Chapter 31 - Open-Economy Macroeconomics: Basic Concepts

Closed economy: an economy that does not interact with other economies in the world
Open economy: an economy that interacts freely with other economies around the world

31-1 The International Flows of Goods and Capital

Exports: goods and services produced domestically and sold abroad
Imports: goods and services produced abroad and sold domestically
Net exports: the value of a nation’s exports minus the value of its importance, also called the trade balance
- Net exports = Value f country’s exports - Value of country’s imports
Trade balance: the value of a nation’s exports minus the value of its imports, also called net exports
Trade surplus: an excess of exports over imports
Trade deficit: an excess of imports over exports
Balanced trade: a situation in which exports equal imports
Influencers working against exports, imports, and net exports
- Consumer tastes
- Prices of goods at home and abroad
- Exchange rates
- Incomes of consumers
- Costs of transportation of products
- Government policies

Net capital outflow: the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners
- Purchase of foreign assets by domestic residents - Purchase of domestic assets by foreigners
- Often called the net foreign investment, net capital outflow can be positive or negative
Variables that might influence net capital outflow:
The real interest rates paid on foreign assets
The real interest rates paid on domestic assets
The perceived economic and political risks of holding assets abroad
The government policies that affect foreign ownership of domestic assets

Y = C + I + G + NX
Y - C - G = I + NX, so S = I + NX
Saving = Domestic investment + net capital outflow
In a closed economy, NCO = 0 so S = I; saving equals investment
An open economy has two uses for saving money: domestic investment and net capital outflow
Saving, investment, and international capital flows are linked

Nominal exchange rate: the rate at which a person can trade the currency of one country for the currency of another
Appreciation: An increase in the value of a currency as measured by the amount of foreign currency it can buy
Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy
When a currency appreciates, it strengthens. When a currency depreciates, it weakens

Real exchange rate: the rate at which a person can trade the goods and services of one country for the goods and services of another
Real exchange rate = (Nominal exchange rate * Domestic price) / Foreign price
The real exchange rate is important to find a country exports and imports
Real exchange rate = (e * P) / P*
- P = price index for a US basket
- P* = a price index for a foreign basket
- e = nominal exchange rate between the US dollar and foreign currencies
- An appreciation in the US real exchange rate causes US net exports to fall. A depreciation in the US real exchange rate causes US net exports to rise.

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

Law of one price: a good must sell for the same price in all locations, otherwise there would be opportunities for profit left unexploited
Arbitrage: the process of taking advantage of price differences for the same item in different markets
Parity means equality
Purchasing power means the value of money in terms of the number of goods it can buy

The nominal exchange rate between currencies of two countries depends on the price levels in those countries
1/P = e/P*
- P = price index for a US basket
- P* = a price index for a foreign basket
- e = nominal exchange rate between the US dollar and foreign currencies
1 = eP / P*
If the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate-the relative price of domestic and foreign goods-cannot change
e = P*/P
According to the theory of purchasing-power parity, the nominal exchange rate between the currencies of two countries must reflect the price levels in those countries.
When the central bank prints large quantities of money, that money loses value both in terms of the goods and services it can buy and in terms of the number of other currencies it can buy.

Exchange rates do not always ensure a dollar has the same real value in all countries all the time
Theory #1: Some goods are not easily traded. If place A is more expensive than place B, producers will move to place A and consumers will move to place B
Theory #2: Purchasing-power parity does not always hold is that even tradable goods are not always perfect substitutes when produced in different countries

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