9. Openeconomy.pdf

Open Economy Macroeconomics: Basic Concepts

• Chapter Outline: • How are the international transactions and macroeconomic variables are related?

• 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?

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Open-Economy Macroeconomics: Basic Concepts

 When we decide to buy a new product, we start comparing products made available by both by domestic producers and multinationals.  When we plan to invest money, we look for avenues both in domestic market and international markets.  So openness to international markets and economies yield choices and potential benefits

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Introduction  One of the Principles of Economics : Trade can make everyone better off.  This chapter introduces basic concepts of international macroeconomics:  The trade balance (trade deficits, surpluses)  International flows of assets (FDI and FII)  Exchange rates

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Closed vs. Open Economies  A closed economy does not interact with other economies in the world.  An open economy interacts freely with other economies around the world.  In an open economy framework, each transactions influences the macroeconomic variables and get influenced by these variables, such as; inflation, interest rate, GDP employment etc.

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The Flow of Goods & Services  Exports: domestically-produced G&S sold abroad  Imports: foreign-produced G&S sold domestically  Net exports (NX), or the trade balance = value of exports – value of imports  Exchange rate: The rate at which one currency is exchanged with another.

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ACTIVE LEARNING

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Variables that affect NX What do you think would happen to Indian net exports (NX) if: A. US experiences a recession (falling incomes, rising unemployment) B. Indian consumers decide to be patriotic and buy more products “Made in India.” C. Prices of goods produced in UK rise faster than prices of goods produced in the India.

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ACTIVE LEARNING

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Answers

A. US experiences a recession (falling incomes, rising unemployment)

India net exports would fall due to a fall in US consumers’ purchases of Indian exports B. Indian consumers decide to be patriotic and buy more products “Made in India.”

India’s net exports would rise due to a fall in imports © 2013 © Cengage 2013 Cengage Learning. Learning. All Rights AllReserved. Rights Reserved. May notMay be copied, not be copied, scanned,scanned, or duplicated, or duplicated, in wholeinorwhole in part, or in except part,for except use as for use as permitted permitted in a license in a distributed license distributed with a certain with a certain productproduct or service or service or otherwise or otherwise on a password-protected on a password-protected website website for classroom for classroom use. use.

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ACTIVE LEARNING

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Answers

C. Prices of UK goods rise faster than prices of Indian goods

This makes Indian goods more attractive relative to Mexico’s goods. Exports to UK increase, imports from UK decrease, so India’s net exports increase.

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Variables that Influence Net Exports  Consumers’ preferences for foreign and domestic goods  Prices of goods at home and abroad  Incomes of consumers at home and abroad  The exchange rates at which foreign currency trades for domestic currency  Transportation costs  Government policies and so on…

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Trade Surpluses & Deficits NX measures the imbalance in a country’s trade in goods and services.  Trade deficit: an excess of imports over exports  Trade surplus: an excess of exports over imports  Balanced trade: when exports = imports

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Percent of GDP

The India’s Economy’s Increasing Openness 20% 18% 16%

Imports

14% 12% 10%

Exports

8% 6% 4% 2% 0% 1960

1965

1970

1975

1980

1985

1990

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1995

2000

2005

11 2010

The Flow of Capital  Net capital outflow (NCO): domestic residents’ purchases of foreign assets minus foreigners’ purchases of domestic assets  NCO is also called net foreign investment.

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The Flow of Capital The flow of capital abroad takes two forms:  Foreign direct investment (FDI): Domestic residents actively manage the foreign investment, e.g., McDonalds opens a fast-food outlet in India.  Foreign portfolio/institutional investment (FPI/FII): Domestic residents purchase foreign stocks or bonds, supplying “loanable funds” to a foreign firm. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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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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 Definition of net exports: the value of a nation’s exports minus the value of its imports, also called the trade balance  Definition of net capital outflow (NCO): the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.

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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)  When a foreigner purchases a good from the India,  India exports and NX increase  the foreigner pays with currency or assets, so the India acquires some foreign assets, causing NCO to rise. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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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)  When a Indian citizen buys foreign goods,  India’s imports rise, NX falls  the Indian buyer pays with rupees or assets, so the other country acquires Indian assets, causing India’s NCO to fall.

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The Equality of NX and NCO  The Equality of Net Exports and Net Capital Outflow  1. Net exports and net capital outflow each measure a type of imbalance in a world market.  a. Net exports measure the imbalance between a country’s exports and imports in world markets for goods and services.  b. Net capital outflow measures the imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners in world financial markets.    2. For an economy, net exports must be equal to net capital outflow.   3. Example: You are a computer programmer who sells some software to a Japanese consumer for 10,000 yen. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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The Equality of NX and NCO  a. The sale is an export for the India so net exports increases.  b. There are several things you could do with the 10,000 yen   c. You could hold the yen (which is a Japanese asset) or use it to purchase another Japanese asset. Either way, net capital outflow rises.  d. Alternatively, you could use the yen to purchase a Japanese good. Thus, imports will rise so the net effect on net exports will be zero.  e. One final possibility is that you could exchange the yen for rupees at a bank. This does not change the situation though, because the bank then must use the yen for something.

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The Equality of NX and NCO  This example can be generalized to the economy as a whole:  a. When a nation is running a trade surplus (NX > 0), it must be using the foreign currency to purchase foreign assets. Thus, capital is flowing out of the country (NCO > 0).  b. When a nation is running a trade deficit (NX < 0), it must be financing the net purchase of these goods by selling assets abroad. Thus, capital is flowing into the country (NCO < 0). © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Saving, Investment, and International Flows of Goods & Assets Y = C + I + G + NX accounting identity Y – C – G = I + NX rearranging terms S = I + NX since S = Y – C – G S = I + NCO since NX = NCO  When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow.  When S < I, foreigners are financing some of the country’s investment, and NCO < 0. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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International Flows of Goods and Capital

 Trade Deficit: Export < Imports; Net Export < 0  Y (C + I + G + NX) < C + I + G  Saving < Investment; NCO < 0 (selling assest abroad)  Trade Surplus: Export > Imports; Net Export > 0  Y (C + I + G + NX) > C + I + G  Saving > Investment; NCO > 0 (Saving abroad)  Balance Trade : Export = Imports; Net Export = 0  Y=C+I+G  Saving = Investment; NCO = 0 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Case Study: The U.S. Trade Deficit  The U.S. trade deficit reached record levels in 2006 and remained high in 2007–2008. (World’s largest debtor)  Recall, NX = S – I = NCO. A trade deficit means I > S, so the nation borrows the difference from foreigners.  In 2007, foreign purchases of U.S. assets exceeded U.S. purchases of foreign assets by $775 million.  Such deficits have been the norm since 1980… © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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U.S. Saving, Investment, and NCO, 1950–2012 24% 21%

Investme nt

18%

(% of GDP)

15% 12%

Savin g

9% 6% 3%

NCO

0% -3% -6% 25 1960 1965May not1970 1975 1985 1995 2000 2005 2010 © 2013 Cengage Learning. All Rights Reserved. be copied, scanned, or duplicated,1980 in whole or in part, except for use1990 as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Case Study: The U.S. Trade Deficit Why U.S. saving has been less than investment:  In the 1980s and early 2000s, huge govt budget deficits and low private saving depressed national saving.  In the 1990s, national saving increased as the economy grew, but domestic investment increased even faster due to the information technology boom.

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Case Study: The U.S. Trade Deficit  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. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Case Study: The U.S. Trade Deficit as of 31-12-2011 People abroad owned $25 trillion in U.S. assets. U.S. residents owned $21 trillion in foreign assets. U.S.’ net indebtedness to other countries = $4 trillion. Higher than every other country’s net indebtedness, hence, U.S. is “the world’s biggest debtor nation.”  So far, the U.S. earns higher interest rates on foreign assets than it pays on its debts to foreigners.  But if U.S. debt continues to grow, foreigners may demand higher interest rates, and servicing the debt may become a drain on U.S. income. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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US Trade Deficits – A Different Story  From 1991 to 2000, capital flow went from 0.5 to 3.6 % of GDP  However, during this period saving has actually increased and investment increased from 13.4 to 17.7 % of GDP due to information technology boom.  From 2000- 2006, capital flow into US increased due federal Govt. budget deficit..

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Price for International Transactions: Real and Nominal exchange rates

 Exchange rates are expressed in two ways;  Example: exchange rate is 80 yen per dollar or 1/80 = 0.0125 dollar per yen.  We will express here the exchange rate as unit of foreign currency per 1 US $.

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The Nominal Exchange Rate  Nominal exchange rate: the 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 as of 8 July 2012, all per US$ Canadian dollar: Euro:

1.02

0.81

Japanese yen: 79.67 Mexican peso: 13.39 Indian Rupee:

55.86

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The Nominal Exchange Rate  Nominal exchange rate: the 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 as of 18 April 2014, all per US$ Canadian dollar: Euro:

1.10

0.72

Japanese yen:

102.49

Mexican peso:

13.05

Indian Rupee:

59.52

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The Nominal Exchange Rate  Nominal exchange rate: the 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 as of 24 April 2015, all per US$ Canadian dollar: Euro:

1.22

0.93

Japanese yen:

119.57

Mexican peso:

15.36

Indian Rupee:

66.34

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The Nominal Exchange Rate  Nominal exchange rate: the 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 as of 12 April 2016, all per US$ Canadian dollar: Euro:

1.29

0.87

Japanese yen:

108.69

Mexican peso:

17.54

Indian Rupee:

66.66

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Appreciation and Depreciation  Appreciation (or “strengthening”): an increase in the value of a currency as measured by the amount of foreign currency it can buy  Example: dollar buys more foreign currency, appreciation of dollar

 Depreciation (or “weakening”): a decrease in the value of a currency as measured by the amount of foreign currency it can buy  Examples: During 2015-16, the U.S. dollar…  Appreciated against rupee  appreciated against Euro © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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The Real Exchange Rate  Real exchange rate: the rate at which the G&S of one country trade for the G&S of another  Real exchange rate = e x P P* where P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate, i.e., foreign currency per unit of domestic currency

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Example With One Good  A Pizza costs $2.50 in U.S., 400 yen in Japan  e = 120 yen per $  e x P = price in yen of a U.S. Pizza = (120 yen per $) x ($2.50 per Pizza) = 300 yen per U.S. Pizza  Compute the real exchange rate: 300 yen per U.S. Pizza ex = P P* 400 yen per Japanese Pizza = 0.75 Japanese Pizza per U.S. Pizza © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Interpreting the Real Exchange Rate

This example shows that the real exchange rate is the price of domestic goods relative to the price of foreign goods. “The real exchange rate = 0.75 Japanese Pizza per U.S. Pizza” Correct interpretation: To buy a Pizza in the U.S., a Japanese citizen must sacrifice an amount that could purchase 0.75 Pizza in Japan. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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ACTIVE LEARNING

2

Compute a real exchange rate

e = 10 pesos per $ price of a Soft drink P = $3 in U.S., P* = 24 pesos in Mexico A. What is the price of a U.S. soft drink measured

in pesos? B. Calculate the real exchange rate,

measured as Mexican Soft drink per U.S. Soft drink.

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ACTIVE LEARNING

2

Answers

e = 10 pesos per $ price of a Soft Drink P = $3 in U.S., P* = 24 pesos in Mexico A. What is the price of a U.S. Soft Drink in e pesos? xP = (10 pesos per $) x (3 $ per U.S. soft drink)

= 30 pesos per U.S. Soft Drink B. Calculate the real exchange rate. 30 pesos per U.S. soft ex = drink P P* 24 pesos per Mexican soft drink = 1.25 Mexican soft drink per U.S. soft 40 drink

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The Real Exchange Rate With Many Goods Real exchange rate measures the price of basket of goods and services available domestically relative to basket of goods available abroad. P = U.S. price level, e.g., Consumer Price Index, measures the price of a basket of goods P* = foreign price level Real exchange rate = (e x P)/P* = price of a domestic basket of goods relative to price of a foreign basket of goods  Country’s real exchange rate is the key determinant of its exports and imports. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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The Law of One Price  Law of one price: the notion that a good should sell for the same price in all markets  Suppose coffee sells for $4/pound in Seattle and $5/pound in Boston, and transport cost is nil.  There is an opportunity for arbitrage, making a quick profit by buying coffee in Seattle and selling it in Boston.  Such arbitrage drives up the price in Seattle and drives down the price in Boston, until the two prices are equal. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Purchasing-Power Parity (PPP)  Purchasing-power parity:  Parity means equality and purchasing power means the value of money inn terms of quantity of G&S it can buy.  A theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries  Based on the law of one price  Implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries

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Purchasing-Power Parity (PPP)  Example: The “basket” contains a Big Mac. P = price of U.S. Big Mac (in dollars) P* = price of Japanese Big Mac (in yen) e = exchange rate, yen per dollar  According to PPP, exP =

P*

price of U.S. Big Mac, in yen

 Solve for e:

e =

price of Japanese Big Mac, in yen

P* P

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PPP and Its Implications  PPP implies that the nominal exchange rate between two countries should equal the ratio of price levels.

e =

P* P

 If the two countries have different inflation rates, then e will change over time:  If inflation is higher in Mexico than in the U.S., then P* rises faster than P, so e rises— the dollar appreciates against the peso.  If inflation is higher in the U.S. than in Japan, then P rises faster than P*, so e falls— the dollar depreciates against the yen. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Limitations of PPP Theory Two reasons why exchange rates do not always adjust to equalize prices across countries:  Many goods cannot easily be traded  Examples: haircuts, going to the movies  Price differences on such goods cannot be arbitraged away  Foreign, domestic goods not perfect substitutes  E.g., some U.S. consumers prefer Toyotas over Chevrolet, or vice versa  Price differences reflect taste differences © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Applications of PPP Theory  Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends.  For example, PPP implies: the greater a country’s inflation rate, the faster its currency should depreciate (relative to a low-inflation country like the US).  The data can support this prediction…

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Inflation & Depreciation in a Cross-Section of 31 Countries 10,000.0

Ukraine

1,000.0

Avg annual 100.0 depreciatio n 10.0 relative to US dollar 1.0 1993–2003 (log scale) 0.1

Romani a Argentin a Canad a Japan

Brazil

Mexic o Kenya

0.1 1.0 10.0 100.0 1,000.0 Avg annual CPI inflation 1993–2003 (log scale)

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