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OPEN-ECONOMY MACROECONOMICS:
BASIC CONCEPTS

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Open-Economy Macroeconomics:
Basic Concepts
• 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.
– An open economy is one that interacts freely with
other economies around the world.

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Open-Economy Macroeconomics: Basic
Concepts
• 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.

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THE INTERNATIONAL FLOW OF
GOODS AND CAPITAL
• The Flow of Goods: Exports, Imports, and Net
Exports
– An open economy is one which imports and
exports significant quantities of goods and
services.
– Over the past four decades, international trade and
finance have become increasingly important.

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The Flow of Goods: Exports, Imports, Net
Exports
• Exports are goods and services that are
produced domestically and sold abroad.
• Imports are goods and services that are
produced abroad and sold domestically.

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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.

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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.

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The Flow of Goods: Exports, Imports, Net
Exports
• 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.

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The Flow of Goods: Exports, Imports, Net
Exports
• 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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Table 1 Trade Openness of Some Asian Countries

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The Flow of Financial Resources: Net
Capital Outflow
• Net capital outflow refers to the purchase of
foreign assets by domestic residents minus the
purchase of domestic assets by foreigners.
• When a local resident buys shares in a foreign
company, net capital outflow increases.
• When a foreigner buys local government bonds,
net capital outflow decreases.

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The Flow of Financial Resources: Net
Capital Outflow
• Variables that Influence Net Capital Outflow
• 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.

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The Equality of Net Exports and Net
Capital Outflow
• 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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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

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Saving, Investment, and Their
Relationship to the International Flows
• National saving (S) equals Y – C – G so:
S = I + NX
• or
Saving =
Domestic + Net Capital
Investment Outflow
S = I + NCO

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Table 2 International Flows of Goods and Capital: Summary

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Figure 1 National Saving, Domestic Investment, and Net
Capital Outflow for Singapore
(a) National Saving and Domestic Investment (as a percentage of GDP)

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Figure 1 National Saving, Domestic Investment, and Net
Capital Outflow for Singapore
(b) Net Capital Outflow (as a percentage of GDP)

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THE PRICES FOR INTERNATIONAL TRANSACTIONS:
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.

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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.

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Nominal Exchange Rates

• The nominal exchange rate is expressed in two

ways:
• In units of foreign currency per one unit of local
currency.
• And in units of local currency per one unit of
foreign currency.

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Nominal Exchange Rates

• Assume the exchange rate between Thai baht

and Singapore dollar is 25 Thai baht to one
Singapore dollar.
• One Singapore dollar trades for 25 baht.
• One baht trades for 1/25 (= 0.04) of a Singapore
dollar.

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Nominal Exchange Rates

• Appreciation refers to an increase in the value

of a currency as measured by the amount of
foreign currency it can buy.
• Depreciation refers to a decrease in the value of
a currency as measured by the amount of
foreign currency it can buy.

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Nominal Exchange Rates

• If a local currency buys more foreign currency,

there is an appreciation of the local currency.
• If it buys less there is a depreciation of the local
currency.

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Real Exchange Rates

• The real exchange rate is the rate at which a

person can trade the goods and services of one
country for the goods and services of another.

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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
locally produced beer, the real exchange rate is 1/2
case of German beer per case of locally produced
beer.

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Real Exchange Rates

• The real exchange rate depends on the nominal

exchange rate and the prices of goods in the two
countries measured in local currencies.

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Real Exchange Rates

• The real exchange rate is a key determinant of

how much a country exports and imports.

Nominal exchange rate × Domestic price

Real exchange rate =
Foreign price

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Real Exchange Rates

• A depreciation (fall) in the real exchange rate

means that domestic goods have become
cheaper relative to foreign goods.
• This encourages consumers both at home and
abroad to buy more domestic goods and fewer
goods from other countries.

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Real Exchange Rates

• As a result, the home country’s exports rise,

and imports fall, and both of these changes raise
home country’s net exports.
• Conversely, an appreciation in the real
exchange rate means that domestic goods have
become more expensive compared to foreign
goods, so home country net exports fall.

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A FIRST THEORY OF
EXCHANGE-RATE DETERMINATION:
PURCHASING-POWER PARITY
• The purchasing-power parity theory is the
simplest and most widely accepted theory
explaining the variation of currency exchange
rates.

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The Basic Logic of Purchasing-Power
Parity
• Purchasing-power parity is 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.
• 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.

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The 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.
• 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.

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The 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.

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Implications of Purchasing-Power Parity

• If the purchasing power of the local currency 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.

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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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Figure 2 Money, Prices, and the Nominal Exchange Rate During the
German Hyperinflation
Indexes
(Jan. 1921 = 100)

1,000,000,000,000,000

Money supply
10,000,000,000

Price level
100,000

Exchange rate
.00001

.0000000001
1921 1922 1923 1924 1925
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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.

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 Summary

• Net exports are the value of domestic goods

and services sold abroad minus the value of
foreign goods and services sold domestically.
• Net capital outflow is the acquisition of
foreign assets by domestic residents minus the
acquisition of domestic assets by foreigners.

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 Summary

• An economy’s net capital outflow always

equals its net exports.
• An economy’s saving can be used to either
finance investment at home or to buy assets
abroad.

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 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.

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 Summary

• When the nominal exchange rate changes so

that each unit of home currency buys more
foreign currency, the home currency is said to
appreciate or strengthen.
• When the nominal exchange rate changes so
that each unit of domestic currency buys less
foreign currency, the home currency is said to
depreciate or weaken.

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 Summary

• According to the theory of 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.

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