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Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 12: Open Economy Macroeconomics: Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 12: Open Economy Macroeconomics: Basic Concepts Econ 202 Dr. Ugur Aker

Definitions • Closed economy: Self-sufficient economy. • Open economy: involved in international trade and Definitions • Closed economy: Self-sufficient economy. • Open economy: involved in international trade and international flow of capital. • Exports: goods and services sold abroad. • Imports: goods and services bought from abroad. • Trade balance: Exports – imports = net exports • Trade deficit: Imports > exports. • Trade surplus: Exports > imports. Econ 202 Dr. Ugur Aker 2

Factors That Influence Net Exports • Tastes 1. Tastes of American consumers change toward Factors That Influence Net Exports • Tastes 1. Tastes of American consumers change toward domestic products. 2. Tastes of foreign consumers change toward American products. 3. Tastes of American consumers change toward foreign products. 4. Tastes of foreign consumers change toward their own products. Econ 202 Dr. Ugur Aker 3

Factors That Influence Net Exports • 1. 2. 3. 4. Prices Domestic prices rise. Factors That Influence Net Exports • 1. 2. 3. 4. Prices Domestic prices rise. Domestic prices fall. Foreign prices rise. Foreign prices fall. Econ 202 Dr. Ugur Aker 4

Factors That Influence Net Exports • 1. 2. 3. 4. Exchange rates The dollar Factors That Influence Net Exports • 1. 2. 3. 4. Exchange rates The dollar appreciates (100 yen to 110 yen). The dollar depreciates (2 pounds to 1. 5 pounds). The peso appreciates ($0. 1 to $0. 2). The peso depreciates ($0. 1 to $0. 08). Econ 202 Dr. Ugur Aker 5

Factors That Influence Net Exports • 1. 2. 3. 4. Incomes of American consumers Factors That Influence Net Exports • 1. 2. 3. 4. Incomes of American consumers increase. Incomes of foreign consumers increase. Incomes of American consumers decrease. Incomes of foreign consumers decrease. Econ 202 Dr. Ugur Aker 6

Factors That Influence Net Exports • Transportation and transaction costs 1. Transportation costs increase. Factors That Influence Net Exports • Transportation and transaction costs 1. Transportation costs increase. 2. Transportation costs decrease. Econ 202 Dr. Ugur Aker 7

Factors That Influence Net Exports • 1. 2. 3. 4. Government policies US imposes Factors That Influence Net Exports • 1. 2. 3. 4. Government policies US imposes tariffs on imports. US imposes quotas on imports. Trading partners impose tariffs. Trading partners impose quotas. Econ 202 Dr. Ugur Aker 8

Net Foreign Investment • Foreign assets purchased by Americans minus American assets purchased by Net Foreign Investment • Foreign assets purchased by Americans minus American assets purchased by foreigners is American NFI. • Canadian purchases of foreign assets minus foreign purchases of Canadian assets is Canadian NFI. • Coca Cola establishing a plant in Ukraine to produce coke there, is foreign direct investment by US. • You send $500 to a mutual fund that buys Japanese stocks. That is foreign portfolio investment by US. Econ 202 Dr. Ugur Aker 9

Factors That Influence NFI • The real interest paid on foreign assets (real rate Factors That Influence NFI • The real interest paid on foreign assets (real rate of return). • The real interest paid on domestic assets. • The perceived economic and political risks of holding assets abroad. • The government policies that affect foreign ownership of domestic assets. • The expected exchange rate in the future. Econ 202 Dr. Ugur Aker 10

NFI = NX • Net exports are matched by net foreign investment. • Trade NFI = NX • Net exports are matched by net foreign investment. • Trade surplus is equal to net positive foreign investment. • Trade deficit is equal to net negative foreign investment. • When Dell sells a computer to the French, it acquires a bank deposit in France. – US NFI increases. • When VW sells a Beetle in US, it acquires a bank deposit in US. – US NFI decreases. Econ 202 Dr. Ugur Aker 11

Circular Flow Equilibrium Y = C + I + G + NX Y=C+S+T C Circular Flow Equilibrium Y = C + I + G + NX Y=C+S+T C + S + T = C + I + G + NX S + (T – G) = I + NX Private Saving + Government Saving = Investment + Net Exports National Saving = Investment + Net Foreign Investment Econ 202 Dr. Ugur Aker 12

National Saving • If the national saving is low and NFI is zero, we National Saving • If the national saving is low and NFI is zero, we would invest less and grow slowly and have lower standard of living in the future. • If the national saving is low foreign savings (negative net foreign investment) help us grow more. • Low national saving forces trade deficits if investments are to be high. Econ 202 Dr. Ugur Aker 13

Exchange Rates • Nominal exchange rate is the price of one currency in terms Exchange Rates • Nominal exchange rate is the price of one currency in terms of another. – $1 is equal to C$1. 50 – $0. 87 equal to € 1. • Depreciation means the price of a currency loses value in terms of another currency. • Appreciation means the price of a currency rises. Econ 202 Dr. Ugur Aker 14

Exchange Rates • Real exchange rates show the value of a product in both Exchange Rates • Real exchange rates show the value of a product in both countries. • Real exchange rates will determine who will export and who will import a product under free trade. • Suppose a TV monitor sells for $100 in the US and for ¥ 5000 in Japan. If the exchange rate between $ and ¥ is ¥ 100=$1, then the price of TV in US compared to Japan will be [($100)(¥ 100/$)]/¥ 5000 = 2. • TVs are twice as expensive in the US compared to Japan. Econ 202 Dr. Ugur Aker 15

Real Exchange Rate • For the whole economy, real exchange rates will be a Real Exchange Rate • For the whole economy, real exchange rates will be a comparison of price levels. • Nominal and real exchange rates will be the same when both countries use the base year CPI. • What will happen to the real $ exchange rate when US inflation is higher than Japanese inflation. • R. E. R. = (¥ 100/$)($P)/¥P • US real exchange rate would appreciate and US exports would fall and US imports would rise. Econ 202 Dr. Ugur Aker 16

Purchasing Power Parity • PPP is a theory that explains how exchange rates adjust Purchasing Power Parity • PPP is a theory that explains how exchange rates adjust in the long run. • PPP is based on law of one price. – If the same product has two different prices in two localities people will buy at the cheap place and sell at the expensive place: arbitrage. – Demand up in cheap place: price up. – Supply up in expensive place: price down. Econ 202 Dr. Ugur Aker 17

Purchasing Power Parity • PPP between two currencies will affect both local prices and Purchasing Power Parity • PPP between two currencies will affect both local prices and the exchange rates. • Arbitrage makes the prices converge. • To buy in the cheap country, say Mexico, foreigners should buy pesos. – Demand for pesos goes up. – Price of pesos goes up: $0. 15/peso to $0. 20/peso. – Peso appreciates and USD depreciates. – Mexican products become more expensive; US products cheaper. Econ 202 Dr. Ugur Aker 18

Purchasing Power Parity • If PPP holds the same basket of goods in US Purchasing Power Parity • If PPP holds the same basket of goods in US and Mexico should cost the same. • Mexican basket costs Pp. • US basket costs P$. • Exchange rate is $/peso (or peso/$). • Pp($/peso)=P$ • P$(peso/$)=Pp • $/peso=P$/Pp or peso/$=Pp/P$ Econ 202 Dr. Ugur Aker 19

Purchasing Power Parity • According to PPP, the nominal exchange rates between two currencies Purchasing Power Parity • According to PPP, the nominal exchange rates between two currencies must reflect their respective price levels. • Inflation in a country will depreciate its nominal exchange rate. • For PPP to hold, the real exchange rate remains constant at 1. ($/peso)(Pp/P$)=1. Econ 202 Dr. Ugur Aker 20

Purchasing Power Parity • PPP can explain movements between exchange rates over 5 -10 Purchasing Power Parity • PPP can explain movements between exchange rates over 5 -10 years. • It doesn’t explain why exchange rates fluctuate from day to day. – Many services are not traded. – Many products are not perfect substitutes. Econ 202 Dr. Ugur Aker 21

Source: http: //www. economist. com/markets/bigmac/displaystory. cfm? story_id=305167&CFID=143098&CFTOKEN=58326587 Econ 202 Dr. Ugur Aker 22 Source: http: //www. economist. com/markets/bigmac/displaystory. cfm? story_id=305167&CFID=143098&CFTOKEN=58326587 Econ 202 Dr. Ugur Aker 22

Econ 202 Dr. Ugur Aker 23 Econ 202 Dr. Ugur Aker 23