Open Economy I Flashcards
Define Closed Economy
Economy that does NOT Interact with other Economies in the world
Define Open Economy
Economy that does Interact with other Economies in the world
Why is International Trade good?
Countries Specialise in G+S they have Comparative Advantage in
How do Open Economies Interact with the world
Buy + Sell G+S and Assets
Define Exports
G+S Produced Domestically + Sold/Consumed Abroad
Define Imports
G+S Produced Abroad + Bought/Consumed Domestically
Define Net Exports
Value of a nation’s Exports – Imports
Trade Balance
Define Trade Surplus
Excess of Exports over Imports
Define Trade Deficit
Excess of Imports over Exports
Define Balanced Trade
Exports = Imports
What factors affect Exports, Imports + NX?
- Tastes of Consumers fro Domestic + Foreign G+S
- Prices of G+S at Home vs Abroad
- Exchange Rates
- Incomes of Consumers at Home + Abroad
- Cost of Transporting Good between countries
- Gov. Policy towards International Trade
What is NCO?
Net Capital Outflow
NCO = Purchase of Foreign Assets by Domestic Residents – Purchase of Domestic Assets by Foreign Residents
What are the 2 main flows of Capital?
FDI- buying FoPs– e.g. Factories
FPI- buying Equities– e.g. Shares
What factors affect NCO?
- Real Interest Rate paid on Foreign Assets
- Real Interest Rate paid on Domestic Assets
- Perceived Economic + Political risks of holding Assets abroad
- Gov. Policy that affects Foreign ownership of Domestic Assets
Why is NX = NCO all the time?
If NX > 0 - Trade Surplus
–> Sells more G+S to Foreigners than it’s Buying–> Increased NX
- From Net Sale of G+S- Country receives Foreign Currency –> Increased NCO- Foreign Asset
THEREFORE- NX = NCO > 0
What is the National Account Identity under an Open Economy?
Y = C + I + G + NX
What is the National Savings Identity?
S = Y – C – G = I + NX
= I + NCO, since NCO = NX
National Saving = Domestic Investment + NCO
What happens to Savings Identity if there is a Trade Surplus?
Trade Surplus–> NX > 0
S = Y – C – G = I + NX
=> NCO = S –I > 0
Define Nominal Exchange Rate
Rate at which a Currency of one country can be traded for another
Define Appreciation
Increase in Value of a Currency
- Can buy more Foreign Currency
How is the Value of a Currency measured?
Amount of Foreign Currency one Unit of Domestic Currency can buy
Define Depreciation
Decrease in Value of a Currency
- Can buy less Foreign Currency
Define Real Exchange Rate
Ratio at which one can trade G+S of Country for G+S of another country
How is Real Exchange Rate calculated?
R.E.R = [ Nominal ER x Domestic Prices] ÷ Foreign Prices
= [ e x P ] ÷ P*
What does [ e x P ] ÷ P* show?
Quantity of Basket of Goods which a Domestic Unit of the Basket can buy Abroad
How does a Depreciation in UK R.E.R affect NX?
UK G+S relatively Cheaper than Foreign G+S –> Consumers at home + abroad– Buy more UK G+S –> Increased X + Decreased M –> Increased NX
What is PPP?
Purchasing Power Parity
- LR Theory of ER
- A unit of any given currency should be able to Buy the SAME Quantity of G+S in ALL Countries
What condition is necessary for PPP?
R.E.R must = 1
[ e x P ] ÷ P* = 1
Why must [ e x P ] ÷ P* = 1 for PPP?
Arbitrage- If R.E.R differs–> Can Buy cheap in one country + Sell in another for Profit
- Arbitrage would continue until Equality (Parity) in Prices sets in
What does Theory of PPP say about Nominal ER + Price Levels?
Nominal ER between 2 countries reflects Price Levels in the countries
Since [ e x P ] ÷ P* = 1 => If e = P* ÷ P, when Relative Prices change–> e Changes
How does M.S affect e?
Increased M.S –> Increased Prices –> Decreased e- Depreciation
What does Quantity Theory of Money explain?
How M.S affects Price Level
What does PPP explain?
How Price Level affect Nominal ER
What’s the main Limitations of PPP?
Theory does NOT always hold in practice- except LR
- Shown by fact that R.E.R is NOT Constant over time
1. Many G+S NOT traded easily- e.g. Haircut service
2. Even Tradable G+S NOT always Perfect Substitutes- May have different characteristics - Transaction costs- Reduce Profitable Arbitrage
