Open Economy Macroeconomics: Basics Concepts

1. Open Economy Macroeconomics: Basics Concepts

2. Closed economy – an economy that does not interact with other economies in the world • Open economy – an economy that interacts freely with other economies around the world

3. The Economic Basis for Trade: comparative advantage and absolute advantage David Ricardo’s theory of comparative advantageasserted that specialization and free trade will benefit all trading partners, even those that may be absolutely less efficient producers Absolute advantage – the advantage in the production of a product enjoyed by one country over another when it uses fewer resources to produce that product than the other country does Comparative advantage - the advantage in the production of a product enjoyed by one country over another when that product can be produced at lower cost in terms of other goods than it could be in the other country

4. Example: Gains from Mutual Absolute Advantage • Assuming there are 2 countries (New Zealand and Australia), producing 2 products: Wheat and Cotton Assume also that each country has only 100 acres of land for planting as given in table below. NZ AUS 3:1 (NZ can produce 3 times the wheat that Aus can) 1:3 (Aus can produce 3 times the cotton that NZ can) In this case , NZ has an absolute advantage in the production of wheat and Australia has an absolute advantage in the production of cotton – so two countries have mutual absolute advantage

5. Total production of Wheat and Cotton Assuming No Trade, Mutual Absolute Advantage and 100 Acres Available Suppose each country divides its land to obtain equal units of cotton and wheat production. So without trade, each country produces 150 unit of wheat and 150 units cotton New Zealand Australia

6. Production and Consumption of Wheat and Cotton after Specialization 1. Specialization means that Australia will put all land into cotton and produce 600 units of cotton (100 acres X 6 units) and no wheat. And if it put all its land into wheat it produce 200 units of wheat (100 acres X 2 units) and no cotton. 2. While New Zealand the opposite will take place. 3. Because both countries have absolute advantage in the production of one product – specialization and trade will benefit both countries. a. Production b. Consumption NZ Aust NZ Aust

7. Example: Gains from Comparative Advantage • Initially New Zealand has absolute advantage in the production of both cotton and wheat ( 1 acre land gives 6 times as much as wheat and twice as much of cotton as 1 acre in Australia • 2. Even though NZ has absolute advantage in the production of both wheat and cotton, according to Ricardo – specialization and trade are still mutually benefit

8. Total production of Wheat and Cotton Assuming No Trade, Mutual Absolute Advantage and 100 Acres Available • With no trade – NZ divide its 100 available acre evenly (50/50) between 2 crops. The results would be 300 units of cotton and 300 units of wheat • Australia divide its land (75/25) to produce 75 units of cotton and 75 units of wheat

9. Realizing a Gain from Trade When One Country has a Double Absolute Advantage Stage 1 1. Australia transfer all its land into cotton production and no wheat – so it will produce 300 units of cotton 2. While NZ – cannot completely specialize in wheat because it needs 300 cotton and will not be able to get enough cotton from Australia ( assuming each country wants to consume equal amounts of cotton and wheat This is represented in Table below

10. Stage 2 • Suppose NZ transfers 25 acres out of cotton into wheat. • Now NZ has 25 acres in cotton that produce 150 units and 75 acres in wheat that produce 450 units

11. Stage 3 • The 2 countries finally trade • Assume NZ ships 100 units of wheat to Australia in exchange for 200 units of cotton • After trade NZ has 350 units of cotton and 350 units of wheat • Australia has 100 units of wheat and 100 units of cotton • Both countries are better off than they were before the trade

12. When countries specializes in producing goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently • Comparative advantage (CA) means lower opportunity cost ( real cost of producing cotton is the wheat that must be sacrificed to produce it) • In terms of opportunity cost, 3 units of cotton in NZ cost 3 units of wheat (means that half of the land must transferred from wheat to cotton) • In Australia, 3 units of cotton cost only 1 unit of wheat ( means that to get 3 units of cotton, Australia has to transfer 1acre land from wheat to cotton production • So Australia has CA over NZ in cotton production , while NZ has CA over Australia in wheat production

13. Terms of trade • Terms of trade is the ratio at which a country can trade domestic products for imported products • This ratio determine how the gains from trade are distributed among trading partners • E.g. if terms of trade is 1 unit wheat: 2 units of cotton – means that NZ can get 2 unit of cotton for each unit of wheat, while Australia can get 1 unit of wheat for 2 units of cotton

14. International flows of goods and capital • The flow of goods: Exports, Imports and Net Exports • Exports – goods & services that are produced domestically and sold abroad • Imports – goods & services that are produced abroad and sold domestically • Net exports – the value of a nation’s exports minus the value of its imports

15. 4. Trade balance – the value of a nation’s exports minus the value of its imports (also called as net exports) 5.Trade surplus – an excess of exports over imports 6.Trade deficits – an excess of imports over exports 7.Balanced trade – a situation in which exports equal imports

16. 2. The Flow of Financial Resources: Net Capital Outflow • Net capital outflow – the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners

17. Balance of Payments • A country’s balance of payments summarizes all economic transactions that occur during a given period between residents (people, firms, and governments) of that country and residents of other countries • Balance of payments measures a flow, or the balance of economic transactions • Balance-of-payments accounts are maintained according to the principles of double-entry bookkeeping, in which entries on one side called credits, and entries on the other side are called debits

18. All transactions requiring payments from foreigners to U.S. residents are entered as credits, indicated by a plus sign (+), because they result in an inflow of funds from foreign residents to U.S. residents. • All transactions requiring payments to foreigners from U.S. residents are entered as debits, indicated by a minus sign (- ), because they result in an outflow of funds from U.S. residents to foreign residents.

19. Merchandise Trade Balance • Equals the value of merchandise exports minus the value of merchandise imports • Reflects trade in goods, or tangible products, and is often referred to as the trade balance • If the value of merchandise exports > value of merchandise imports, there is a trade surplus • If the value of merchandise imports > the value of merchandise exports, there is a trade deficit

20. Unilateral Transfers • Unilateral transfers consist of government transfers to foreign residents: foreign aid, personal gifts to individuals abroad, etc. • Net unilateral transfers equal the unilateral transfers received from abroad by U.S. residents minus unilateral transfers sent to foreign residents by U.S. residents

21. Balance on Current Account • The portion of a country’s balance-of-payments account that measures that country’s balance on goods and services plus its net unilateral transfers • Can be negative = current account deficit • Can be positive = current account surplus

22. Capital Account • The record of a country’s international transactions involving purchases or sales of financial and real assets

23. Balance of Payments 2003(billions of dollars)

24. International Finance:Foreign Exchange and Exchange Rates • Foreign exchange: foreign money needed to carry out international transactions • Exchange rate: the price measured in the currency of one country that is needed to purchase one unit of another country’s currency • Example the euro is now the common currency of the euro area. The price, or exchange rate, of the euro in terms of the dollar is the number of dollars required to purchase one euro

25. Foreign Exchange • Currency depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy • E.g. if dollars falls from 100 yen to 80 yen, the dollar depreciates by 20 percent • Currency appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy • E.g. if dollar rises from 100 yen to 120 yen, the dollar appreciates against the yen by 20 percent.

26. Nominal exchange rates – the rate at which a person can trade the currency of one country for the currency of another (e.g. US $1: 80 Japanese Yen) • Real Exchange Rates – the rate at which a person can trade the goods and services of one country for the goods and services of another country • RER = Nominal Exchange Rate X Domestic Price Foreign Price

27. Example: • Suppose a bushel of American rice sells for $100 and a bushel of Japanese rice sells for 16,000 Yen, so the RER between American and Japanese rice is, RER = (80 Yen per dollar) X ($100 per bushel of American rice 16,000 per bushel price of Japanese rice = 8,000 Yen per bushel of American rice 16,000 Yen per bushel of Japanese rice = ½ bushel of Japanese rice per bushel of American rice

28. Demand for Foreign Exchange • The demand curve for euros the inverse relationship between the dollar price of the euro and the quantity of euros demanded, other things constant • E.g. U.S. residents need euros to pay for goods and services produced in the euro area) • Other factors: • Incomes and preferences of U.S. consumers • The expected inflation rates in the U.S. and the euro area • The euro price of goods in the euro area • Interest rates in the U.S. and the euro area

29. Supply of Foreign Exchange • The supply of foreign exchange is generated by the desire of foreign residents to acquire dollars • The positive relationship between the dollar-per-euro exchange rate and the quantity of euros supplied in the foreign exchange market - an upward-sloping supply curve • Assumed constant are: • euro area incomes and preferences • expectations about the rates of inflation in the euro area and the United States • interest rates in the euro area and the United States

30. The Foreign Exchange Market Exchange rate , e (dollars per euro) • Initial equilibrium exchange rate is $1.10 • If the exchange rate is allowed to adjust freely, or to float in response to market forces, the market will clear continually S Surplus so e ↓ 1.20 1.10 1.00 Shortage, e ↑ D 0 Foreign exchange (millions of euros) 800 820

31. Effect on the Foreign Exchange Market of an Increased Demand for Euros • Suppose an increase in U.S. incomes causes Americans to increase their demand for all normal goods, including those from the euro area: demand curve shifts from D to D‘ • The shift of the demand curve leads to an increase in the exchange rate from $1.10 to $1.12 per euro • The euro appreciates and the dollar depreciates: euro area people purchase more American products Exchange rate (dollars per euro) S $1.12 1.10 D' D 0 Foreign exchange (millions of euros) 820 800

32. Arbitrageurs • Dealers who take advantage of temporary geographic differences in exchange rates by simultaneously buying a currency in one market and selling it in another • If one euro costs $0.89 in New York and $0.90 in Frankfurt, the arbitrageur would buy euros in New York and at the same time sell them in Frankfurt • Demand for euros in New York would increase • Supply of euros in Frankfurt would increase • Price differential would be eliminated

33. Speculators • Speculators buy or sell foreign exchange in hopes of profiting from fluctuations in the exchange rate over time • trading the currency at a more favorable exchange rate later • By taking risks, speculators aim to profit from market fluctuations by trying to buy low now and sell high later

34. Purchasing Power Parity (The Law of One Price • Purchasing power parity theory (PPP): predicts the exchange rate between two currencies will adjust in the long run to reflect price-level differences between the two currency regions • This is true as long as trade across borders is unrestricted and exchange rates are allowed to adjust freely • PPP is generally a long-run indicator • A given basket of internationally traded goods should therefore sell for about the same around the world after adjusting for transportation costs and the like

35. Flexible Exchange Rates • Exchange rate determined by the forces of demand and supply without government intervention

36. Fixed Exchange Rates • Fixed exchange rates: rate of exchange between currencies pegged within a narrow range and maintained by the central bank’s ongoing purchases and sales of currencies • Suppose the European Central Bank selects what it thinks is an appropriate rate of exchange between the dollar and the euro: it attempts to fix, or peg, the exchange rate within a narrow band around the particular value selected

37. Current System: Managed Float • Managed float system: combines features of a freely floating exchange rate with intervention by central banks as a way of moderating exchange rate fluctuations among the world’s major currencies • Most smaller countries still peg their currencies to one of the major currencies or to a basket of major currencies