659
W
hen you decide to buy a car, you may compare the latest models offered
by Ford and Toyota. When you take your next vacation, you may consider
spending it on a beach in Florida or in Mexico. When you start saving
for your retirement, you may choose between a mutual fund that buys stock in
U.S. companies and one that buys stock in foreign companies. In all these cases,
you are participating not just in the U.S. economy but in economies around
the world.
Openness to international trade yields clear benefits: Trade allows people to
produce what they produce best and to consume the great variety of goods
and services produced around the world. Indeed, one of the Ten Principles of
Economics highlighted in Chapter 1 is that trade can make everyone better off.
International trade can raise living standards in all countries by allowing
each country to specialize in producing those goods and services in which it
has a comparative advantage.
Chapter
31
Open-Economy
Macroeconomics:
Basic Concepts
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660	 PART XI	 THE MACROECONOMICS OF OPEN ECONOMIES
So far, our development of macroeconomics has largely ignored the economy’s
interaction with other economies around the world. For most questions in
macroeconomics, international issues are peripheral. For instance, when we
discuss the natural rate of unemployment and the causes of inflation, the effects
of international trade can safely be ignored. Indeed, to keep their models simple,
macroeconomists often assume a closed economy—an economy that does not
interact with other economies.
Yet when macroeconomists study an open economy—an economy that interacts
freely with other economies around the world—they encounter a whole set of
new issues. This chapter and the next provide an introduction to open-economy
macroeconomics. We begin in this chapter by discussing the key macroeconomic
variables that describe an open economy’s interactions in world markets.
You may have noticed mention of these variables—exports, imports, the trade
balance, and exchange rates—when reading news reports or watching the nightly
news. Our first job is to understand what these data mean. In the next chapter,
we develop a model to explain how these variables are determined and how they
are affected by various government policies.
closed economy
an economy that does
not interact with other
economies in the world
open economy
an economy that
interacts freely with other
economies around the
world
An open economy interacts with other economies in two ways: It buys and sells
goods and services in world product markets, and it buys and sells capital assets
such as stocks and bonds in world financial markets. Here we discuss these two
activities and the close relationship between them.
31-1a The Flow of Goods: Exports, Imports,
and Net Exports
Exports are domestically produced goods and services that are sold abroad,
and imports are foreign-produced goods and services that are sold domestically.
When Boeing, the U.S. aircraft manufacturer, builds a plane and sells
it to Air France, the sale is an export for the United States and an import for
France. When Volvo, the Swedish car manufacturer, makes a car and sells
it to a U.S. resident, the sale is an import for the United States and an export
for Sweden.
The net exports of any country are the difference between the value of
its exports and the value of its imports:
Net exports 5 Value of country’s exports 2 Value of country’s imports.
The Boeing sale raises U.S. net exports, and the Volvo sale reduces U.S. net
exports. Because net exports tell us whether a country is, in total, a seller or
a buyer in world markets for goods and services, net exports are also called
the trade balance. If net exports are positive, exports are greater than imports,
indicating that the country sells more goods and services abroad than it buys
from other countries. In this case, the country is said to run a trade surplus.
If net exports are negative, exports are less than imports, indicating that
the country sells fewer goods and services abroad than it buys from other
31-1 The International Flows of Goods and Capital
exports
goods and services that
are produced domestically
and sold abroad
imports
goods and services that
are produced abroad and
sold domestically
net exports
the value of a nation’s
exports minus the value
of its imports; also called
the trade balance
trade balance
the value of a nation’s
exports minus the value
of its imports; also called
net exports
trade surplus
an excess of exports over
imports	THEAREPEEE	THEAREPEEE
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	 CHAPTER 31  OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 661
countries. In this case, the country is said to run a trade deficit. If net exports
are zero, its exports and imports are exactly equal, and the country is said to
have balanced trade.
In the next chapter, we develop a theory that explains an economy’s trade balance,
but even at this early stage, it is easy to think of many factors that might influence
a country’s exports, imports, and net exports. Those factors include the following:
•	 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 cost of transporting goods from country to country.
•	 Government policies toward international trade.
As these variables change, so does the amount of international trade.
trade deficit
an excess of imports over
exports
balanced trade
a situation in which
exports equal imports
“But we’re not just
talking about buying a
car—we’re talking about
confronting this country’s
trade deficit with Japan.”
©MortGerberg/TheNewYorker
Collection/www.cartoonbank.com
The Increasing Openness of the U.S. Economy
One dramatic change in the U.S. economy over the past six decades
has been the increasing importance of international trade and finance.
This change is illustrated in Figure 1, which shows the total value of goods
and services exported to other countries and imported from other countries
expressed as a percentage of gross domestic product (GDP). In the 1950s, imports
and exports of goods and services were typically between 4 and 5 percent of GDP.
In recent years, they have been about three times that level. The trading partners
of the United States include a diverse group of countries. As of 2012, the largest
case
study
The Internationalization
of the U.S. Economy
This figure shows exports
and imports of the U.S.
economy as a percentage
of U.S. GDP since 1950.
The substantial increases
over time show the
increasing importance
of international trade and
finance.
Source: U.S. Department of Commerce.
Percent
of GDP
Exports
Imports
0
5
10
15
20
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
FIGURE 1	 PEEAREAEPT	 PEEAREAEPT
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662	 PART XI	 THE MACROECONOMICS OF OPEN ECONOMIES
trading partner, as measured by imports and exports combined, was Canada,
followed by China, Mexico, Japan, Germany, and the United Kingdom.
The increase in international trade over the past several decades is partly due
to improvements in transportation. In 1950, the average merchant ship carried
less than 10,000 tons of cargo; today, many ships carry more than 100,000 tons.
The long-distance jet was introduced in 1958, and the wide-body jet in 1967,
making air transport far cheaper than it had been. Because of these developments,
goods that once had to be produced locally can now be traded around the world.
Cut flowers grown in Israel are flown to the United States to be sold. Fresh fruits
and vegetables that can grow only in summer in the United States can now
be consumed in winter as well because they can be shipped from countries in the
Southern Hemisphere.
The increase in international trade has also been influenced by advances in
telecommunications, which have allowed businesses to reach overseas customers
more easily. For example, the first transatlantic telephone cable was not laid
Jeremy Lin and America’s
“New Exports”
By Austan Goolsbee
Linsanity swept the nation last week.
The undrafted Harvard graduate Jeremy
Lin seemed to transform himself from benchwarmer
to MVP candidate in a matter of days.
New York Knicks #17 jerseys became the
biggest seller in the NBA and interest in
Mr. Lin surged world-wide.
That same week we learned that
China’s president-to-be, Xi Jinping, is an
NBA fan. After meeting President Obama at
the White House, Mr. Xi traveled to Iowa and
then attended a Lakers game in Los Angeles.
Mr. Obama, for his part, visited a Boeing
787 plant to tout exports as an engine of
growth.
Though seemingly unrelated, these three
events together highlighted one of the more
promising ways out of our economic doldrums:
growing exports—with exports broadly
defined to include things like entertainment
royalties, tourism, travel and services.
While U.S. economic conditions have
improved in recent months, anxiety lingers
and the slumps in housing and consumer
spending remain. Exports, however, have
grown impressively and have plenty of room
to keep expanding.
During our last economic expansion, we
focused on the home market while the other
advanced economies’ exports grew three
times faster than ours did. Big emerging
markets grew even more.
Today, growing exports are a natural
opportunity for us and one of the last areas
of bipartisan agreement in Washington.
And exports are not confined to traditional
manufactured goods.
When a foreign visitor comes to America
on vacation and, like Mr. Xi, buys an NBA
ticket in Los Angeles or a lunch in Muscatine,
Iowa, those count in official statistics as exports.
If a fan in Indonesia watches an NBA
game or buys a Jeremy Lin jersey, the royalties
count as an export. Many services increase
our exports: tuition paid by foreign students,
fares paid on U.S. airlines by foreign fliers, ad
sales on Google from foreign companies.
These things add up. Last year, according
to the Bureau of Economic Analysis (BEA),
the U.S. exported $2.1 trillion of goods and
services (the most ever) and more than
$600 billion of that came from services.
Think of them as the New Exports. We
already export far more of them than any
other country. We export more educations than
computers and more tourism than aerospace
products or machinery. Unlike our massive
trade deficit in goods, we run major trade
surpluses in the New Exports—$179 billion
of surplus in 2011 and probably more in
2012, according to the BEA. This supports
millions of jobs across America.
The Changing Nature of
U.S. Exports
International trade can show up in surprising places.
In the News	THEAREPEEE	THEAREPEEE
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 31  OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 663
until 1956. As recently as 1966, the technology allowed only 138 simultaneous
conversations between North America and Europe. Today, because e-mail is
such a common form of business communication, it is almost as easy to communicate
with a customer across the world as it is to communicate with one
across town.
Technological progress has also fostered international trade by changing the
kinds of goods that economies produce. When bulky raw materials (such as steel)
and perishable goods (such as foodstuffs) were a large part of the world’s ­output,
transporting goods was often costly and sometimes impossible. By contrast, goods
produced with modern technology are often light and easy to transport. Consumer
electronics, for instance, have low weight for every dollar of value, which makes
them easy to produce in one country and sell in another. An even more extreme
­example is the film industry. Once a studio in Hollywood makes a movie, it can
send copies of the film around the world at almost zero cost. And indeed, movies
are a major export of the United States.
Promoting the New Exports requires more
than just the conventional prying open of
foreign markets and reducing tariff and
regulatory barriers to our goods. It involves
fighting restrictions on Internet commerce
and enforcing intellectual-property rules.
It also involves some less confrontational (and
often easier) strategies such as improving
foreigners’ opinions of America so they want
to come visit or send their children to school
here, and then expanding student and tourist
visas to enable them to do so.
Modest investments can facilitate major
private-sector economic gains. Take tourists
coming from countries like Brazil. In a recent
survey, 94% of Brazilians said it was either
difficult or nearly impossible to get here.
To obtain a visa, they must undergo a multistage
ordeal that includes traveling to
a personal interview in a city with a U.S.
consulate—of which there are only four in all
of Brazil. Start to finish, the process can take
up to five months.
Last month President Obama called for
speeding up the visa process to promote tourism
here. The U.S. Travel Association estimates that
adding a consular official costs, with overhead,
around $280,000 per year. Since the average
Brazilian traveler to the U.S. spends around
$5,000, the association estimates that a single
official can generate as much as $50 million
of travel exports for U.S. business (not to mention
more than $1 million in visa fees to the U.S.
government).
Supporting New Exports doesn’t require
diplomatic battles with China or shepherding
new trade agreements through Congress.
These are exports that other countries want us
to have and that we have missed by our own
short-sightedness. Last week we extended the
payroll tax cut to help the economy. We have
given tax incentives to encourage companies
to invest. Why not also use short-run government
incentives to encourage New Exports,
such as limited-time discounts on airline
taxes, visa-application costs and airportlanding
fees?
As a Chicago Bulls fan, I find the resurgent
Knicks irritating. Still, I will root for more
Linsanity because with every game watched
in Asia, jersey sold in Europe or visit to an NBA
game by a foreign tourist, this young man is
doing more than just helping his team. He’s
demonstrating a way for our economy to grow.
Playing for a .500 team, Mr. Lin probably won’t
be up there cutting down the nets in celebration
at the end of the year. He was an economics
major, though, so if it’s any consolation to him,
he’s already helped cut down the trade deficit.
Mr. Goolsbee is a professor of economics
at the University of Chicago. He was formerly
an economic adviser to President Obama.
Source: Reprinted with permission of The Wall Street
Journal, Copyright © 2012 Dow Jones & Company, Inc. All
Rights Reserved Worldwide.Jeremy Lin: Export Promoter.
AlBello/GettyImages	 PEEAREAEPT	 PEEAREAEPT
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664	 PART XI	 THE MACROECONOMICS OF OPEN ECONOMIES
31-1b The Flow of Financial Resources:
Net Capital Outflow
So far, we have been discussing how residents of an open economy participate in
world markets for goods and services. In addition, residents of an open economy
participate in world financial markets. A U.S. resident with $25,000 could use that
money to buy a car from Toyota, or she could instead use that money to buy stock
in the Toyota Corporation. The first transaction would represent a flow of goods,
whereas the second would represent a flow of capital.
The term net capital outflow refers to the difference between the purchase
of foreign assets by domestic residents and the purchase of domestic assets by
foreigners:
Net capital outflow 5 Purchase of foreign assets by domestic residents
        2 Purchase of domestic assets by foreigners.
When a U.S. resident buys stock in Telmex, the Mexican telecommunications
company, the purchase increases the first term on the right side of this equation
and, therefore, increases U.S. net capital outflow. When a Japanese resident buys
a bond issued by the U.S. government, the purchase increases the second term on
the right side of this equation and, therefore, decreases U.S. net capital outflow.
The flow of capital between the U.S. economy and the rest of the world takes
two forms. If McDonald’s opens up a fast-food outlet in Russia, that is an example
of foreign direct investment. Alternatively, if an American buys stock in a Russian
corporation, that is an example of foreign portfolio investment. In the first case, the
American owner (McDonald’s Corporation) actively manages the investment,
whereas in the second case, the American owner (the stockholder) has a more passive
role. In both cases, U.S. residents are buying assets located in another country,
so both purchases increase U.S. net capital outflow.
The net capital outflow (sometimes called net foreign investment) can be either
positive or negative. When it is positive, domestic residents are buying more
foreign assets than foreigners are buying domestic assets. Capital is said to be
flowing out of the country. When the net capital outflow is negative, domestic residents
are buying less foreign assets than foreigners are buying domestic assets.
Capital is said to be flowing into the country. That is, when net capital outflow is
negative, a country is experiencing a capital inflow.
We develop a theory to explain net capital outflow in the next chapter. Here
let’s consider briefly some of the more important variables that influence net
capital outflow:
•	 The real interest rates paid on foreign assets.
•	 The real interest rates paid on domestic assets.
•	 The perceived economic and political risks of holding assets abroad.
•	 The government policies that affect foreign ownership of domestic assets.
The government’s trade policies have also been a factor in increasing international
trade. As we discussed earlier in this book, economists have long believed that
free trade between countries is mutually beneficial. Over time, most policymakers
around the world have come to accept these conclusions. International agreements,
such as the North American Free Trade Agreement (NAFTA) and the General
Agreement on Tariffs and Trade (GATT), have gradually lowered tariffs, import
quotas, and other trade barriers. The pattern of increasing trade illustrated in Figure 1
is a phenomenon that most economists and policymakers endorse and encourage.
net capital outflow
the purchase of foreign
assets by domestic
residents minus the
purchase of domestic
assets by foreigners	THEAREPEEE	THEAREPEEE
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	 CHAPTER 31  OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 665
For example, consider U.S. investors deciding whether to buy Mexican government
bonds or U.S. government bonds. (Recall that a bond is, in effect, an IOU
of the issuer.) To make this decision, U.S. investors compare the real interest rates
offered on the two bonds. The higher a bond’s real interest rate, the more attractive
it is. While making this comparison, however, U.S. investors must also take
into account the risk that one of these governments might default on its debt (that
is, not pay interest or principal when it is due), as well as any restrictions that the
Mexican government has imposed, or might impose in the future, on foreign investors
in Mexico.
31-1c The Equality of Net Exports
and Net Capital Outflow
We have seen that an open economy interacts with the rest of the world in two
ways—in world markets for goods and services and in world financial markets. Net
exports and net capital outflow each measure a type of imbalance in these markets.
Net exports measure an imbalance between a country’s exports and its imports. Net
capital outflow measures an imbalance between the amount of foreign assets bought
by domestic residents and the amount of domestic assets bought by foreigners.
An important but subtle fact of accounting states that, for an economy as a
whole, net capital outflow (NCO) must always equal net exports (NX):
NCO 5 NX.
This equation holds because every transaction that affects one side of this equation
affects the other side by exactly the same amount. This equation is an identity—
an equation that must hold because of how the variables in the equation are
defined and measured.
To see why this accounting identity is true, let’s consider an example. Imagine
that you are a computer programmer residing in the United States. One day, you
write some software and sell it to a Japanese consumer for 10,000 yen. The sale of
software is an export of the United States, so it increases U.S. net exports. What
else happens to ensure that this identity holds? The answer depends on what you
do with the 10,000 yen you are paid.
First, let’s suppose that you simply stuff the yen in your mattress. (We might
say you have a yen for yen.) In this case, you are using some of your income to
invest in the Japanese economy. That is, a domestic resident (you) has acquired a
foreign asset (the Japanese currency). The increase in U.S. net exports is matched
by an increase in the U.S. net capital outflow.
More realistically, however, if you want to invest in the Japanese economy, you
won’t do so by holding on to Japanese currency. More likely, you would use the
10,000 yen to buy stock in a Japanese corporation, or you might buy a Japanese
government bond. Yet the result of your decision is much the same: A domestic
resident ends up acquiring a foreign asset. The increase in U.S. net capital outflow
(the purchase of the Japanese stock or bond) exactly equals the increase in U.S. net
exports (the sale of software).
Let’s now change the example. Suppose that instead of using the 10,000 yen
to buy a Japanese asset, you use them to buy a good made in Japan, such as a
Nintendo Wii. As a result of the Wii purchase, U.S. imports increase. Together, the
software export and the Wii import represent balanced trade. Because exports and
imports increase by the same amount, net exports are unchanged. In this case, no
American ends up acquiring a foreign asset and no foreigner ends up acquiring a
U.S. asset, so there is also no impact on U.S. net capital outflow.	 PEEAREAEPT	 PEEAREAEPT
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666	 PART XI	 THE MACROECONOMICS OF OPEN ECONOMIES
A final possibility is that you go to a local bank to exchange your 10,000 yen
for U.S. dollars. But this doesn’t change the situation because the bank now has
to do something with the 10,000 yen. It can buy Japanese assets (a U.S. net capital
outflow); it can buy a Japanese good (a U.S. import); or it can sell the yen to
another American who wants to make such a transaction. In the end, U.S. net exports
must equal U.S. net capital outflow.
This example all started when a U.S. programmer sold some software abroad,
but the story is much the same when Americans buy goods and services from
other countries. For example, if Walmart buys $50 million of clothing from China
and sells it to American consumers, something must happen to that $50 million.
One possibility is that China could use the $50 million to invest in the U.S. economy.
This capital inflow from China might take the form of Chinese purchases
of U.S. government bonds. In this case, the purchase of the clothing reduces U.S.
net exports, and the sale of bonds reduces U.S. net capital outflow. Alternatively,
China could use the $50 million to buy a plane from Boeing, the U.S. aircraft
manufacturer. In this case, the U.S. import of clothing balances the U.S. export of
­aircraft, so net exports and net capital outflow are both unchanged. In all cases,
the transactions have the same effect on net exports and net capital outflow.
We can summarize these conclusions for the economy as a whole.
•	 When a nation is running a trade surplus (NX . 0), it is selling more goods and
services to foreigners than it is buying from them. What is it doing with the foreign
currency it receives from the net sale of goods and services abroad? It must be using
it to buy foreign assets. Capital is flowing out of the country (NCO . 0).
•	 When a nation is running a trade deficit (NX , 0), it is buying more goods and
services from foreigners than it is selling to them. How is it financing the net
purchase of these goods and services in world markets? It must be selling
assets abroad. Capital is flowing into the country (NCO , 0).
The international flow of goods and services and the international flow of capital
are two sides of the same coin.
31-1d Saving, Investment, and Their Relationship
to the International Flows
A nation’s saving and investment are crucial to its long-run economic growth.
As we have seen earlier in this book, saving and investment are equal in a closed
economy. But matters are not as simple in an open economy. Let’s now consider
how saving and investment are related to the international flows of goods and
capital as measured by net exports and net capital outflow.
As you may recall, the term net exports appeared earlier in the book when
we discussed the components of GDP. The economy’s GDP (Y) is divided among
four components: consumption (C), investment (I), government purchases (G),
and net exports (NX). We write this as
Y 5 C 1 I 1 G 1 NX.
Total expenditure on the economy’s output of goods and services is the sum of expenditure
on consumption, investment, government purchases, and net exports.
Because each dollar of expenditure is placed into one of these four components,
this equation is an accounting identity: It must be true because of the way the
variables are defined and measured.	THEAREPEEE	THEAREPEEE
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	 CHAPTER 31  OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 667
Recall that national saving is the income of the nation that is left after paying
for current consumption and government purchases. National saving (S) equals
Y 2 C 2 G. If we rearrange the equation to reflect this fact, we obtain
Y 2 C 2 G 5 I 1 NX
      S 5 I 1 NX.
Because net exports (NX) also equal net capital outflow (NCO), we can write this
equation as
               S 5 I 1 NCO
Saving 5
Domestic
1
Net capital
investment   outflow  
.
This equation shows that a nation’s saving must equal its domestic investment
plus its net capital outflow. In other words, when a U.S. citizen saves a dollar of
her income for the future, that dollar can be used to finance the accumulation
of domestic capital or it can be used to finance the purchase of foreign capital.
This equation should look somewhat familiar. Earlier in the book, when we
analyzed the role of the financial system, we considered this identity for the special
case of a closed economy. In a closed economy, net capital outflow is zero
(NCO 5 0), so saving equals investment (S 5 I). By contrast, an open economy has
two uses for its saving: domestic investment and net capital outflow.
As before, we can view the financial system as standing between the two sides
of this identity. For example, suppose the Garcia family decides to save some of
its income for retirement. This decision contributes to national saving, the left side
of our equation. If the Garcias deposit their saving in a mutual fund, the mutual
fund may use some of the deposit to buy stock issued by General Motors, which
uses the proceeds to build a factory in Ohio. In addition, the mutual fund may
use some of the Garcias’ deposit to buy stock issued by Toyota, which uses the
proceeds to build a factory in Osaka. These transactions show up on the right
side of the equation. From the standpoint of U.S. accounting, the General Motors
expenditure on a new factory is domestic investment, and the purchase of Toyota
stock by a U.S. resident is net capital outflow. Thus, all saving in the U.S. economy
shows up as investment in the U.S. economy or as U.S. net capital outflow.
The bottom line is that saving, investment, and international capital flows are
inextricably linked. When a nation’s saving exceeds its domestic investment, its
net capital outflow is positive, indicating that the nation is using some of its saving
to buy assets abroad. When a nation’s domestic investment exceeds its saving,
its net capital outflow is negative, indicating that foreigners are financing some of
this investment by purchasing domestic assets.
31-1e Summing Up
Table 1 summarizes many of the ideas presented so far in this chapter. It describes
the three possibilities for an open economy: a country with a trade deficit, a country
with balanced trade, and a country with a trade surplus.
Consider first a country with a 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 5 C 1 I 1 G 1 NX must be greater than domestic spending C 1 I 1 G.
But if income Y is more than spending C 1 I 1 G, then saving S 5 Y 2 C 2 G must 	 PEEAREAEPT	 PEEAREAEPT
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668	 PART XI	 THE MACROECONOMICS OF OPEN ECONOMIES
be more than investment I. 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.
Similar logic applies to a country with a trade deficit (such as the U.S. economy
in recent years). By definition, a trade deficit means that the value of exports is
less than the value of imports. Because net exports are exports minus imports, net
exports NX are negative. Thus, income Y 5 C 1 I 1 G 1 NX must be less than
domestic spending C 1 I 1 G. But if income Y is less than spending C 1 I 1 G,
then saving S 5 Y 2 C 2 G must be less than investment I. Because the country is
investing more than it is saving, it must be financing some domestic investment
by selling assets abroad. That is, the net capital outflow must be negative.
A country with balanced trade falls between these cases. Exports equal imports,
so net exports are zero. Income equals domestic spending, and saving equals investment.
The net capital outflow equals zero.
International Flows
of Goods and Capital:
Summary
This table shows
the three possible
outcomes for an
open economy.
Trade Deficit Balanced Trade Trade Surplus
Exports , Imports Exports 5 Imports Exports . Imports
Net Exports , 0 Net Exports 5 0 Net Exports . 0
Y , C 1 I 1 G Y 5 C 1 I 1 G Y . C 1 I 1 G
Saving , Investment Saving 5 Investment Saving . Investment
Net Capital Outflow , 0 Net Capital Outflow 5 0 Net Capital Outflow . 0
Table 1
Is the U.S. Trade Deficit a National Problem?
You may have heard the press call the United States “the world’s
largest debtor.” The nation earned that description by borrowing heavily
in world financial markets during the past three decades to finance large
trade deficits. Why did the United States do this, and should this event give
Americans reason to worry?
To answer these questions, let’s see what the macroeconomic accounting identities
tell us about the U.S. economy. Panel (a) of Figure 2 shows national saving
and domestic investment as a percentage of GDP since 1960. Panel (b) shows net
capital outflow (that is, the trade balance) as a percentage of GDP. Notice that, as
the identities require, net capital outflow always equals national saving minus
domestic investment. The figure shows that both national saving and domestic
investment, as a percentage of GDP, fluctuate substantially over time. Before 1980,
they tended to fluctuate together, so the net capital outflow was typically small—
between 21 and 1 percent of GDP. Since 1980, national saving has often fallen
well below domestic investment, leading to sizable trade deficits and substantial
inflows of capital. That is, the net capital outflow is often a large negative number.
To understand the fluctuations in Figure 2, we need to go beyond these data and
discuss the policies and events that influence national saving and domestic investment.
History shows that there is no single cause of trade deficits. Rather, they can
arise under a variety of circumstances. Here are three prominent historical episodes.
Unbalanced fiscal policy: From 1980 to 1987, the flow of capital into the United
States went from 0.5 to 3.1 percent of GDP. This 2.6 percentage point change
is largely attributable to a fall in national saving of 3.2 percentage points.
case
study	THEAREPEEE	THEAREPEEE
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	 CHAPTER 31  OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 669
This decline in national saving, in turn, is often explained by the decline in public
saving—that is, the increase in the government budget deficit. These budget deficits
arose because President Ronald Reagan cut taxes and increased defense spending,
while he found his proposed cuts in nondefense spending harder to enact.
An investment boom: A different story explains the trade deficits that arose during
the following decade. From 1991 to 2000, the capital flow into the United States
went from 0.5 to 3.8 percent of GDP. None of this 3.3 percentage point change is
attributable to a decline in saving; in fact, saving increased over this time, as the
government’s budget switched from deficit to surplus. But investment went from
National Saving, 	
Domestic Investment, 	
and Net Capital 	
Outflow
Panel (a) shows
national saving and
domestic investment
as a percentage of
GDP. 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.
Source: U.S. Department of Commerce.
Percent
of GDP
Percent
of GDP
(a) National Saving and Domestic Investment (as a percentage of GDP)
(b) Net Capital Outflow (as a percentage of GDP)
8
10
12
14
16
18
20
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
–6
–5
–4
–3
–2
–1
0
1
2
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Domestic investment
National saving
Net capital
outflow
FIGURE 2	 PEEAREAEPT	 PEEAREAEPT
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670	 PART XI	 THE MACROECONOMICS OF OPEN ECONOMIES
Quick Quiz  Define net exports and net capital outflow. Explain how they are related.
13.4 to 17.8 percent of GDP, as the economy enjoyed a boom in information technology
and many firms were eager to make these high-tech investments.
An economic downturn: During the period from 2000 to 2012, the capital flow into
the United States remained large. The consistency of this variable, however, stands in
stark contrast to the remarkable changes in saving and investment, both of which fell
by about 4.5 percentage points. Investment fell because tough economic times starting
in 2008 made additional capital less profitable, while national saving fell because the
government began running extraordinarily large budget deficits in response to
the downturn. At the end of this period, national saving was financing only about
two-thirds of domestic investment, while flows of capital from abroad financed the rest.
Are these trade deficits and international capital flows a problem for the U.S.
economy? There is no easy answer to this question. One has to evaluate the
circumstances and the possible alternatives.
Consider first a trade deficit induced by a fall in saving, as occurred during
the 1980s. Lower saving means that the nation is putting away less of its income
to provide for its future. Once national saving has fallen, however, there is no
reason to deplore the resulting trade deficits. If national saving fell without inducing
a trade deficit, investment in the United States would have to fall. This fall in
investment, in turn, would adversely affect the growth in the capital stock, labor
productivity, and real wages. In other words, given that U.S. saving has declined,
it is better to have foreigners invest in the U.S. economy than no one at all.
Now consider a trade deficit induced by an investment boom, like the trade
deficits of the 1990s. In this case, the economy is borrowing from abroad to
finance the purchase of new capital goods. If this additional capital provides
a good return in the form of higher production of goods and services, then the
economy should be able to handle the debt that is being accumulated. On
the other hand, if the investment projects fail to yield the expected returns, the
debts will look less desirable, at least with the benefit of hindsight.
Just as an individual can go into debt in either a prudent or a profligate manner,
so can a nation. A trade deficit is not a problem in itself, but it can sometimes be a
symptom of a problem.
So far, we have discussed measures of the flow of goods and services and the flow
of capital across a nation’s border. In addition to these quantity variables, macroeconomists
also study variables that measure the prices at which these international
transactions take place. Just as the price in any market serves the important role of
coordinating buyers and sellers in that market, international prices help coordinate the
decisions of consumers and producers as they interact in world markets. Here we discuss
the two most important international prices: the nominal and real exchange rates.
31-2a 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. For example, when you go to
a bank, you might see a posted exchange rate of 80 yen per dollar. If you give
31-2 The Prices for International Transactions: Real and
Nominal Exchange Rates
nominal exchange rate
the rate at which a person
can trade the currency
of one country for the
currency of another	THEAREPEEE	THEAREPEEE
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	 CHAPTER 31  OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 671
the bank 1 U.S. dollar, you will receive 80 Japanese yen in return; and if you give
the bank 80 Japanese yen, you will receive 1 U.S. dollar. (In actuality, the bank will
post slightly different prices for buying and selling yen. The difference gives the
bank some profit for offering this service. For our purposes here, we can ignore
these differences.)
An exchange rate can always be expressed in two ways. If the exchange rate is
80 yen per dollar, it is also 1/80(5 0.0125) dollar per yen. Throughout this book,
we always express the nominal exchange rate as units of foreign currency per U.S.
dollar, such as 80 yen per dollar.
If the exchange rate changes so that a dollar buys more foreign currency, that
change is called an appreciation of the dollar. If the exchange rate changes so
that a dollar buys less foreign currency, that change is called a depreciation of the
dollar. For example, when the exchange rate rises from 80 to 90 yen per dollar,
the dollar is said to appreciate. At the same time, because a Japanese yen now
appreciation
an increase in the value
of a currency as measured
by the amount of foreign
currency it can buy
depreciation
a decrease in the value of
a currency as measured
by the amount of foreign
currency it can buy
The Euro
You may have once heard of, or perhaps even
seen, currencies such as the French franc,
the German mark, or the Italian lira. These types
of money no longer exist. During the 1990s, many
European nations decided to give up their national
currencies and use a common currency called the
euro. The euro started circulating on January 1,
2002, when twelve nations began using it as
theirofficialmoney.Asof2013,therewereseventeen
nations using the euro. Several European nations,
such as the United Kingdom, Sweden, and Denmark,
have declined joining and have kept their own
currencies.
Monetary policy for the euro area is set by the
European Central Bank (ECB), with representatives
from all of the participating countries. The ECB issues the euro and
controls the supply of this money, much as the Federal Reserve controls
the supply of dollars in the U.S. economy.
Why did these countries adopt a common currency? One benefit of
a common currency is that it makes trade easier. Imagine that each
of the fifty U.S. states had a different currency. Every time you crossed a
state border, you would need to change your money and perform the kind
of exchange-rate calculations discussed in the text. This would be inconvenient,
and it might deter you from buying goods and services outside
your own state. The countries of Europe decided that as their economies
became more integrated, it would be better to avoid this inconvenience.
To some extent, the adoption of a common currency in Europe was a
political decision based on concerns beyond the scope of standard economics.
S o m e
advoc
a t e s
of the euro
wanted to reduce nationalistic
feelings and to make Europeans appreciate
more fully their shared history and destiny.
A single money for most of the continent, they
argued, would help achieve this goal.
There are, however, costs of choosing a common
currency. If the nations of Europe have only
one money, they can have only one monetary policy.
If they disagree about what monetary policy is best,
they will have to reach some kind of agreement,
rather than each going its own way. Because adopting
a single money has both benefits and costs, there is debate among
economists about whether Europe’s adoption of the euro was a good
decision.
From 2010 to 2012, the euro question heated up as several
European nations dealt with a variety of economic difficulties. Greece,
in particular, had run up a large government debt and found itself facing
possible default. As a result, it had to raise taxes and cut back
government spending substantially. Some observers suggested that
dealing with these problems would have been easier if the government
had an additional tool—a national monetary policy. The possibility of
Greece’s leaving the euro area and reintroducing its own currency was
even discussed. As this book was going to press, however, that outcome
looked unlikely.
FYI
PeterStone/Alamy	 PEEAREAEPT	 PEEAREAEPT
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672	 PART XI	 THE MACROECONOMICS OF OPEN ECONOMIES
buys less of the U.S. currency, the yen is said to depreciate. When the exchange
rate falls from 80 to 70 yen per dollar, the dollar is said to depreciate, and the yen
is said to appreciate.
At times, you may have heard the media report that the dollar is either “strong”
or “weak.” These descriptions usually refer to recent changes in the nominal exchange
rate. When a currency appreciates, it is said to strengthen because it can
then buy more foreign currency. Similarly, when a currency depreciates, it is said
to weaken.
For any country, there are many nominal exchange rates. The U.S. dollar can
be used to buy Japanese yen, British pounds, Mexican pesos, and so on. When
economists study changes in the exchange rate, they often use indexes that average
these many exchange rates. Just as the consumer price index turns the many
prices in the economy into a single measure of the price level, an exchange rate
index turns these many exchange rates into a single measure of the international
value of a currency. So when economists talk about the dollar appreciating or
­depreciating, they often are referring to an exchange rate index that takes into
­account many individual exchange rates.
31-2b 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. For example, if you go
shopping and find that a pound of Swiss cheese is twice as expensive as a pound
of American cheese, the real exchange rate is 1⁄2 pound of Swiss cheese per pound
of American cheese. Notice that, like the nominal exchange rate, we express the
real exchange rate as units of the foreign item per unit of the domestic item. But in
this instance, the item is a good rather than a currency.
Real and nominal exchange rates are closely related. To see how, consider
an example. Suppose that a bushel of American rice sells for $100 and a bushel
of Japanese rice sells for 16,000 yen. What is the real exchange rate between
American and Japanese rice? To answer this question, we must first use
the nominal exchange rate to convert the prices into a common currency. If
the nominal exchange rate is 80 yen per dollar, then a price for American rice of
$100 per bushel is equivalent to 8,000 yen per bushel. American rice is half as expensive
as Japanese rice. The real exchange rate is 1⁄2 bushel of Japanese rice per
bushel of American rice.
We can summarize this calculation for the real exchange rate with the following
formula:
Real exchange rate 5
Nominal exchange rate 3 Domestic price
Foreign price
.
Using the numbers in our example, the formula applies as follows:
Real exchange rate 5
(80 yen/dollar) 3 ($100/bushel of American rice)
16,000 yen/bushel of Japanese rice
5
8,000 yen/bushel of American rice
16,000 yen/bushel of Japanese rice
          5 ½ bushel of Japanese rice/bushel of American rice.
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	THEAREPEEE	THEAREPEEE
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	 CHAPTER 31  OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 673
Thus, 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.
Why does the real exchange rate matter? As you might guess, the real exchange
rate is a key determinant of how much a country exports and imports. When Uncle
Ben’s, Inc., is deciding whether to buy U.S. rice or Japanese rice to put into its boxes,
it will ask which rice is cheaper. The real exchange rate gives the answer. As another
example, imagine that you are deciding whether to take a seaside vacation in Miami,
Florida, or in Cancún, Mexico. You might ask your travel agent the price of a hotel
room in Miami (measured in dollars), the price of a hotel room in Cancún (measured
in pesos), and the exchange rate between pesos and dollars. If you decide where to
vacation by comparing costs, you are basing your decision on the real exchange rate.
When studying an economy as a whole, macroeconomists focus on overall
prices rather than the prices of individual items. That is, to measure the real exchange
rate, they use price indexes, such as the consumer price index, which measure
the price of a basket of goods and services. By using a price index for a U.S.
basket (P), a price index for a foreign basket (P*), and the nominal exchange rate
between the U.S. dollar and foreign currencies (e), we can compute the overall real
exchange rate between the United States and other countries as follows:
Real exchange rate 5 (e 3 P)/P*.
This real exchange rate measures the price of a basket of goods and services available
domestically relative to a basket of goods and services available abroad.
As we examine more fully in the next chapter, a country’s real exchange rate is
a key determinant of its net exports of goods and services. A depreciation (fall) in
the U.S. real exchange rate means that U.S. goods have become cheaper relative to
foreign goods. This change 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; both of these changes raise U.S. net exports. Conversely,
an appreciation (rise) 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.
Quick Quiz  Define nominal exchange rate and real exchange rate, and explain how
they are related. • If the nominal exchange rate goes from 100 to 120 yen per dollar, has
the dollar appreciated or depreciated?
31-3 A First Theory of Exchange-Rate Determination:
Purchasing-Power Parity
Exchange rates vary substantially over time. In 1970, a U.S. dollar could be used
to buy 3.65 German marks or 627 Italian lira. In 1998, as both Germany and
Italy were getting ready to adopt the euro as their common currency, a U.S. dollar
bought 1.76 German marks or 1,737 Italian lira. In other words, over this period,
the value of the dollar fell by more than half compared to the mark, while it more
than doubled compared to the lira.
What explains these large and opposite changes? Economists have developed
many models to explain how exchange rates are determined, each emphasizing
just some of the many forces at work. Here we develop the simplest theory of 	 PEEAREAEPT	 PEEAREAEPT
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