Unit 8 Open Ecowwqnomy Macroeconomics.pptx

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1. Unit 8 Open Economy Macroeconomics

2. Introduction Trade can make everyone better off International trade yields clear benefits Trade allows people to focus on what they do best and to consume goods and services from around the world Can raise living standards in all countries by allowing each country to specialize in producing the goods and services for which it has a comparative advantage

3. Trade Balances and Trade Negotiations “A typical country can increase its citizens’ welfare by enacting policies that would increase its trade surplus (or decrease its trade deficit).” Source: IGM Economic Experts Panel, December 9, 2014 and March 22, 2016.

4. International Flows Closed economy Economy that does not interact with other economies in the world Open economy Economy that interacts freely with other economies around the world Buys and sells goods and services in world product markets Buys and sells capital assets such as stocks and bonds in world financial markets

5. The Flow of Goods: Exports, Imports, and Net Exports Exports Goods and services that are produced domestically and sold abroad Imports Goods and services that are produced abroad and sold domestically Net exports (NX) Value of a nation’s exports minus the value of its imports Trade balance Value of a nation’s exports minus the value of its imports; also called net exports

6. The Flow of Goods: Exports, Imports, and Net Exports Trade surplus Exports are greater than imports The country sells more goods and services abroad than it buys from other countries Trade deficit Imports are greater than exports The country sells fewer goods and services abroad than it buys from other countries

7. The Flow of Goods: Exports, Imports, and Net Exports Balanced trade A situation in which exports equal imports Country’s net exports are zero

8. The Flow of Goods: Exports, Imports, and Net Exports Factors that might influence a country’s exports, imports, and net exports Consumer tastes for domestic and foreign goods Prices of goods at home and abroad Exchange rates at which people can use domestic currency to buy foreign currencies Incomes of consumers at home and abroad Cost of transporting goods from country to country Government policies toward international trade

9. Variables That Affect NX What do you think would happen to U.S. net exports if Canada experiences a recession (falling incomes, rising unemployment) U.S. consumers decide to be patriotic and buy more products “Made in the U.S.A.” Prices of goods produced in Mexico rise faster than prices of goods produced in the U.S.

10. Answers U.S. net exports would fall due to a fall in Canadian consumers’ purchases of U.S. exports. U.S. net exports would rise due to a fall in imports. This makes U.S. goods more attractive relative to Mexico’s goods. Exports to Mexico increase, imports from Mexico decrease, so, U.S. net exports increase.

11. 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.

12. The Flow of Financial Resources: Net Capital Outflow Net capital outflow (net foreign investment) Purchase of foreign assets by domestic residents Foreign direct investment Foreign portfolio investment Minus the purchase of domestic assets by foreigners

13. The Flow of Financial Resources: Net Capital Outflow Variables that influence net capital outflow Real interest rates paid on foreign assets Real interest rates paid on domestic assets Perceived economic and political risks of holding assets abroad Government policies that affect foreign ownership of domestic assets

14. The Equality of Net Exports and Net Capital Outflow Net exports ( NX ) Imbalance between a country’s exports and imports Net capital outflow ( NCO ) Imbalance between Amount of foreign assets bought by domestic residents Amount of domestic assets bought by foreigners Identity: NCO = NX

15. The Equality of Net Exports and Net Capital Outflow When NX > 0 (trade surplus) Selling more goods and services to foreigners Than it is buying from them From net sale of goods and services Receives foreign currency Buy foreign assets Capital is flowing out of the country: NCO > 0

16. The Equality of Net Exports and Net Capital Outflow When NX < 0 (trade deficit) Buying more goods and services from foreigners Than it is selling to them The net purchase of goods and services Needs financed Selling assets abroad Capital is flowing into the country: NCO < 0

17. Saving, Investment, and Their Relationship to International Flows Open economy: Y = C + I + G + NX National saving: S = Y − C − G Y − C − G = I + NX S = I + NX NX = NCO S = I + NCO Saving = Domestic investment + Net capital outflow

18. 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 = Imports Exports > Imports Net Exports < 0 Net Exports = 0 Net Exports > 0 Y < C + I + G Y = C + I + G Y > C + I + G Saving < Investment Saving = Investment Saving > Investment Net Capital Outflow < 0 Net Capital Outflow = 0 Net Capital Outflow > 0

19. 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

20. Trade Balances and Trade Negotiations “An important reason why many workers in Michigan and Ohio have lost jobs in recent years is because U.S. presidential administrations over the past 30 years have not been tough enough in trade negotiations.” Source: IGM Economic Experts Panel, December 9, 2014 and March 22, 2016.

21. Trade Balances and Trade Negotiations

22. Nominal Exchange Rates Nominal exchange rate Rate at which a person can trade currency of one country for currency of another Can be expressed in two ways, for example 80 yen per dollar 1/80 (= 0.0125) dollar per yen

23. Appreciation Appreciation Increase in the value of a currency as measured by the amount of foreign currency it can buy For example, dollar appreciation, yen depreciation Exchange rate (old) = 80 yen per dollar Exchange rate (new) = 90 yen per dollar

24. Depreciation Depreciation Decrease in the value of a currency As measured by the amount of foreign currency it can buy For example, dollar depreciation, yen appreciation Exchange rate (old) = 80 yen per dollar Exchange rate (new) = 70 yen per dollar

25. Real Exchange Rates Real exchange rate Rate at which a person can trade goods and services of one country For goods and services of another

26. Real Exchange Rates Real exchange rate = ( e × P ) / P* e : Nominal exchange rate between the U.S. dollar and foreign currencies P : Price index for U.S. basket P* : Price index for foreign basket

27. Real Exchange Rates Depreciation (fall) in the U.S. real exchange rate U.S. goods: Cheaper relative to foreign goods Consumers at home and abroad buy more U.S. goods and fewer goods from other countries Higher exports, lower imports Higher net exports

28. Real Exchange Rates An appreciation (rise) in the U.S. real exchange rate U.S. goods: More expensive compared to foreign goods Consumers at home and abroad buy fewer U.S. goods and more goods from other countries Lower exports, higher imports Lower net exports

29. Compute a Real Exchange Rate The exchange rate is e = 20 pesos per $. The price of a tall Starbucks Latte is P = $3 in U.S. and P * = 40 pesos in Mexico. What is the price of a U.S. latte measured in pesos? Calculate the real exchange rate, measured as Mexican lattes per U.S. latte.

30. Answers e = 20 pesos per $; P = $3 in U.S., P * = 40 pesos in Mexico U.S. latte: e × P = (20 pesos per $) × ($3 per U.S. latte) = 60 pesos per U.S. latte Mexican lattes: e × P / P * = 60 pesos per U.S. latte / 40 pesos per Mexican latte = 1.5 Mexican lattes per U.S. latte

31. Real Exchange Rates

32. The Basic Logic of Purchasing-Power Parity Purchasing-power parity (PPP) A theory of exchange rates that says a unit of any given currency should be able to buy the same quantity of goods in all countries Arbitrage Take advantage of price differences for the same item in different markets Result: The law of one price

33. The Basic Logic of Purchasing-Power Parity Based on the law of one price A good should sell for the same price in all locations PPP A currency must have the same purchasing power in all countries A U.S. dollar must buy the same quantity of goods in the United States and Japan And a Japanese yen must buy the same quantity of goods in Japan and the United States

34. Implications of Purchasing-Power Parity If purchasing power of the dollar is always the same at home and abroad Then real exchange rate cannot change Theory of purchasing-power parity Nominal exchange rate between the currencies of two countries must reflect the price levels in those countries

35. Implications of Purchasing-Power Parity Implications Nominal exchange rates change when price levels change When a central bank in any country increases the money supply Causes the price level to rise Also causes that country’s currency to depreciate relative to other currencies in the world

36. Money, Prices, and the Nominal Exchange Rate during the German Hyperinflation This figure shows the money supply, the price level, and the nominal exchange rate (measured as U.S. cents per mark) for the German hyperinflation from January 1921 to December 1924. Notice how similarly these three variables move. When the quantity of money started growing quickly, the price level followed, and the mark depreciated relative to the dollar. When the German central bank stabilized the money supply, the price level and exchange rate stabilized as well. Source: Adapted from Thomas J. Sargent, “The End of Four Big Inflations,” in Robert Hall, ed., Inflation (Chicago: University of Chicago Press, 1983), pp. 41–93.

37. Limitations of Purchasing-Power Parity Theory of purchasing-power parity does not always hold in practice Many goods are not easily traded Price differences on such goods cannot be arbitraged Even tradable goods are not always perfect substitutes when they are produced in different countries No opportunity for profitable arbitrage

38. Limitations of Purchasing-Power Parity Purchasing-power parity Not a perfect theory of exchange-rate determination Real exchange rates fluctuate over time Large and persistent movements in nominal exchange rates Typically reflect changes in price levels at home and abroad

39. Purchasing-Power Parity

40. Conclusion The macroeconomic variables introduced here provide a starting point for analyzing an open economy’s interactions with the rest of the world You should now understand What a nation’s trade balance represents In an open economy, domestic investment can differ from national saving A nation with a trade surplus must be sending capital abroad A nation with a trade deficit must be experiencing a capital inflow Nominal and real exchange rates Implications and limitations of purchasing-power parity as a theory of exchange rates