AND NCO
An accounting identity: NCO = NX
 Every transaction that affects NX also affects NCO
by the same amount (and vice versa)
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When a U.S. citizen buys foreign goods,
 U.S. imports rise, NX falls
 The U.S. buyer pays with U.S. dollars or assets, so
the other country acquires U.S. assets,
causing U.S. NCO to fall.
THE EQUALITY OF NX AND NCO
An accounting identity: NCO = NX
 Arises because every transaction that affects
NX also affects NCO by the same amount
(and vice versa)
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SAVING AND INVESTMENT
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
• Saving = Domestic investment + Net capital outflow
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INTERNATIONAL FLOWS
Trade surplus: Exports > Imports
• Net exports > 0
• Y > Domestic spending (C+I+G)
• S > I
• NCO > 0
Trade deficit: Exports < Imports
• Net exports < 0
• Y < Domestic spending (C+I+G)
• S < I
• NCO < 0
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IS THE U.S. TRADE DEFICIT A NATIONAL
PROBLEM?
Before 1980
 National saving and domestic investment were close:
small net capital outflow (between – 1 and 1 % of GDP)
After 1980
 National saving – often falling below domestic
investment
 Sizable trade deficits, substantial inflows of capital
 Net capital outflow is often a large negative number
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25
U.S. SAVING, INVESTMENT, AND NCO, 1950–2016
(%ofGDP)
-6
0
6
12
18
24
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
Investment
NCO
Saving
IS THE U.S. TRADE DEFICIT A NATIONAL
PROBLEM?
Unbalanced fiscal policy: 1980 to 1987
 Flow of capital into the U.S. declines due to a fall
in national saving
An investment boom: 1991 to 2000
 Increase flow of capital
 Saving increased
 Government budget surplus
 Investment increased
26
IS THE U.S. TRADE DEFICIT A NATIONAL
PROBLEM?
An economic downturn and recovery: 2000 to 2015
 2000-2009, saving and investment fell by about 6
percentage points.
➢ Investment: tough economic times made capital
accumulation less profitable
➢ Saving: government began running extraordinarily
large budget deficits
 2009-2015, as the economy recovered, saving
and investment increased by about 3 percentage
points 27
IS THE U.S. TRADE DEFICIT A NATIONAL
PROBLEM?
Trade deficit: by a fall in saving (1980s)
 The nation is putting away less of its income to provide
for its future
➢ Better to have foreigners invest in the U.S. economy
than no one at all
Trade deficit: by an investment boom (1990s)
 Economy is borrowing from abroad to finance the
purchase of new capital goods
➢ For lower return on investment - debts will look less
desirable
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IS THE U.S. TRADE DEFICIT A NATIONAL
PROBLEM?
Is the U.S. trade deficit a problem?
 The extra capital stock from the ’90s investment boom
may well yield large returns.
 The fall in saving of the ’80s and ’00s, while not
desirable, at least did not depress domestic investment,
since firms could borrow from abroad.
A country, like a person, can go into debt for good reasons
or bad ones.
 A trade deficit is not necessarily a problem, but might be
a symptom of a problem.
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THE U.S. TRADE DEFICIT
as of Q4 2020
People abroad owned $32.2 trillion in U.S. assets.
U.S. residents owned $46.3 trillion in foreign assets.
U.S.’ net indebtedness to other countries = $14.1
trillion.
 Higher than every other country’s
 hence, U.S. is “world’s biggest debtor nation.”
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THE NOMINAL EXCHANGE RATE
Nominal exchange rate:
 Rate at which one country’s currency trades for another
 We express all exchange rates as foreign currency per
unit of domestic currency.
Some exchange rates, per US$
32
12.06.2016 11.04.2018 22.04.2021 21.04.2022
Canadian dollar 1.31 1.34 1.25 1.25
Euro 0.90 0.89 0.83 0.92
Japanese yen 104.13 111.66 107.95 128.07
Mexican peso 18.39 18.83 19.93 20.09
Czech koruna 24.02 20.48 21.51 22.42
PRICES FOR INTERNATIONAL TRANSACTIONS
Appreciation (or “strengthening”)
 Increase in the value of a currency as measured
by the amount of foreign currency it can buy
Example: dollar appreciation
 Exchange rate (old) = 20 CZK per dollar
 Exchange rate (new) = 23 CZK per dollar
 (CZK depreciation)
33
PRICES FOR INTERNATIONAL TRANSACTIONS
Depreciation (or “weakening”)
 Decrease in the value of a currency
 As measured by the amount of foreign currency
it can buy
Example: dollar depreciation
 Exchange rate (old) = 20 CZK per dollar
 Exchange rate (new) = 17 CZK per dollar
 (CZK appreciation)
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THE REAL EXCHANGE RATE
Real exchange rate:
 Rate at which the goods and services of one country
trade for the goods and services of another
Real exchange rate = e x P / P*
Where
 P = domestic price
 P* = foreign price (in foreign currency)
 e = nominal exchange rate (foreign currency per
unit of domestic currency) 35
EXAMPLE WITH ONE GOOD
A Big Mac costs $2.50 in U.S., 400 yen in Japan
• e = 120 yen per $
• e x P = price in yen of a U.S. Big Mac
= (120 yen per $) x ($2.50 per Big Mac)
= 300 yen per U.S. Big Mac
Compute the real exchange rate:
e x P / P* = 300 yen per U.S. Big Mac / 400 yen
per Japanese Big Mac =
= 0.75 Japanese Big Macs per U.S. Big Mac
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38
ACTIVE LEARNING 2 COMPUTE A REAL EXCHANGE RATE
e = 10 pesos per $
price of a tall Starbucks Latte:
• P = $3 in U.S.,
• P* = 24 pesos in Mexico
A. What is the price of a U.S. latte measured in
pesos?
B. Calculate the real exchange rate, measured as
Mexican lattes per U.S. latte.
ACTIVE LEARNING 2 ANSWERS
e = 10 pesos per $
price of a tall Starbucks Latte:
P = $3 in U.S., P* = 24 pesos in Mexico
A. What is the price of a U.S. latte measured in pesos?
e x P = (10 pesos per $) x (3 $ per U.S. latte)
= 30 pesos per U.S. latte
B. Calculate the real exchange rate, measured as Mexican
lattes per U.S. latte.
e x P / P* = 30 pesos per U.S. latte / 24 pesos per
Mexican latte = 1.25 Mexican lattes per U.S. latte 39
THE BIG MAC INDEX
40
• informal way of measuring the purchasing power
parity (PPP) between two currencies
• test of the extent to which market exchange rates
result in goods costing the same in different countries
• As a Big Mac is a completely standardized product
across the world, the argument goes that it should
have the same relative cost in every country
41
42
43
THE REAL EXCHANGE RATE WITH MANY GOODS
Real exchange rate = (e x P)/P*
= price of a domestic basket of goods relative to
price of a foreign basket of goods
• P = U.S. price level, e.g., Consumer Price Index,
measures the price of a basket of goods
• P* = foreign price level
 If U.S. real exchange rate appreciates, U.S. goods
become more expensive relative to foreign goods.
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THE LAW OF ONE PRICE
Law of one price
 A good should sell for the same price in all markets
Arbitrage
 Take advantage of price differences for the same
item in different markets
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EXAMPLE: THE LAW OF ONE PRICE
Beer sells for CZK15/bottle in Ostrava and
CZK20/bottle in Brno; can be costlessly transported.
 Opportunity for arbitrage: making a quick profit
by buying beer in Ostrava and selling it in Brno.
 Drives up the price in Ostrava and drives down the
price in Brno, until the two prices are equal.
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PURCHASING-POWER PARITY, PPP
Purchasing-power parity
 Theory of exchange rates
 A unit of any given currency should be able to buy
the same quantity of goods in all countries
Basic logic of purchasing-power parity
 Based on the law of one price
 A good must sell for the same price in all locations
 Implies the nominal exchange rates adjust to
equalize the price of a basket of goods across
countries
47
EXAMPLE: PURCHASING-POWER PARITY (PPP)
Example: The “basket” contains a Big Mac.
P = price of U.S. Big Mac (in dollars)
P* = price of Czech Big Mac (in CZK)
e = exchange rate, CZK per dollar
According to PPP,
48
Solve for e we get: e = P* / P
e x P = P*
price of Czech
Big Mac, in CZK
price of U.S.
Big Mac, in CZK
IMPLICATIONS OF PPP
If purchasing power of the dollar is always the same at
home and abroad
 Then the real exchange rate cannot change
Theory of purchasing-power parity
 Nominal exchange rate between the currencies of
two countries must reflect the price levels in those
countries
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IMPLICATIONS OF PPP
Implications:
 Nominal exchange rates change when price levels
change
 When a central bank in any country increases the
money supply
➢ And causes the price level to rise
➢ It also causes that country’s currency to
depreciate relative to other currencies in the
world
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LIMITATIONS OF PPP
Theory of purchasing-power parity does not always
hold in practice
1. Many goods/services are not easily traded
 Examples: haircuts, going to the movies
 Price differences on such goods cannot be
arbitraged away
2. Even tradable goods are not always perfect
substitutes
 Price differences reflect taste differences
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LIMITATIONS OF PPP
Purchasing-power parity
 Not a perfect theory of exchange-rate
determination
 Real exchange rates fluctuate over time
Large and persistent movements in nominal
exchange rates
 Typically reflect changes in price levels at home
and abroad
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0.1
1.0
10.0
100.0
1,000.0
10,000.0
0.1 1.0 10.0 100.0 1,000.0
53
INFLATION & DEPRECIATION IN A CROSS-SECTION
OF 31 COUNTRIES
Average
annual
depreciation
relative to
US dollar
1993–2003
(log scale)
Avg annual CPI inflation
1993–2003 (log scale)
Ukraine
Brazil
Japan
Canada
Mexico
Argentina
Romania
Kenya
54
ACTIVE LEARNING 3 CHAPTER REVIEW QUESTIONS
1. Which of the following statements about a country
with a trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving
D. Y < C + I + G
2. A Ford Escape SUV sells for $24,000 in the U.S.
and 720,000 CZK in Czech Republic.
If purchasing-power parity holds, what is the nominal
exchange rate (CZK per dollar)?
1. Which of the following statements about a country
with a trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving
D. Y < C + I + G
55
A trade deficit means NX < 0.
Since NX = S – I, a trade deficit implies I > S.
ACTIVE LEARNING 3 ANSWERS
ACTIVE LEARNING 3 ANSWERS
2. A Ford Escape SUV sells for $24,000 in the U.S. and
720,000 CZK in Czech Republic. If purchasing-power
parity holds, what is the nominal exchange rate (CZK
per dollar)?
56
P* = 720,000 CZK
P = $24,000
e = P*/P = 720000/24000 = 30 CZK per dollar
SUMMARY
• 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).
• An economy’s net capital outflow = its net exports
• Because every international transaction involves an
exchange of an asset for a good or service.
57
SUMMARY
• An economy’s saving can be used either to finance
investment at home or to buy assets abroad.
• 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.
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SUMMARY
• 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 PPP, a dollar (or a unit of any
other currency) should be able to buy the same quantity of
goods in all countries.
- Implies that the nominal exchange rate between the
currencies of two countries should reflect the price levels in
those countries.
- Countries with relatively high inflation should have
depreciating currencies, and countries with relatively low
inflation should have appreciating currencies.
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