03 26 2013 Chapter 18 Vocab Closed Economy Open Economy world Exports Imports imports Trade Surplus an economy that does not interact with other economies an economy that interacts freely with other economies around the are domestically produced goods and services that are sold abroad are foreign produced goods and services that are sold domestically Net Exports Trade Balance the difference between the value of its exports and the value of its Net exports Value of country s exports Value of country s imports 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 Trade Deficit Net exports are negative exports are less than imports indicating that the country sells fewer goods and services abroad than it buys from other countries Balanced Trade Net exports are zero its exports and imports are exactly equal Net Capital Outflow Net Foreign Investment The difference between the purchase of foreign assets by domestic residents and the purchase of domestic assets by foreigners o Net capital outflow Purchase of foreign assets by domestic residents Purchase of domestic assets by foreigners o The net capital outflow 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 o 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 The rate at which a person can trade the currency of one country Nominal Exchange Rate for the currency of another 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 Real exchange rate e P P Appreciation Strengthen An increase in the value of a currency as measured by the amount of foreign currency it can buy If the exchange rate changes so that a dollar buys more foreign currency Depreciation Weaken A decrease in the value of a currency as measured by the amount of foreign currency it can buy If the exchange rate changes so that a dollar buys less foreign currency Purchasing power Parity Based on the law of one price 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 The process of taking advantage of price differences for the same item in different markets Continues until the prices in both markets become the same through fluctuations in the supply and Arbitrage demand Notes Trade allows people to produce what they produce best and to consume the great variety of goods and services produced around the world 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 An open economy interacts with other economies in two ways o It buys and sells goods and services in world product markets o It buys and sells capital assets such as stocks and bonds in Net capital outflow NCO must always equal net exports NX world financial markets NCO NX 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 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 It must be selling assets abroad Capital is flowing into the country NCO o Y C I G NX 0 o o 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 A country with a trade surplus 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 income Y is more than spending C I G then saving S Y C G must 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 A trade deficit such as the U S economy in recent years 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 C I G NX must be less than domestic spending C I G But if income Y is less than spending C I G then saving S Y C 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 is 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 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 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 Parity means equality and purchasing power refers to the value of money in terms of the quantity of goods it can buy Purchasing power Parity states that a unit of a currency must have the same real value in every country 1 P e P or 1 eP P o P Price of basket in the US Measured in Dollars o P Price of basket in Japan Measured in Yen o e Nominal exchange rate number of yen a dollar can buy o Purchasing power of 1 in the U S is 1 P A dollar can buy 1 P quantity of goods o Abroad a dollar can be exchanged into e units of foreign currency which in turn have purchasing power e P If the purchasing power of the dollar is always the same at home and abroad then the real exchange rate the relative price of domestic and foreign
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