Open Economy

STUDY
PLAY
What is a Closed Economy
An economy that does not interact with the rest of the world
What benefit of international trade is linked to specialisation?
By allowing each country to produce what it can produce with a comparative advantages, it can generate the largest amount of revenue.
What benefit of international trade is linked with living standards?
Trade allows people to consume a great variety of goods that would not be available to them otherwise (strawberries in winter in Europe for example)
Why do economists usually suppose a closed economy in macroeconomic analysis?
To keep their models simple.
What is an open economy?
An economy that interacts freely with other economies around the world. An open economy has movement of capital into and out of a country/market.
True or false: You can tell if an economy is open or not by whether it is buying and selling goods and services from other countries.
False: it may also be an open economy if it buys and sells capital assets from other countries.
What is a trade balance?
The value of a nation's exports minus the nations imports. Also called net exports.
What is a trade surplus?
An excess of exports over imports.
What is a trade deficit?
An excess of imports over exports.
What is balanced trade?
A situation where exports equals imports.
What factors can influence a country's exports and imports?
TASTE of consumers, PRICE of goods, EXCHANGE RATE at which people use domestic currency for foreign goods, the INCOMES of consumers, the COST OF TRANSPORTATION, and the POLICIES OF GOVERNMENT.
True or false: GDP is growing faster than exports.
False: Exports are growing much faster than GDP.
What factors can explain the quicker growth of exports in the last 50 years?
Transport has became cheaper (larger amount of goods can be put on planes and ships for example). Communication has became easier (phones), and political supranationalities promoting trade (the WTO, UN, EU, ECOWAS, AU, ASEAN, etc.)
What is net capital outflow?
The purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
What is foreign direct investment?
FDIs are a capital investment by a company in one country into another country.
What is a foreign portfolio investment?
FPIs are an equity investment by one company in a country into another company in another country.
What variables affect net capital outflow?
1) Real interest rates paid on foreign assets
2) Real interest rates being paid on domestic assets
3) Perceived economic and political risks of holding assets abroad
4) Government policies that affect foreign ownership
Why does real interest rates paid on foreign assets, or domestic assets, affect net capital outflow?
Suppose the foreign asset is a bond. The higher the real interest rate (or coupon), the more is gained from buying the bond. Suppose the foreign asset is a carwash. The higher the real interest rate, the more expensive it is to buy the carwash.
Why do the perceived economic and political risks of holding assets abroad affect net capital outflow?
If a country is seen as economically unstable, it may default on bonds, etc. If a country is politically unstable, its defence of property rights may be dubious. This creates additional risk, making investment more expensive.
Why do government policies affect net capital outflow?
Government policies can make more cheap/expensive, remove, or ban foreign investment, and so increase/decrease risks.
What is it that both net exports and net capital outflows both measure?
Both measure the imbalance between exports and imports, or the imbalance between foreign goods bought domestically and domestic goods bought abroad.
True or false: NCO = NX, as long as we assume an open economy.
The identity is true regardless of whether we are in an open economy or not. In fact, in a closed economy, they are both equal zero.
Why is NCO equal to NX?
Every international transaction is an exchange. The values of the goods exchanged are equal. Therefore, the value of goods exported would be equal to the value of assets acquired.
How do you calculate national saving?
National Saving equals domestic investment plus net export, or net capital outflow.
How does an open economy use its savings?
It invests its savings between domestic investments and foreign assets.
If a country is running a trade deficit, are its net exports above 0?
No, it is importing more than it is exporting, and so it has a net negative export rate.
What a country has a balanced trade, what is the equation for the GDP in the economy?
Y=C+I+G
"If a nation has balanced trade, it might as well not be trading". True or false?
False: while it may not be clearly profiting from trade, trade creates a comparative advantage, thus allowing more consumption than a PPF allows. Moreover, people have access to a larger variety of goods, increasing the welfare of the country.
What is a nominal exchange rate
The rate at which a person can trade the currency of one country for the currency of another.
What is appreciation?
An increase in the value of a currency as measured by the amount of foreign currency it can buy.
What is depreciation?
A decrease in the value of a currency as measured by the amount of foreign currency it can buy.
Suppose the exchange rate rises from 125 to 127 Yen per Euro. Did the Euro appreciate or depreciate?
The Euro appreciated, because it could buy more yen per euro.
Suppose you must now spend 220 Yen, instead of 200, to buy a British Pound. Did the Yen appreciate or depreciate?
The Yen depreciated, because it could buy less pounds per Yen.
Suppose you must now spend 220 Yen, instead of 200, to buy a British Pound. Did the Pound appreciate or depreciate?
The Pound appreciated, because you can now buy more Yen per pound.
Because there are many nominal exchange rates, what do economists use to make it easier to study changes in exchange rates?
Economists use an index which turns many exchange rates into a single measure of the international value of the currency.
How is Northern Ireland an example of how changing exchange rates affect an economy?
During the recession, the Pound depreciated so much that Republic of Ireland shoppers went to Northern Ireland to do their shopping, because it was so much cheaper.
What is a real exchange rate?
The rate at which a person can trade the goods and services of one country for the goods and services of another. A nominal exchange rate is the exchange of currency, not goods.
Why are the real exchange rates and the nominal exchange rates of countries so similar?
As currency is a unit of account, it acts as a yardstick for the value of a good. Moreover, trade means the prices of goods ought to be the same everywhere. So currencies track the global price of a good.
What is the equation for the real exchange rate of a single good?
The real exchange rate = (nominal exchange rate * domestic price) / (foreign price)
What is the general equation for a real exchange rate?
Real exchange rate = (foreign currency per domestic currency* Price Index for a domestic basket) / (Price Index for a foreign basket)
True or false: A depreciation in the real exchange rate of the euro means that EU goods have become cheaper relative to foreign goods.
True.
True or false: An appreciation of the real interest rate of the pound means that foreign goods are more expensive, relative to the pound.
True.
True or false: if the pound appreciates, then British net exports will (ceteris paribus) fall.
True.
What is purchasing power parity?
The theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries.
What is the Law of One Price?
A good must sell for the same price in all locations - or else, there would be opportunities for profit left unexploited.
What is arbitrage?
The process of taking advantage of differences in prices in different markets.
How does arbitrage relate to the law of one price?
If one can commit arbitrage, one can buy e.g. coffee beans in London and sell them in Manchester for a profit. This leads to extra supply in Manchester, and greater demand in London, which eventually balances out to one price, where the good sells for the same price in all locations.
How does the law of one price relate to purchasing power parity.
If one can commit international arbitrage - e.g. buy coffee beans in London and sell them in Paris for a profit - then London's extra demand and Paris' extra supply leads to a balancing out to one price, and the price would be the same everywhere. This would occur regardless of the currency however - the real price would be the same.
True or false: According to the Purchasing Power Parity theory, the nominal exchange rate changes as price levels change.
True.
According to Purchasing Power Parity theory, why did the UK lose value compared to the dollar from 1970 to 1985?
As the UK printed more money, the currency lost value in terms of the goods and services the money could buy.
What is a common currency area?
A geographical area in which a common currency is used.
What does the German hyperinflation experience show about the price level?
When the supply of money starts growing quickly, the price level also takes off and the German mark depreciates. When the money supply stabilizes, so does the price level and exchange rate.
What is the PPS?
Purchasing Power Standard: it is an artificial currency expressing the purchasing power of the EU27 against the euro.
Why does goods not being easily tradeable cause problems for the theory of purchasing power parity?
Some goods are not easily tradeable across nations - for example, hairdressers or dog walkers may be more expensive in the UK than the US. However, arbitrage would be too limited to eliminate the price differences between the two nations.
Why does nationalism cause a problem for the theory of purchasing power parity?
Arbitrage assumes that a good from Japan, all else being equal, is equally as good as that product from Germany. However, some people might just prefer German-made cars more. The two goods may not be equivalent because they are from different nations.
Is the Big Mac Index an example of a purchasing power parity index?
Yes.
True or false: you can buy 2 Big Macs in China, for the price of one Big Mac in America!
True! Yaay!
What is the relationship between saving, investment, and net capital outflow?
Saving = Domestic Investment + Net Capital Outflow
Describe the economic logic behind the theory of purchasing power parity
Use the words: "Law of One Price" and "arbitrage" and their relations to PPP.
If the ECB printed a large number of euros, what would happen to the Japanese Yen?
The Yen would be able to buy a lot more Euros, as the Euro would depreciate in value.