Chapter 18 Open Economy Macroeconomics Basic Concepts 1 Basic Concepts Closed Economy Economy that does not interact with other economies in the world Open Economy Interacts with other economies o Buys and sells G S in world product markets o Buys and sells capital assets such as stocks and bonds in world financial markets The Flow of Goods Exports G S produced domestically and sold abroad Trade balance Net exports Imports G S produced abroad sold domestically o Value of nations exports imports Trade Surplus Positive net exports o Exports imports Country sells more G S abroad than it buys from other countries Trade Deficit Neg net exports o Imports exports countries Balanced Trade o Exports Imports Country sells fewer G S abroad than it buys from other Influential factors on a country s imports exports net exports o Consumer taste for domestic and foreign goods o Prices at home abroad o Exchange rates domestic currency used to buy foreign currency o Incomes of consumers at home abroad o Transportation cost of goods from country to country o Govt international trade policies Increasing openness in the U S economy Inc importance of international trade and finance o 1950s imports exports 4 5 of GDP o recent years 3 times that level largest trading partner 2012 imports and exports combined o Canada China Mexico Japan Germany UK international trade o improvements in transportation cargo ships long distance jets wide body jet o advances in telecommunications Chapter 18 Open Economy Macroeconomics Basic Concepts 2 telephone e mail o technological progress ease in transporting goods o govt trade policies NAFTA GATT Internationalization of the U S Economy The Flow of Financial Resources Net Capital Outflow o Purchase of foreign assets by domestic residents Foreign direct investment Foreign portfolio investment o Minus purchase of domestic assets by foreigners o Capital Outflow Capital Inflow Variables that influence net capital outflow o Real interest rates paid on foreign assets o Real interest rates paid on domestic assets o Perceived economic and political risks of holding assets abroad o Govt policies that affect foreign ownership of domestic assets Net Exports Net Capital Outflow o Imbalances between a country s exports and its exports Net Exports NX Net Capital Outflow NCO o Imbalance between Amt of foreign assets bought by domestic residents amt of domestic assets bought by foreigners Chapter 18 Open Economy Macroeconomics Basic Concepts 3 NCO NX When NX 0 trade surplus When NX 0 trade deficit o Selling more G S to foreigners than buying from them o From net sale of G S Receives foreign currency Buy foreign assets Capital is flowing out of the country NCO 0 o Buying more G S from foreigners than selling to them o Net purchase of G S Needs finances Capital is flowing into the country NCO 0 Selling assets abroad Saving Investment Open economy Y C I G NX National Saving S Y C G o Y C G I NX I NCO S NX NCO o S I NCO o Saving Domestic Investment Net Capital Outflow International Flows Domestic spending C I G Is the U S trade deficit a national problem The U S the world s largest debtor borrowing heavily in the world financial markets during past 3 decades to finance large financial trade deficits Chapter 18 Open Economy Macroeconomics Basic Concepts 4 By 1980 After 1980 National saving and domestic investment were close Small net capital outflow between 1 1 of GDP national saving often falling below domestic investment net capital outflow often large neg number sizable trade deficits substantial inflows of capital Unbalanced fiscal policy 1980 to 1987 flow of capital into U S declines o from 0 5 to 3 1 of GDP 2 6 point change o due to fall in national saving of 3 2 points due to decline in public saving Pres Ronald Reagan cut taxes and inc defense spending inc govt budget deficit Investment boom 1991 to 2000 Inc flow of capital 0 5 3 9 of GDP Savings govt budget surplus Investment from 13 4 17 8 of GDP Economic downturn 2000 to 2012 Large capital flow into U S Investment fell 4 5 pts o 2008 recession additional capital less profitable national saving fell 4 5 pts o Extraordinarily large budget deficits in response to the downturn At end of econ Downturn National saving was financing only about 2 3 domestic investment Flows of capital from abroad financed the rest Are these trade deficits and international capital flows a problem for the U S Trade deficits induced by a fall in saving 1980s Nation is putting away less of its income to provide for its future No reason to deplore the resulting trade deficits o Better to have foreigners incest in the U S economy than no one at all Trade deficits induced by an investment boom 1990s Economy is borrowing from abroad to finance the purchase of new capital goods o For good return on investment the economy should be able to handle the debts that are accumulated o For lower return on investment debts less desirable Chapter 18 Open Economy Macroeconomics Basic Concepts 5 Prices for International Transactions Nominal Exchange rate Chapter 18 Open Economy Macroeconomics Basic Concepts 6 o Rate at which a person can trade currency of one country for currency of another E g 80 yen 1 USD o Appreciation strengthen value of currency measured by amt of foreign currency it can buy able to buy more currency ex Dollar appreciation 80 yen USD 90 yen USD yen depr o Depreciation weaken Dec value of currency able to buy less currency Real exchange rate o Rate at which a person can trade G S of one currency for G S of another e g 1 German car 2 Am Cars o Real exchange rate e x P P Using CPI E nom Exchange rate between two currencies P CPI U S basket P CPI foreign basket o Nom Exchange rate x Domestic Price Foreign Price E PD PF E x Real Exchange 80yen 100 16000 yen 0 5 1 US wine bottle 0 5 Jap Wine bottles 2 US wine bottles 1 Jap Wine bottle o Depreciation fall in U S real exchange rate U S goods cheaper relative to foreign goods Consumers at home abroad buy more U S goods fewer goods from other countries Higher exports Lower imports Higher net exports o Appreciation rise in U S real exchange rate U S goods more expensive Consumers buy fewer U S goods Lower exports higher imports Lower net exports Purchasing Power Parity Purchasing Power Parity PPP o Theory of exchange rates o A unit of any given currency should be able to buy same quantity of goods in all countries Chapter 18 Open Economy Macroeconomics Basic Concepts 7 o Parity equality o Purchasing power value