OPEN-ECONOMY

MACROECONOMICS:
BASIC CONCEPTS

CHAPTER 31
THE INTERNATIONAL FLOWS
OF GOODS AND CAPITAL

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THE FLOW OF GOODS:
EXPORTS, IMPORTS, AND NET EXPORTS

 Exports: goods and services that are produced

domestically and sold abroad.
 Imports: goods and services that are produced abroad
and sold domestically.

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Net Exports (TRADE BALANCE): the difference between the
value of a country’s exports and the value of its imports.

NET EXPORTS = value of country’s exports – value of country’s imports

(TRADE BALANCE)

 NX > 0: E > I => Trade surplus

 NX = 0: E = I => Balanced trade
 NX < 0: E < I => Trade deficit

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 Factors that might influence a country’s exports, imports and net
exports:
1. The tastes of consumers for domestic and foreign goods.
2. The prices of goods at home and abroad.
3. The exchange rates at which people can use domestic currency
to buy foreign currencies.
4. The incomes of consumers at home and abroad.
5. The cost of transporting goods from country to country.
6. Government policies toward international trade.

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THE FLOW OF FINANCIAL RESOURCES:
NET CAPITAL OUTFLOW

NET CAPITAL OUTFLOW = Purchase of foreign assets by domestic residents

– Purchase of domestic assets by foreigners

 Two forms of the flow of capital:

 Foreign direct investment.
Ex: McDonald’s opens up a fast-food outlet in Russia
 Foreign portfolio investment.
Ex: An American buys stock in a Russian corporation
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 NCO > 0: Capital is flowing out of the country.
NCO < 0: Capital is flowing into the country.
=> Capital inflow.

 Important variables that influence NCO:

1. The real interest rates paid on foreign assets.
2. The real interest rates paid on domestic assets.
3. The perceived economic and political risks of holding assets abroad.
4. The government policies that affect foreign ownership of domestic assets.

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The identity:

NX = NCO

Small question:

What will happen to NX and NCO

of China when that Chinese farmer
receives your rubber?

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SAVING, INVESTMENT AND THEIR RELATIONSHIP
TO THE INTERNATIONAL FLOWS
 In an open economy:
Domestic
investment
National
saving

Net capital
outflow
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CONCLUSION
Trade Deficit Balanced Trade Trade Surplus
Exports < Imports Exports = Imports Exports > Imports

Net Exports < 0 Net Exports = 0 Net Exports > 0

Y<C+I+G Y=C+I+G Y>C+I+G

Saving < Investment Saving = Investment Saving > Investment

Net Capital Outflow < 0 Net Capital Outflow = 0 Net Capital Outflow > 0
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 What does a positive VN net capital inflow indicate?

A. Nothing. C. More funds are invested in VN by

foreigners than VN invests abroad.
B. The country runs a trade surplus. D. The nation sells more goods and
services abroad than it buys from other
countries.

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THE PRICES FOR
INTERNATIONAL
TRANSACTION
Real and Nominal
Exchange Rates

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NOMINAL EXCHANGE RATE:
The rate at which a person can trade the
currency of one country for the currency of
another.

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 NOMINAL EXCHANGE RATE
Update: 2/2/2019
Source: Sacombank

Foreign currency Buy in cash (VND/ foreign currency)

USD (America) 23.140

AUD (Australia) 16.556

CAD (Canada) 17.453

CHF (Switzerland) 23.025

EUR (Europe) 26.300

GBP (England) 30.088

JPY (Japan) 209,17

SGD (Singapore) 16,917

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EXPRESSION There are two ways to express

• 80 yen per dollar

• 1/80 (=0.0125) dollar per yen

 Always expressed as follows:

NOMINAL EXCHANGE RATE as units of foreign currency
per U.S dollar.

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 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.
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EXERCISE

Would each of the following groups be happy or

unhappy if the U.S dollar appreciated? Explain.

1. Vietnamese tourists plan a trip to the United States.

2. Mexicans use U.S importers.

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REAL EXCHANGE RATE:
The rate at which a person can trade goods and services
of one country for the goods and services of another.

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FORMULA:

Nominal exchange rate × Domestic price

REAL EXCHANGE RATE =
Foreign price

(e × P)
REAL EXCHANGE RATE =
P* Where:
P: price index for a domestic basket
P*: price index for a foreign basket
e: nominal exchange rate between the
domestic currency and foreign currency

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EXAMPLE:

400.000VND/t-shirt $20/t-shirt

What is the real exchange rate between

Vietnamese and American t-shirt?

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 Nominal exchange rate × Domestic price
 FORMULA: Real exchange rate =
Foreign price

(20.000VND/dollar) × ($20/American t-shirt)

Real exchange rate =
400.000VND/Vietnamese t-shirt
Situation 1: NER = 20.000 VND/ US dollar
400.000VND/American t-shirt
=
400.000VND/Vietnamese t-shirt

= 1 Vietnamese t-shirt / American t-shirt

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 Nominal exchange rate × Domestic price
 FORMULA: Real exchange rate =
Foreign price

(23.000VND/dollar) × ($20/American t-shirt)

Real exchange rate =
400.000VND/Vietnamese t-shirt
Situation 2: NER = 23.000 VND/ US dollar
460.000VND/American t-shirt
=
400.000VND/Vietnamese t-shirt

= 1,15 Vietnamese t-shirt / American t-shirt

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 Nominal exchange rate × Domestic price
 FORMULA: Real exchange rate =
Foreign price

(19.000VND/dollar) × ($20/American t-shirt)

Real exchange rate =
400.000VND/Vietnamese t-shirt

Situation 3: NER = 19.000 VND/ US dollar

380.000VND/American t-shirt
=
400.000VND/Vietnamese t-shirt

= 0,95 Vietnamese t-shirt / American t-shirt

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CONCLUSION
According to above example

• If RER > 1 • If RER = 1 • If RER < 1

VND depreciates 1 T-shirt in VN Dollar depreciates

 VN takes equals to 1 T-shirt  US takes

advantage of having the same advantage of
EXPORT quality in US EXPORT

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A FIRST THEORY OF EXCHANGE-RATE
DETERMINATION:
PURCHASING-POWER PARITY

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2
CONTENT

1.Concept
2.The basic logic
3.Implications
4.Limitations

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 CONCEPT

 The Purchasing-Power Parity theory states that a unit of any given

currency should be able to buy the same quantity of goods in all
countries.

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THE BASIC LOGIC OF PURCHASING-POWER PARITY (PPP)

The theory of PPP is based on the Law of one price (LOP).

The LOP asserts that if there is a price difference between the two markets
 There will be unexploited profits  People take advantage of these
profits (arbitrage)  Eventually, the price is the same in two markets.

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SUMMARY IN FIGURES

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IMPLICATIONS OF PURCHASING-POWER PARITY
Suppose that:
P is the price of a basket of goods in country A ( measured in A )
P* is the price of a basket of goods in country B ( measured in B )
e is the nominal exchange rate ( the number of B A can buy)
For the purchasing power of A to be the same in the two countries:
1 e
=
P P*
e×P
1= P*
P*
e=
P
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KEY IMPLICATION

The nominal exchange rate changes when price level changes.

 Nominal exchange rate also depends on the supply and
demand of money.
 When the central bank prints large quantities of money, that
money loses value in terms of the G&S and the amount of other
currencies it can buy.

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IMPLICATION

 In general, the theory of purchasing power parity can

analyze the relationship between inflation and the
nominal exchange rate.

 Specifically, this theory explains how exchange rates

change when there is a change in inflation rates between
countries.

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LIMITATIONS OF PURCHASING-POWER PARITY

 The theory of PPP is not completely accurate because:

• Many goods and services are not easily traded.

• Even tradable goods and services are not always

perfect substitutes when they are produced in
different countries.

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EXERCISE
A soda can costs $0.75 in the U.S and 15.000 VND in
Vietnam. A nominal exchange rate is recorded to be
20.000 VND per dollar.

a. What is the real exchange rate between U.S and Vietnam soda can?
b. If purchasing-power parity holds, what will happen to the nominal and
real exchange rate?

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SUMMARY

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 THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

NET CAPITAL OUTFLOW = Purchase of foreign assets by domestic residents

– Purchase of domestic assets by foreigners

NET EXPORTS = value of country’s exports – value of country’s imports

(TRADE BALANCE)

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THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

NX=NCO
Finance
domestic
investment
An economy’s
saving
Net capital
outflow

=> National Saving = Domestic investment + NCO

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 THE PRICES FOR INTERNATIONAL TRANSACTIONS:
REAL AND NOMINAL EXCHANGE RATE
Nominal exchange rate: The rate at which a person can trade the currency of one country
for the currency of another.
Real exchange rate: The rate at which a person can trade goods and services of one country
for the goods and services of another.

Nominal exchange rate × Domestic price

REAL EXCHANGE RATE =
Foreign price
FORMULA:
(e × P)
REAL EXCHANGE RATE = P: price index for a domestic basket
P* P*: price index for a foreign basket
e: nominal exchange rate between the
U.S dollar and foreign currency

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 A FIRST THEORY OF EXCHANGE-RATE DETERMINATION:
PURCHASING-POWER PARITY

 The purchasing-Power parity theory states that a unit of any given

currency should be able to buy the same quantity of goods in all
countries.

 LOP: Price difference in 2 market  Arbitrage  Balanced prices

in the 2 markets.

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 A FIRST THEORY OF EXCHANGE-RATE DETERMINATION:
PURCHASING-POWER PARITY

 Implication: Large amount of money printed  Money loses value

in term of goods or other currency it can buy
 PPP has 2 limitations:
+ Many G&S are not easily traded.
+ Many Tradable G&S are not always perfect substitutes when
they are produced in different countries.

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