Open Economy Concepts: International Macroeconomics Study Notes

Open Economy Concepts

Introduction

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

• Trade balance: The difference between exports and imports.

• International flows of assets: Movement 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 result of these flows is measured by net exports (NX), also known as the trade balance.

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

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

• Net exports (NX): $\text{NX} = \text{Exports} - \text{Imports}$

Variables Affecting Net Exports

Net exports are influenced by various economic factors:

• Foreign recessions (e.g., Canada): Lower foreign income reduces demand for U.S. exports, decreasing NX.

• Domestic consumer preferences: Increased preference for domestic goods raises exports or reduces imports, increasing NX.

• Relative price changes: If foreign goods become more expensive, domestic goods are more attractive, increasing NX.

Trade Surpluses & Deficits

Net exports measure the imbalance in a country's 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 percent of GDP from 1960 to 2024.

• Exports (EX) and Imports (IM) have both increased as a share of GDP.

The Flow of Capital

Net Capital Outflow (NCO)

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

• Net capital outflow (NCO): $\text{NCO} = \text{Domestic purchases of foreign assets} - \text{Foreign purchases of domestic assets}$

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 Net Exports and Net Capital Outflow

Accounting Identity: $\text{NCO} = \text{NX}$

Every transaction that affects net exports also affects net capital outflow by the same amount, and vice versa.

• 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 NCO.

Saving, Investment, and International Flows

National Income Accounting

The relationship between saving, investment, and international flows is captured by the following identities:

• $Y = C + I + G + NX$

• $Y - C - G = I + NX$

• $S = I + NX$ since $S = Y - C - G$

• $S = I + NCO$ since $NX = NCO$

Implications:

• If $S > I$, excess loanable funds flow abroad as positive NCO.

• If $S < I$, foreigners finance some domestic investment, and NCO < 0.

Exchange Rates

Nominal Exchange Rate

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

• Expressed as foreign currency per unit of domestic currency.

• Examples (per US$ as of July 2025): Canadian dollar: 1.37 Euro: 0.86 Japanese yen: 146.44 Mexican peso: 18.62

Appreciation and Depreciation

• Appreciation: Increase in the value of a currency (buys more foreign currency).

• Depreciation: Decrease in the value of a currency (buys less foreign currency).

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

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

• $P$ = domestic price

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

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

Example: Big Mac Index

• U.S. Big Mac: $5.15, Japan Big Mac: 450 yen

• $e = 146$ yen per $

• $e \times P = 146 \times 5.15 = 751.9$ yen per U.S. Big Mac

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

Example: Starbucks Latte

• U.S. Latte: $3, Mexico Latte: 90 pesos

• $e = 19$ pesos per $

• Price of U.S. latte in pesos: $e \times P = 19 \times 3 = 57$ pesos

• Real exchange rate: $\dfrac{57}{90} = 0.63$ Mexican lattes per U.S. latte

• Additional info: Example calculation filled in for clarity.

Real Exchange Rate with Many Goods

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

• $P^*$ = foreign price level

• Real exchange rate: $\dfrac{e \times P}{P^*}$

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

The Law of One Price

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 in a more expensive one until prices equalize.

• Example: Coffee sells for $10/pound in Seattle and $12/pound in Boston; arbitrage will equalize prices.

Purchasing-Power Parity (PPP)

Definition and Theory

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

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

PPP Formula and Example

• Let $P$ = price of U.S. Big Mac (in dollars), $P^*$ = price of Japanese Big Mac (in yen), $e$ = exchange rate (yen per dollar).

• According to PPP: $e \times P = P^*$

• Solve for $e$: $e = \dfrac{P^*}{P}$

PPP Implications

• PPP implies the nominal exchange rate between two countries equals the ratio of their price levels.

• If inflation is higher in Japan than in the U.S., $P^*$ rises faster than $P$, so $e$ rises—the dollar appreciates against the yen.

• If inflation is higher in the U.S. than in Japan, $P$ rises faster than $P^*$, so $e$ falls—the dollar depreciates against the yen.

Empirical Evidence: Inflation & Depreciation

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

Limitations of PPP Theory

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

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

Chapter Review Questions

• Trade deficit: Not all statements about trade deficits are true. For example, investment can be greater than saving in a country with a trade deficit.

• PPP calculation: If a Ford Escape SUV sells for $24,000 in the U.S. and 720,000 rubles in Russia, the PPP exchange rate is$e = \dfrac{720,000}{24,000} = 30$ rubles per dollar.

• Additional info: PPP calculation completed for clarity.

Summary Table: Key Concepts

Concept	Definition	Formula
Net Exports (NX)	Exports minus Imports	$\text{NX} = \text{Exports} - \text{Imports}$
Net Capital Outflow (NCO)	Domestic purchases of foreign assets minus foreign purchases of domestic assets	$\text{NCO} = \text{Domestic purchases of foreign assets} - \text{Foreign purchases of domestic assets}$
Equality of NX and NCO	Accounting identity	$\text{NCO} = \text{NX}$
Real Exchange Rate	Relative price of domestic goods to foreign goods	$\text{Real exchange rate} = \dfrac{e \times P}{P^*}$
Purchasing-Power Parity (PPP)	Exchange rate equals ratio of price levels	$e = \dfrac{P^*}{P}$