ECN 3100

1. ECN 3100 Chapter 31 Open-Economy Macroeconomics: Basic Concepts Chapter 31

2. Basic Concepts Trade makes everyone better off: - allows people to produce what they produce best (specialization) - consume variety of goods and services produced around the world Closed economy does not interact with other economies in the world. Open economy interacts freely with other economies around the world. • buys and sells capital assets in world financial markets. • buys and sells goods and services in world product markets. Chapter 31

3. The Flow of Goods Exports (goods & services produced domestically and sold abroad) Imports (goods & services produced abroad and sold domestically) Net exports = trade balance NX = X - M Trade deficit imports > exports Balanced trade Export = imports Trade surplus exports > imports Chapter 31

4. Trade Balance • Factors affecting trade balance: • Consumer taste & preference • Domestic vs foreign prices of goods & services • Exchange rate • Consumer income • Transportation costs • Government trade policy Case study: 1950s 2000s Exports <5% of GDP Exports >10% of GDP Cargo 10,000 tons 100,000 tons Air transport limited jumbo jets Telecommunication local calls global wireless Policy restricted free trade (NAFTA) Chapter 31

5. $$ The Flow of Financial Resources $$ a US citizen with $20,000 may Example: US resident buys Toyota stock  Net Capital Outflow ↑ Mexican resident buys Ford stock  Net Capital Outflow ↓ buy a Toyota car  flow of goods buy a Toyota stock  flow of capital Net Capital Outflow = (a.k.a Net Foreign Investment) purchase of foreign assets by domestic residents - purchase of domestic assets by foreigners Chapter 31

6. $$ The Flow of Capital $$ The Flow of Capital Foreign Direct Investment Open a McD outlet in Russia Net Capital Outflow ↑ Foreign Portfolio Investment Buy stock in a Russian company Net Capital Outflow ↑ • Factors determining Net Capital Outflow: • Real interest rate on foreign assets • Real interest rate on domestic assets • Economic & political risks abroad • Government policies on foreign ownership r foreign bond↑, investment abroad ↑, net capital outflow ↑ r foreign bond↓, investment abroad ↓, net capital outflow ↓ r domestic bond ↑, domestic investment ↑, net capital outflow ↓ r domestic bond↓, domestic investment ↓, net capital outflow ↑ Chapter 31

7. The NCO = NX Identity • Net Capital Outflow = Net Exports • “every transaction that affects one side • must also affect the other side by the same amount” • i.e. Boeing sold planes to Japan  Net Exports ↑ • Japan pays Boeing in Yen: • Yen is used to buy Japanese Sony stock  Net Capital Outflow ↑ • Net Capital Outflow = Net Exports • Or Boeing sold planes to Japan  Net Exports ↑ • Japan pays Boeing in Yen: • Yen is used to buy Toshiba TVs  Net Exports ↓ • Net Capital Outflow = Net Exports Chapter 31

8. Open Economy Savings = Foreign + Domestic Investments Gross Domestic Product (GDP) Y = C + I + G + NX Y = GDP, I = Investment, G = Government Purchases, NX = Net Exports Then Y = C + I + G + NX can be rewritten as Y – C – G = I + NX, And if National Savings = S and S = Y – (C + G) or S = Y – C – G, S = I + NX Savings = Domestic Investment + Net Exports From NCO = NX Identity, S = I + NCO Savings = Domestic Investment + Net Capital Outflow Savings = Domestic Investment + Foreign Investment Chapter 31

9. Closed Economy Savings = Domestic Investments Y = C + I + G Y = GDP, I = Investment, G = Government Purchases If National Savings = S, and S = Y – (C + G) Or S = Y – C – G Then, S = I Savings = Domestic Investment From NCO = NX Identity, Net Capital Outflow = Net Exports Since NX in a closed economy is zero, NCO = NX = 0 and S = Domestic Investment Chapter 31