Open and Closed Economies

A closed economy is one that does not interact with other economies in the world.
- There are no exports, no imports, and no capital flows.

Open and Closed Economies

An Open Economy

An open economy interacts with other countries in two ways.
- It buys and sells goods and services in world product markets.
- It buys and sells capital assets in world financial markets.

An Open Economy

The U.S. is a very large and open economy – it imports and exports huge quantities of goods and services.

Over the past four decades, international trade and finance have become increasingly important.

The Flow of Goods: Exports, Imports, Net Exports

Exports are domestically produced goods and services that are sold abroad.

Imports are foreign produced goods and services that are sold domestically.

The Flow of Goods: Exports, Imports, Net Exports

Net exports (NX) are the value of a nation’s exports minus the value of its imports.

Net exports are also called the trade balance.

The Flow of Goods: Exports, Imports, Net Exports

A trade deficit is a situation in which net exports (NX) are negative.

Imports > Exports

A trade surplus is a situation in which net exports (NX) are positive.

Exports > Imports

Balanced trade refers to when net exports are zero – exports and imports are exactly equal.

Factors That Affect Net Exports

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.

Factors That Affect Net Exports

The incomes of consumers at home and abroad.

The costs of transporting goods from country to country.

The policies of the government toward international trade.

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The Flow of Capital: Net Foreign Investment

Net foreign investment refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
- A U.S. resident buys stock in the Toyota corporation and a Mexican buys stock in the Ford Motor corporation.

The Flow of Capital: Net Foreign Investment

When a U.S. resident buys stock in Telmex, the Mexican phone company, the purchase raises U.S. net foreign investment.

When a Japanese residents buys a bond issued by the U.S. government, the purchase reduces the U.S. net foreign investment.

Variables that Influence Net Foreign Investment

The real interest rates being paid on foreign assets.

The real interest rates being 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 Equality of Net Exports and Net Foreign Investment

Net exports (NX) and net foreign investment (NFI) are closely linked.

For an economy as a whole, NX and NFI must balance each other so that:

This holds true because every transaction that affects one side must also affect the other side by the same amount.

Saving, Investment, and Their Relationship to the International Flows

Net exports is a component of GDP:

Y = C + I + G + NX

National saving is the income of the nation that is left after paying for current consumption and government purchases:

Y - C - G = I + NX

Saving, Investment, and Their Relationship to the International Flows

National saving (S) equals Y-C-G so:

S = I + NX

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(as a percentage of GDP)

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Real and Nominal Exchange Rates

International transactions are influenced by international prices.

The two most important international prices are the nominal exchange rate and the real exchange rate.

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.

Nominal Exchange Rates

The nominal exchange rate is expressed in two ways:
- In units of foreign currency per one U.S. dollar.
- And in units of U.S. dollars per one unit of the foreign currency.

Nominal Exchange Rates

Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one dollar.
- One U.S. dollar trades for eighty yen.
- One yen trades for 1/80 (=0.0125) of a dollar.

Nominal Exchange Rates

If a dollar buys more foreign currency, there is an appreciation of the dollar.

If it buys less there is a depreciation of the dollar.

Real Exchange Rates

The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy.
- If a case of German beer is twice as expensive as American beer, the real exchange rate is 1/2 case of German beer per case of American beer.

Real Exchange Rates

The real exchange rate is a key determinant of how much a country exports and imports.

Real Exchange Rates

A depreciation (fall) in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods.

This encourages consumers both at home and abroad to buy more U.S. goods and fewer goods from other countries.

Real Exchange Rates

As a result, U.S. exports rise, and U.S. imports fall, and both of these changes raise U.S. net exports.

Conversely, an appreciation 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.

Purchasing-Power Parity

The purchasing-power parity theory is the simplest and most widely accepted theory explaining the variation of currency exchange rates.

Purchasing-Power Parity

According to the purchasing-power parity theory, 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

The theory of purchasing-power parity is based on a principle called the law of one price.

According to the law of one price, a good must sell for the same price in all locations.

Basic Logic of Purchasing-Power Parity

If the law of one price were not true, unexploited profit opportunities would exist.

The process of taking advantage of differences in prices in different markets is called arbitrage.

Basic Logic of Purchasing-Power Parity

If arbitrage occurs, eventually prices that differed in two markets would necessarily converge.

According to the theory of purchasing-power parity, a currency must have the same purchasing power in all countries and exchange rates move to ensure that.

Implications of Purchasing-Power Parity

If the purchasing power of the dollar is always the same at home and abroad, then the exchange rate cannot change.

The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries.

Implications of Purchasing-Power Parity

When the central bank prints large quantities of money, the money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.

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Limitations of Purchasing-Power Parity

Many goods are not easily traded or shipped from one country to another.

Tradable goods are not always perfect substitutes when they are produced in different countries.

Summary

Net exports are the value of domestic goods and services sold abroad minus the value of foreign goods and services sold domestically.

Net foreign investment is the acquisition of foreign assets by domestic residents minus the acquisition of domestic assets by foreigners.

Summary

An economy’s net foreign investment always equals its net exports.

An economy’s saving can be used to either finance investment at home or to buy assets abroad.

Summary

The nominal exchange rate is the relative price of the currency of two countries.

The real exchange rate is the relative price of the goods and services of two countries.

Summary

When the nominal exchange rate changes so that each dollar buys more foreign currency, the dollar is said to appreciate or strengthen.

When the nominal exchange rate changes so that each dollar buys less foreign currency, the dollar is said to depreciate or weaken.

Summary

According to the theory or purchasing-power parity, a unit of currency should buy the same quantity of goods in all countries.

The nominal exchange rate between the currencies of two countries should reflect the countries’ price levels in those countries.