• 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

18.1: The International Flows of Goods and Capital

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

• Net exports- the value of a nation’s exports minus the value of its imports; also called the trade balance

• Trade balance- the value of a nation’s exports minus the value of its imports; also called net exports

• Trade surplus- the excess of exports over imports

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

• Important variables that 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:

• The net capital outflow (NCO) must always equal net exports (NX)

  • NCO=NX

  • This equation holds because every transaction that affects one side of this equation affects the other side by the exact same amount

    • Known as an identity equation

Saving, Investment, and Their Relationship to the International Flows:

• A nation’s savings and investment are crucial to its long-run economic growth

• Saving, investment, and international capital flows are linked

  • When a nation’s saving exceeds its domestic investment, its net capital outflow is position, indicating that the nation is using some of its savings to buy assets abroad

18.2: 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

Real Exchange Rates:

• Real exchange rates- the rate at which a person can trade the goods and services of one country for the goods and services of another

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

The Basic Logic of 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

• ALL BASED ON ONE PRINCIPAL “Law of one price”

  • This law asserts that a good must sell for the same price in all locations

Implications of Purchasing-Power Parity:

• The nominal exchange rate between the currencies of two countries must reflect the price levels in those countries

  • When price levels change, the nominal exchange rates change

Limitations of Purchasing-Power Parity:

• Many goods are not easily traded

• When tradable goods are not always perfect substitutes when they are produced in different countries