• 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

The Flow of Goods: Exports, Imports, and Net Exports

• 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

The Flow of Financial Resources: Net Capital Outflow

• 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

The Equality of Net Exports and Net Capital Outflow

• NCO = NX

• Net capital outflow = Net exports

• The equation is an identity

• A trade surplus (NX > 0). When capital flows out of the company, (NCO > 0)

Saving, Investment and Their Relationship to the International Flows

• 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

Summing Up

• Trade Deficit

  • Exports < Imports

  • Net Exports < 0

  • Y < C + I + G

  • Saving < Investment

  • Net Capital Outflow < 0

• Balanced Trade

  • Exports = Imports

  • Net Exports = 0

  • Y = C + I + G

  • Saving = Investment

  • Net Capital Outflow = 0

• Trade Surplus

  • Exports > Imports

  • Net Exports > 0

  • Y > C + I + G

  • Saving > Investment

  • Net Capital Outflow > 0

31-2 The Prices for International Transactions: Real and Nominal Exchange Rates

Nominal Exchange Rates

• 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 Rates

• 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.

31-3 A First Theory of Exchange-Rate Determination: Purchasing-Power Parity

• 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

The Basic Logic of Purchasing-Power Parity

• 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

Implications of Purchasing-Power Parity

• 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.

Limitations of Purchasing-Power Parity

• 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