Macro: Open Economy Flashcards
Open Economy
Assumes economy interacts with other country through trade and export of goods
Exchange Rates
Help us understand international trade & currency circulation
Nominal Exchange Rate (e)
The rate at which one currency can be exchanged for another
- Currency Appreciation: when a country’s currency increases in value in comparison to another’s
~ Higher demand for currency, either from economic growth or from increased interest rates – IT’S BECOMING MORE VALUABLE BC OF HIGH DEMAND
~ Impact: exports decrease due to high prices, imports increase because more can be bought with domestic money - Currency Depreciation: when a country’s currency decreases in value in comparison to another’s
~ Lower demand for currency, either from low interest rates, poor economic activity, etc.
~ Impact: exports increase because foreign funds can buy more (their currency is worth more) & imports decrease because foreign products are more expensive
Real Exchange Rate (E)
The rate at which a specific good/service of one country can be exchanged for that g/s of another
- Formula: E = e * (Pdom/Pfor)
International Flow of G/S
This occurs through Imports, Exports, and the Trade Balance (NX = X - IM)
Exports (X)
The amount of goods or services traveling out of a given country
This amount is reliant on numerous factors
- E (Exchange Rate): the exchange rate dictates the value of money, & w/ it the amount of g/s being exported
~ HAS INVERSE RELATIONSHIP W/ EXPORTS
* As Exchange Rate increases, the value of money appreciates, and less foreigners want that country’s goods –> Exports decrease
* As Exchange Rate decreases, the value of money depreciates, and more foreigners want the cheaper goods –> Exports increase
- Yfor (Foreign Income): foreign income has a positive relationship w/ exports
- As Foreign Income increases, the amount of exports increases, because they can afford to buy more
- As Foreign Income decreases, the amount of exports decrease, as they cannot afford to buy as many goods
- Tastes: tastes has a positive/negative relationship w/ exports as the amount of exports is dependent on pref.
- Trade Policy [for] (Foreign Trade Policy): negative relationship with Exports when restrictions are applied, and positive relationship with Exports when they are eased
~ Quotas, Tariffs, and other restrictions put on import of exported goods
Imports (IM)
The amount of g/s brought into a country
Dependent on numerous factors
- E (Exchange Rate): positive relationship w/ imports
* As Exchange Rate increases, currency appreciates, and the amount they can import grows as foreign goods are cheaper
* As Exchange Rate decreases, currency depreciates, and the amount they can import decreases as foreign goods are more expensive
- Ydom (Domestic Income): Positive Relationship w/ Imports
- As Domestic Income increases, the amount they can import increases
- As Domestic Income decreases, the amount they can import decreases
- Tastes: Postive/negative relationship with Imports as imports will increase/decrease depending on consumer preference
- Trade Policy [dom] (Domestic Trade Policy): Positive/negative relationship depending on established/eased restrictions
- Tariffs, quotas, and other restrictions
Trade Balance (NX)
Formula: NX = X - IM
- Depicts whether a country leans more toward importing or exporting g/s
~ Trade Surplus (X > IM): when a country is exporting more than it is importing
* There is a net inflow of currency as foreigners are sending money to domestic country
* SIGN OF ECONOMIC STRENGTH
~ Trade Deficit ( X < IM): when a country is importing more than it is exporting
* There is a net outflow of currency as the domestic country is sending more money out onto FX Mrkt
* SIGN OF ECONOMIC WEAKNESS
~ Balanced Trade ( X = IM): when a country’s exports & imports are approximately the same value
* No net flow in or out of the country as imports and exports are balanced
* SIGN OF ECONOMIC STABILITY & SELF-SUFFICIENCY
- RELATION TO EXCHANGE RATE
- A Trade Surplus is associated with currency appreciation, as increased demand for a country’s exports boosts demand for its currency in the foreign exchange (FX) market
~ Exports INCREASE & Imports DECREASE
~ NX INCREASE - A Trade Deficit is associated with currency depreciation, as higher imports create a greater supply of domestic currency on the FX market, lowering its value
~ Exports DECREASE & Imports INCREASE
~ NX DECREASE
Trade Surplus → Currency appreciates, exchange rate increases
Trade Deficit → Currency depreciates, exchange rate decreases
Net Capital Outflow (NCO)
The difference between how much money a country’s investors send abroad to buy foreign assets and how much foreign investors bring in to buy assets in that country
Formula: (DOM purchases of FOR goods) - (FOR purchases of DOM goods)
Two Types of NCO
- Foreign Direct Investment (FDI): direct investment in a long-term business venture in a foreign country, usually along the lines of ownership or management
* Example: US builds a factory in China, and hires employees, etc. – long-term direct investment in foreign corp.
* USUALLY PHYSICAL ASSETS
- Foreign Portfolio Investment (FPI): investment in foreign assets like stocks, bonds, etc., usually short-term
* Example: investor buys shares in Japanese tech company but has no say in management/operations
* NOT PHYSICAL ASSETS
~ Short-term gains through capital appreciation/interest, with easier entry/exit level than FDI
Determinants of NCO
- r(dom): Domestic real interest rate impacts appeal of foreign investment
~ When r(dom) increases, there are higher returns on investments/savings –> domestic market is appealing to foreign investors (NCO decreases, as there is more inflow)
~ When r(dom) decreases, returns on investment/savings are lower –> domestic market is less appealing, and funds flow out –> NCO increase - r(for): Foreign real interest rate impacts appeal of domestic investment
~ When r(for) increases, domestic currency will flow out as ppl want to invest in foreign market (NCO increase)
~ When r(for) decreases, domestic investors won’t invest in foreign markets (NCO decrease) - Risk (for): political/economic risk impacts investment
~ When Foreign Risk is high, domestic investors will not look to invest, or will pull money, so NCO decreases
~ When Foreign Risk is low, domestic investors will invest & put money into FOR mrkts, so NCO increases - Govt Policy (for): impacts the ease of investment
Linking NCO & NX
Shows how domestic currency flows w/ international trade & investment
- Link reflects circular flow of funds across borders
~ Exports generate foreign currency, which is usually then invested abroad
** NCO = NX
~ Imports require funding, often through foreign investment
IT’S A BALANCING ACT
- Trade Surplus → NCO increases: When a country exports more than it imports, it earns extra foreign currency. This surplus can be used to invest in foreign assets, which leads to an increase in Net Capital Outflow (NCO) as more money flows out to invest abroad
- Trade Deficit → NCO decreases: When a country imports more than it exports, it spends more on foreign goods and services than it earns from exports. To cover this gap, it needs foreign investment to flow into the country, leading to a decrease in NCO because more foreign capital is coming in than going out
Foreign Exchange Market Impact
- When foreign currency is converted into domestic currency, it is done through FX Market
- The flow of g/s and capital on global market balance each other out
~ During a Trade Surplus, country exports more and earns a larger foreign profit that can be invested in foreign assets
** Money coming in from exports goes back out for investment –> NCO rises
~ During a Trade Deficit, a country imports more and spends more overseas than it earns from exports. To balance outflow of funds, the country seeks foreign investment in its domestic market, which leads to an inflow of capital.
** Decrease in NCO, as more money is coming in from foreign investors than is going out to invest abroad
Market for LF
Savings and Investment are connect with NCO to demonstrate its interplay
- Supply: National Savings = Private Savings + Public Savings
** Upward sloping bc higher interest rate promotes more savings - Demand: Investment (r) + NCO (r)
** Downward sloping bc lower interest rate brings cheaper borrowing
Foreign Currency Exchange Markets (FX Mrkts)
Supply of USD in FX Mrkt
- Supply: NCO
** The supply of the FX Mrkt is the amount of USD flowing out (NCO) & into FX Mrkt
Demand of USD in FX Mrkt
- Demand: NX
** The demand of FX Mrkt is the amount of USD demanded by foreigners to purchase US g/s
Government Budget Deficit
- When government borrows from LF Mrkt, supply decreases and interest rates rise, crowding out private investors
- Interest rates rise, NCO will fall as foreign investors become interested in domestic investment and capital flows inward
- NCO decreases, and the supply of USD on FX Mrkt decreases, E rises, which will make X decrease, Imports increase, and NX decrease
Three Panel Diagram (Definition & Layout)
Represents interrelationship between LF Mrkt, NCO, & FX Market
- How they interact to determine the flow of g/s & capital in and out of the country, influenced by domestic interest rates and exchange rates
Loanable Funds Market
- S: National Savings = Private Savings + Public Savings
- D: Investment + NCO
NCO Mrkt
- Analyzes flow of financial capital between countries & links LF & FX Mrkt
** If r increases, foreigners will invest in US assets & g/s, increasing net capital inflow and decreasing NCO. Increased demand for USD causes the supply of the FX mrkt to decrease, and exchange rate will increase, USD will appreciate, & exports will decline while imports increase & NX decreases
** If r decreases, foreigners will pull investment from US assets & g/s, decreasing net capital inflow & increasing NCO. Reduced demand for USD causes supply of FX mrkt will increase, and exchange rate will decrease, USD will depreciate, & exports will increase while imports decrease, & NX increases.
FX Mrkt
- S: NCO
** US investment abroad as currency flow out and is exchanged (USD sold on FX Mrkt for other currency)
- D: NX
** Foreign demand for USD in order to invest & purchase g/s
