Open Economy Concepts: International Macroeconomics Study Guide

Open Economy Concepts

Introduction

This chapter introduces foundational concepts in international macroeconomics, focusing on the interactions between countries through trade and finance. Key areas include the trade balance, international flows of assets, and exchange rates.

• Trade balance: The difference between exports and imports, indicating whether a country has a trade surplus or deficit.

• International flows of assets: Movements of financial capital across borders.

• Exchange rates: The price at which one currency can be exchanged for another.

The Flow of Goods & Services

Exports, Imports, and Net Exports

Countries engage in international trade by exporting and importing goods and services. The net exports (NX) measure the overall trade balance.

• Exports: Domestically-produced goods and services sold abroad.

• Imports: Foreign-produced goods and services purchased domestically.

• Net exports (NX): Also known as the trade balance, calculated as:

$\text{NX} = \text{Exports} - \text{Imports}$

Variables Affecting Net Exports

Several factors influence a country's net exports:

• Foreign economic conditions: A recession in a trading partner (e.g., Canada) reduces their demand for U.S. exports, lowering U.S. NX.

• Domestic consumer preferences: If U.S. consumers buy more domestic products, imports fall and NX rises.

• Relative prices: If Mexican goods become more expensive relative to U.S. goods, U.S. exports to Mexico may rise, increasing NX.

Trade Surpluses & Deficits

Net exports indicate whether a country is running a trade surplus, deficit, or balanced trade.

• Trade deficit: Imports exceed exports ($\text{NX} < 0$).

• Trade surplus: Exports exceed imports ($\text{NX} > 0$).

• Balanced trade: Exports equal imports ($\text{NX} = 0$).

U.S. Economy's Increasing Openness

The U.S. has become more open to international trade over time, as shown by the rising share of exports and imports as a percentage of GDP from 1960 to 2024.

Year	Exports (% of GDP)	Imports (% of GDP)
1960	~3%	~4%
2020	~12%	~15%
2024	~13%	~16%
Additional info: Data inferred from chart trends.

The Flow of Capital

Net Capital Outflow (NCO)

International financial transactions are measured by net capital outflow (NCO), also called net foreign investment.

• Net capital outflow (NCO): The difference between domestic residents' purchases of foreign assets and foreigners' purchases of domestic assets.

• Formula: $\text{NCO} = \text{Domestic purchases of foreign assets} - \text{Foreign purchases of domestic assets}$

Forms of Capital Flow

• Foreign direct investment (FDI): Domestic residents actively manage foreign investments (e.g., opening a business abroad).

• Foreign portfolio investment: Domestic residents purchase foreign financial assets (e.g., stocks, bonds), supplying loanable funds to foreign firms.

Capital Outflow and Inflow

• Capital outflow ($\text{NCO} > 0$): Domestic purchases of foreign assets exceed foreign purchases of domestic assets.

• Capital inflow ($\text{NCO} < 0$): Foreign purchases of domestic assets exceed domestic purchases of foreign assets.

The Equality of NX and NCO

Accounting Identity

There is a fundamental accounting identity in open economy macroeconomics:

$\text{NCO} = \text{NX}$

• Every transaction that affects net exports also affects net capital outflow by the same amount.

• When a foreigner buys a U.S. good, U.S. exports and NX increase, and the U.S. acquires foreign assets, increasing NCO.

• When a U.S. citizen buys foreign goods, U.S. imports rise, NX falls, and the other country acquires U.S. assets, decreasing U.S. NCO.

Saving, Investment, and International Flows

National Income Accounting

National income accounting links saving, investment, and international flows:

• Basic identity: $Y = C + I + G + NX$

• Rearranged: $Y - C - G = I + NX$

• Since $S = Y - C - G$, we get $S = I + NX$

• Because $NX = NCO$, $S = I + NCO$

Implications:

• If $S > I$, excess saving flows abroad as positive NCO.

• If $S < I$, foreigners finance some domestic investment, and NCO is negative.

Exchange Rates

Nominal Exchange Rate

The nominal exchange rate is the rate at which one currency can be exchanged for another.

• Expressed as foreign currency per unit of domestic currency.

• Examples (as of July 2025, per US$):

Currency	Exchange Rate
Canadian dollar	1.37
Euro	0.86
Japanese yen	146.44
Mexican peso	18.62

Appreciation and Depreciation

• Appreciation: An increase in the value of a currency, allowing it to buy more foreign currency.

• Depreciation: A decrease in the value of a currency, allowing it to buy less foreign currency.

• Example: In 2007, the U.S. dollar depreciated 9.5% against the Euro and appreciated 1.5% against the South Korean Won.

Real Exchange Rate

The real exchange rate measures the rate at which goods and services of one country trade for those of another, adjusting for price levels.

• Formula: $\text{Real exchange rate} = \frac{e \times P}{P^*}$

• $P$ = domestic price

• $P^*$ = foreign price (in foreign currency)

• $e$ = nominal exchange rate (foreign currency per unit of domestic currency)

Example Calculation

• A Big Mac costs $5.15 in the U.S., 450 yen in Japan.

• $e = 146$ yen per $

• Price in yen of a U.S. Big Mac: $146 \times 5.15 = 751.9$ yen

• Real exchange rate: $\frac{751.9}{450} = 1.67$ Japanese Big Macs per U.S. Big Mac

Real Exchange Rate with Many Goods

• $P$ = U.S. price level (e.g., GDP Deflator, CPI)

• $P^*$ = foreign price level

• Formula: $\text{Real exchange rate} = \frac{e \times P}{P^*}$

• If the U.S. real exchange rate appreciates, U.S. goods become more expensive relative to foreign goods.

The Law of One Price

Definition and Application

The law of one price states that identical goods should sell for the same price in all markets, assuming no transportation costs or trade barriers.

• Arbitrage: Buying goods in a cheaper market and selling them in a more expensive one, which equalizes prices across markets.

• Example: If coffee sells for $10/pound in Seattle and $12/pound in Boston, arbitrage opportunities exist until prices converge.

Purchasing-Power Parity (PPP)

Definition and Theory

Purchasing-power parity is a theory stating that a unit of currency should buy the same quantity of goods in all countries, based on the law of one price.

• Implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries.

• Formula: $e \times P = P^*$, or $e = \frac{P^*}{P}$

PPP Implications

• If inflation is higher in one country, its price level ($P$) rises faster, causing its currency to depreciate relative to others.

• If inflation is lower, its currency appreciates.

Empirical Evidence

Data from 31 countries show a positive relationship between average annual inflation and currency depreciation relative to the U.S. dollar (1993–2003).

Country	Avg Annual CPI Inflation	Avg Annual Depreciation
Japan	Low	Low
Brazil	High	High
Romania	High	High
Mexico	Medium	Medium
Additional info: Data inferred from scatterplot.

Limitations of PPP Theory

• Many goods cannot be easily traded (e.g., haircuts, movie tickets), so price differences persist.

• Foreign and domestic goods are not perfect substitutes; consumer preferences can cause price differences.

Review Questions

Sample 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 U.S. and 720,000 rubles in Russia. If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)?

   • $P^* = 720,000$ rubles

   • $P = 24,000$ dollars

   • $e = \frac{P^*}{P} = \frac{720,000}{24,000} = 30$ rubles per dollar