Chapter 18 Flashcards
In an open economy
S = I + NCO Saving = Domestic investment + Net capital outflow
Closed economy
Economy that does not interact with other economies in the world
Open economy
Economy that interacts freely with other economies around the world
Exports
Goods and services that are produced domestically and sold abroad
Imports
Goods and services that are produced abroad and sold domestically
Net exports(Trade balance)
Value of a nation’s exports minus the value of its imports
Trade surplus (Positive net exports)
Exports are greater than imports
The country sells more goods and services abroad than it buys from other countries
Trade deficit (Negative net exports)
Imports are greater than exports
The country sells fewer goods and services abroad than it buys from other countries
Factors that might influence a country’s exports, imports, and net exports:
- Tastes of consumers for domestic &foreign goods
- Prices of goods at home and abroad
- Exchange rates at which people can use domestic currency to buy foreign currencies
Higher income/economic growth in a foreign country
increases exports, net exports increases
Higher income/economic growth domestically
increases imports, net exports decreases
Variables that influence net capital outflow
Real interest rates paid on foreign assets
Real interest rates paid on domestic assets
Perceived economic and political risks of holding assets abroad
Government policies that affect foreign ownership of domestic assets
Net capital outflow
Purchase of foreign assets by domestic residents
=Domestic Investment Abroad − Foreign Investment
Higher interest rate paid on foreign assets increases purchases of foreign assets by domestic consumers
Net capital outflow increases
Higher interest rate paid on domestic assets increases purchases of domestic assets by foreign consumers.
Net capital outflow decreases
Higher risk of holding assets in a foreign country reduces purchases of foreign assets by domestic consumers
Net capital outflow decreases
Higher risk of holding assets in a domestic country reduces purchases of domestic assets by foreign consumers
net capital outflow increases
NCO
=NX
When NX > 0 (trade surplus)
Selling more goods and services to foreigners
Capital is flowing out of the country: NCO > 0
When NX < 0 (trade deficit)
Buying more goods and services from foreigners
Capital is flowing into the country: NCO < 0
Savings
=Domestic Investment+ Net capital outflow
Trade surplus: Exports > Imports
Net exports > 0
Y > Domestic spending (C+I+G)
S > I
NCO > 0
Trade deficit: Exports < Import
Net exports < 0
Y < Domestic spending (C+I+G)
S < I
NCO < 0
Balanced trade : Exports = Imports
Net exports = 0
Y = Domestic spending (C+I+G)
S = I
NCO = 0
Nominal exchange rate
Rate at which a person can trade currency of one country for currency of another
Example
Appreciation
Increase in the value of a currency as measured by the amount of foreign currency it can buy
Buy more foreign currency
Depreciation
Decrease in the value of a currency
As measured by the amount of foreign currency it can buy
Buy less foreign currency
Real exchange rate
Rate at which a person can trade goods and services of one county
Foreign Price
Real exchange rate
(e ˣ P) / P*
e: nominal exchange rate between the U.S. dollar and foreign currencies
P: price index for U.S. basket
P*: price index for foreign basket
Depreciation (fall) in the U.S. real exchange rate
1.U.S. goods: cheaper relative to foreign goods
2.Consumers at home and abroad buy more U.S. goods and fewer goods from other countries
A)Higher exports, Lower imports
B)Higher net exports
An appreciation (rise) in the U.S. real exchange rate
1.U.S. goods - more expensive compared to foreign goods
2.Consumers at home and abroad - buy fewer U.S. goods and more goods from other countries
A)Lower exports, Higher imports
B)Lower net exports
Arbitrage
Take advantage of price differences for the same item in different markets
Result: the law of one price
Purchasing-power parity, PPP
Parity: Equality
Purchasing-power: Value of money in terms of quantity of goods it can buy
Theory of purchasing-power parity
Nominal exchange rate between the currencies of two countries
Must reflect the price levels in those countries
When NCO > 0, net outflow of capital
Net purchase of capital overseas
Adds to the demand for domestically generated loanable funds
When NCO < 0, net inflow of capital
Capital resources coming from abroad
Reduce the demand for domestically generated loanable funds
Higher real interest rate
Encourages people to save: increases quantity of loanable funds supplied
Discourages investment: decreases quantity of loanable funds demanded
Discourages Americans from buying foreign assets: reduces U.S. net capital outflow
Encourages foreigners to buy U.S. assets: reduces U.S. net capital outflow
The market for foreign-currency exchange
Identity: NCO = NX
Net capital outflow = Net exports
If trade surplus, NX > 0
Exports > Imports
Net sale of goods ad services abroad
Americans use the foreign currency to buy foreign assets
Capital is flowing abroad, NCO > 0
If trade deficit, NX < 0
Imports > Exports
Some of this spending is financed by selling American assets abroad
Foreign capital is flowing into U.S.
NCO < 0
A higher real exchange rate
Makes U.S. goods more expensive
Reduces the quantity of dollars demanded to buy those goods
Equilibrium real exchange rate
Demand for dollars
By foreigners
Arising from U.S. net exports of goods and services
Market for loanable funds: S =
I + NCO
Net-capital-outflow curve
Link between
Market for loanable funds
Market for foreign-currency exchange
Market for loanable funds
Supply: national saving
Demand: domestic investment and net capital outflow
Equilibrium real interest rate, r
Net capital outflow
Slopes downward
Equilibrium interest rate, r
Market for foreign-currency exchange
Supply: net capital outflow
Demand: net exports
Equilibrium real exchange rate, E
Equilibrium real interest rate, r
Price of goods and services in the present
Relative to goods and services in the future
Equilibrium real exchange rate, E
Price of domestic goods and services
Relative to foreign goods and services
E and r adjust simultaneously
To balance supply and demand
In both markets
Loanable funds
Foreign-currency exchange
Government budget deficits
When government spending exceeds government revenue Negative public saving Reduces national saving Reduces supply of loanable funds Increase in interest rate Reduces net capital outflow Crowd-out domestic investment Decrease in supply of foreign-currency exchange Currency appreciates Net exports fall Push the trade balance toward deficit
Tariff:
tax on imports
Import quota
limit on quantity of imports
import quota impact
Decrease imports Increase in net exports Increase in demand for dollars in the market for foreign-currency exchange Real exchange rate appreciates Discourage exports No change in real interest rate No change in net capital outflow No change in net exports Decrease in imports Decrease in exports
Trade policies affect specific
Firms
Industries
Countries
Political instability
Leads to capital flight
Capital flight
Large and sudden reduction in the demand for assets located in a country
Interest rate in Mexico – increases
Reduce domestic investment
Slows capital accumulations
Slows economic growth
The peso depreciates
Exports – cheaper
Imports – more expensive
Trade balance moves toward surplus
Mexico - capital flight affects both markets
U.S. market
Fall in U.S. net capital outflow
The dollar appreciates in value
U.S. interest rates fall
Relatively small impact on the U.S. economy
Because the economy of the United States is so large compared to that of Mexico
