Chapter 32

Open Economy Macroeconomics: Basic Concepts

In this chapter, look for the answers to these questions:

• 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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The International Flows Of Goods And Capital
• A closed economy does not interact with other economies in the world.
• An open economy interacts freely with other economies around the world.
• Exports: Domestically-produced goods and services sold abroad.
• Imports: Foreign-produced goods and services sold domestically.
• Net exports (NX), aka the trade balance = Value of exports – Value of
imports

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Active Learning 1
Variables that affect net exports (NX)

What do you think would happen to your country’s net exports if:
A. a country you trade with experiences a recession (falling incomes,
rising unemployment)?
B. consumers decide to be patriotic and buy more domestic made
products?
C. prices of goods produced in a country you trade with rise faster than
prices of goods produced at home?

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Active Learning 1
Answers

A. A country you trade with experiences a recession (falling incomes, rising

unemployment)
Your country’s net exports would fall due to a fall in the other
country’s consumers’ purchases of your exports.
B. Consumers decide to be patriotic and buy more domestic made
products.
Your country’s net exports would rise due to a fall in imports.

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Active Learning 1
Answers

C. Prices of goods produced in a country you trade with rise faster than
prices of goods produced at home
This makes domestic goods more attractive relative to the other
country’s goods.
Exports to the other country increase, imports from the other country
decrease, so your country’s net exports increase.

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The Flow Of Goods
• Variables that influence net exports
• Consumers’ preferences for foreign and domestic goods
• Prices of goods at home and abroad
• The exchange rates at which foreign currency trades for domestic currency
• Incomes of consumers at home and abroad
• Transportation costs
• Government policies

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The Flow Of Goods
Net exports measure 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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The Flow Of Financial Resources
• Net capital outflow (NCO): Domestic residents’ purchases of foreign
assets minus foreigners’ purchases of domestic assets.
• The flow of capital abroad takes two forms:
• Foreign direct investment: Domestic residents actively manage the
foreign investment.
• Foreign portfolio investment: Domestic residents purchase foreign stocks
or bonds, supplying “loanable funds” to a foreign firm.

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The Flow Of Financial Resources
• 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.
• 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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Net Exports And Net Capital Outflow
• An accounting identity: NCO = NX
• When a foreigner purchases a good from your country,
• your country’s exports and NX increase.
• the foreigner pays with currency or assets, so your country acquires some
foreign assets, causing NCO to rise.

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Saving, Investment And International Flows
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.
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International Flows Of Goods And Capital
• Three possible outcomes for an open economy:

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Real And Nominal Exchange Rates
• Nominal exchange rate: The rate at which a person can trade one country’s currency for
the currency of another.
• Appreciation (or “strengthening”): An increase in the value of a currency as measured
by the amount of foreign currency it can buy.
• Depreciation (or “weakening”): A decrease in the value of a currency as measured by
the amount of foreign currency it can buy.
• Real exchange rate: The rate at which a person can trade one country’s goods
and services for the goods and services of another.
• Real exchange rate =

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Active Learning 2
Compute a real exchange rate

e = 10 AED in UAE per 1BHD in Bahrain

price of a tall Starbucks Coffee
P = 2BHD in Bahrain, P* = 16 AED in UAE
A. What is the price of a Bahrain Coffee measured in UAE?
B. Calculate the real exchange rate,
measured as UAE coffees per Bahrain coffee.

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Active Learning 2
Answers
e = 10 Aed per BHD
price of a tall Starbucks Coffee
P = 2BHD in Bahrain P* = 16 AED in UAE
A. What is the price of a Bahrain coffee in AED?
exP = (10 AED per BHD) x (2 BHD per Bahrain coffee) = 20
AED per Bahrain coffee

B. Calculate the real exchange rate.

exP 20 AED per Bahrain coffee
=
P* 16 AED per UAE coffee
= 1.25 UAE coffees per Bahrain coffee
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The Nominal Exchange Rate During
Hyperinflation
Money, prices and the nominal exchange rate during the German hyperinflation

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Purchasing-Power Parity
• Purchasing-power parity: A theory of exchange rates whereby 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: The notion that a good should sell for the same price
in all markets.
• Suggests that the nominal exchange rate between the currencies of two countries
depends on the price level in those countries

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Implications Of Purchasing-power Parity
• PPP implies that the nominal P*
exchange rate between two countries e=
P
should equal the ratio of price levels.
• If the two countries have different inflation rates, then e will change over
time:
• If inflation is higher in Egypt than in Kuwait, P* rises faster than P, so e rises—
the KWD appreciates against the EGP.
• If inflation is higher in Kuwait than in Egypt, P rises faster than P*, so e falls—
the KWD depreciates against the EGP.

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Limitations Of Purchasing-Power Parity
• Two reasons why exchange rates do not always adjust to equalize prices
across countries:
• Many goods cannot easily be traded.
• Tradeable goods are not always perfect substitutes.
• However, purchasing-power parity works well in many cases,
especially as an explanation of long-run trends.

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Active Learning 3
Chapter review questions

1. Which of the following statements about a country with a trade deficit is

not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving
D. Y<C+I+G
2. A Ford Escape SUV sells for $24,000 in the US and 720,000 rubles in Russia.
If purchasing-power parity holds, what is the nominal exchange rate
(rubles per dollar)?

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Active Learning 3
Answers
1. Which of the following statements about a country
with a trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving not true
D. Y < C + I + G

A trade deficit means NX < 0. Since NX = S – I, a trade

deficit implies I > S.

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Active Learning 3
Answers

2. A Ford Escape SUV sells for $24,000 in the US and 720,000 rubles in
Russia.
If purchasing-power parity holds, what is the nominal exchange rate
(rubles per dollar)?
P* = 720,000 rubles
P = $24,000
e = P*/P = 720,000/24,000 = 30 rubles per dollar

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Summary
• Net exports equal exports minus imports.
• Net capital outflow equals domestic residents’ purchases of foreign
assets minus foreigners’ purchases of domestic assets.
• Every international transaction involves the exchange of an asset for a
good or service, so net exports equal net capital outflow.

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Summary
• Saving equals domestic investment plus net capital outflow.
• 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
the two countries.

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Summary
• According to the theory of purchasing-power parity, a unit of any
country’s currency should be able to buy the same quantity of goods
in all countries.
• This theory implies that the nominal exchange rate between two
countries should equal the ratio of the price levels in the two
countries.
• It also implies that countries with high inflation should have
depreciating currencies.

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