Chapter 8: Open-Economy

Macroeconomics: Basic
Concepts
Chapter 31 in Mankiw (2021)

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Chapter Objectives (1 of 2)
By the end of this chapter, you should be able to:
• Explain the relationship between net exports and net capital
outflow.
• Explain the relationship between saving, investment, and
international flows.
• Given data on prices in various countries, compute the exchange
rate that is consistent with purchasing-power parity.
• Describe the market for foreign-currency exchange.

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Chapter Objectives (2 of 2)
• Contrast a country's nominal exchange rate with its real exchange
rate.
• Determine the implications of purchasing-power parity on
exchange rates.

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8.1 The International Flows
of Goods and Capital

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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
*Words accompanied by an asterisk are key terms from the chapter.

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The Flow of Goods: Exports, Imports, and
Net Exports (1 of 3)
• 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

*Words accompanied by an asterisk are key terms from the chapter.

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The Flow of Goods: Exports, Imports, and
Net Exports (2 of 3)
• 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
• Balanced trade*
• A situation in which exports equal imports
• Country’s net exports are zero

*Words accompanied by an asterisk are key terms from the chapter.

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 The Flow of Goods: Exports, Imports, and
Net Exports (3 of 3)
• 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

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 Active Learning 1: Variables That Affect NX
• What do you think would happen to U.S. net exports if
A. Canada experiences a recession (falling incomes, rising unemployment)
B. U.S. consumers decide to be patriotic and
buy more products “Made in the U.S.A.”
C. Prices of goods produced in Mexico rise faster than prices of goods produced
in the U.S.

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Active Learning 1: Answers

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 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.

Source: U.S. Department of Commerce.

The Flow of Financial Resources: Net
Capital Outflow (1 of 2)
• Net capital outflow* (net foreign investment)
= purchase of foreign assets by domestic residents - the purchase
of domestic assets by foreigners.
• Example:
• When a U.S. resident buys stock in Telmex, the Mexican phone company,
the purchase raises U.S. net capital outflow.
• When a Japanese residents buys a bond issued by the U.S. government,
the purchase reduces the U.S. net capital outflow.

*Words accompanied by an asterisk are key terms from the chapter.

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The Flow of Financial Resources: Net
Capital Outflow (2 of 2)
• 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

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The Equality of Net Exports and Net Capital
Outflow (1 of 3)
• For an economy as a whole, NX and NCO must balance each
other so that:
NCO = NX
• This holds true because every transaction that affects one side must also
affect the other side by the same amount

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The Equality of Net Exports and Net Capital
Outflow (2 of 3)
• 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

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The Equality of Net Exports and Net Capital
Outflow (3 of 3)
• 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

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

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 8.2 The Prices for International
Transactions: Real and Nominal
Exchange Rates

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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
• In units of foreign currency per one domestic currency: 80 yen per
dollar*
• In units of domestic currency per one unit of the foreign currency: 1/80
(= 0.0125) dollar per yen

*Words accompanied by an asterisk are key terms from the chapter.

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

*Words accompanied by an asterisk are key terms from the chapter.

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

*Words accompanied by an asterisk are key terms from the chapter.

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 Real Exchange Rates (1 of 4)
• Real exchange rate*
• Rate at which a person can trade goods and services of one country for goods
and services of another

Nominal exchange rate  Domestic price

Real exchange rate =
Foreign price

*Words accompanied by an asterisk are key terms from the chapter.

Real Exchange Rates (2 of 4)
• 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

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~ McZample ~
• One good: Big Mac
• price in Japan:
P* = 200 Yen
• price in USA:
P = $2.50
• nominal exchange rate
e = 120 Yen/$
To buy a U.S. Big Mac,
e P someone from Japan
ε = would have to pay an
P*
amount that could buy
120  $2.50
= = 1.5 1.5 Japanese Big Macs.
200 Yen
Real Exchange Rates (3 of 4)
• The real exchange rate is a key determinant of how much a
country exports and imports.
• Depreciation (fall) in the U.S. real exchange rate
• U.S. goods: Cheaper relative to foreign goods
• Higher exports, lower imports ➔ Higher net exports
• An appreciation (rise) in the U.S. real exchange rate
• U.S. goods: More expensive compared to foreign goods
• Lower exports, higher imports ➔Lower net exports

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Active Learning 2: 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.
A. What is the price of a U.S. latte measured in pesos?
B. Calculate the real exchange rate, measured as Mexican lattes
per U.S. latte.

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Active Learning 2: Answers

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 8.3 A First Theory of Exchange-Rate
Determination: Purchasing-Power Parity

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The Basic Logic of Purchasing-Power Parity
(1 of 2)
• 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
• Based on the law of one price

*Words accompanied by an asterisk are key terms from the chapter.

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The Basic Logic of Purchasing-Power Parity
(2 of 2)
• Law of one price
• A good should sell for the same price in all locations
• 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.
• Prices would necessarily converge

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Implications of Purchasing-Power Parity (1 of 2)

• If purchasing power of the dollar is always the same at home and

abroad then real exchange rate cannot change
• Theory of PPP
• Nominal exchange rate between the currencies of two countries must
reflect the price levels in those countries

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Implications of Purchasing-Power Parity (2 of 2)

• 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

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 Figure: 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.
 Limitations of Purchasing-Power Parity
• Theory of purchasing-power parity does not always hold in
practice
1. Many goods are not easily traded
• Price differences on such goods cannot be arbitraged
2. Even tradable goods are not always perfect substitutes when they are
produced in different countries
• No opportunity for profitable arbitrage
• Purchasing-power parity
• Not a perfect theory of exchange-rate determination
• Real exchange rates fluctuate over time

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8.4 Conclusion

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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

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Think-Pair-Share Activity
You are watching a national news broadcast with your parents. The news anchor explains that the
exchange rate for the dollar just hit its lowest value in a decade. The report shifts to a spokesperson for
Caterpillar, a heavy equipment manufacturer. The spokesperson reports that sales of its equipment have
hit an all-time high and so has the value of its stock. Your parents are shocked by the report’s positive view
of the low value of the dollar. They just cancelled their European vacation because of the dollar’s low
value.
A. Why do Caterpillar and your parents have different opinions about the value of the dollar?
B. Caterpillar imports many parts and raw materials for their manufacturing processes, and they sell
many finished products abroad. Since they are happy about a low dollar, what must be true about the
proportions of their imports and exports?
C. If someone argues that a strong dollar is “good for America” because Americans are able to exchange
some of their GDP for a greater amount of foreign GDP, is it true that a strong dollar is good for every
American? Why or why not?

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Self-Assessment
• If the Fed started printing large quantities of U.S. dollars, what
would happen to the number of Japanese yen a dollar could buy?
Why?

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Summary
Click the link to review the objectives for this presentation.
Link to Objectives

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