Principles of Economics

1. Principles of Economics Session 15

2. Topics To Be Covered • Open and Closed Economies • Flow of Goods and Capital • Equality of Net Exports and Net Foreign Investment • Nominal and Real Exchange Rate • Purchasing Power Parity Theory • The Market for Loanable Funds

3. Topics To Be Covered • The Market for Foreign-Currency Exchange • Marginal Propensity to Import • Output Determination in Open Economy • Balance of Payments • BP Curve • IS-LM-BP Model • Monetary and Fiscal Policies in Open Economy

4. Open and Closed Economies • A closed economy is one that does not interact with other economies in the world. There are no exports, no imports, and no capital flows. • An open economy is one that interacts freely with other economies around the world.

5. An Open Economy • An open economy interacts with other countries in two ways. • It buys and sells goods and services in world product markets. • It buys and sells capital assets in world financial markets.

6. The Flow of Goods • Exportsare domestically produced goods and services that are sold abroad. They mainly depend on exchange rates. EX = f (e) • Importsare foreign produced goods and services that are sold domestically. They mainly depend on output. IM = f (Y)

7. The Flow of Goods • Net exports (NX) are the value of a nation’s exports minus the value of its imports. • Net exports are also called the trade balance.

8. The Flow of Goods • A trade deficit is a situation in which net exports (NX) are negative. Imports > Exports • A trade surplus is a situation in which net exports (NX) are positive. Exports > Imports • Balanced trade refers to when net exports are zero – exports and imports are exactly equal.

9. Percent of GDP 30 20 10 40 The Internationalization of the Chinese Economy 50 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

10. The Flow of Capital • Net foreign investment refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. • A Chinese resident buys stock in the Toyota corporation and an American buys stock in the Sohu corporation.

11. The Flow of Capital • When a Chinese resident buys stock in IBM, the purchase raises Chinese net foreign investment. • When a Japanese resident buys a bond issued by the Chinese government, the purchase reduces the Chinese net foreign investment.

12. The Equality of NX and NFI • Net exports (NX) and net foreign investment (NFI) are closely linked. • For an economy as a whole, NX and NFI must balance each other so that: NFI = NX • This holds true because every transaction that affects one side must also affect the other side by the same amount.

13. Saving, Investment, and the International Flows • Net exports is a component of GDP: Y = C + I + G + NX • National saving is the income of the nation that is left after paying for current consumption and government purchases: Y - C - G = I + NX

14. Saving, Investment, and the International Flows • National saving (S) equals Y-C-G so: S = I + NX or Domestic Investment Foreign Investment Saving = +

15. Real and NominalExchange Rates • International transactions are influenced by international prices. • The two most important international prices are the nominal exchange rate and the real exchange rate.

16. Nominal Exchange Rates • The nominal exchange rateis the rate at which a person can trade the currency of one country for the currency of another. • The nominal exchange rate is expressed in two ways: • In units of foreign currency per one Chinese yuan. • And in units of Chinese yuan per one unit of the foreign currency.

17. Nominal Exchange Rates • Assume the exchange rate between the U.S. dollar and the Chinese yuan is one dollar to 8 yuan. • One U.S. dollar trades for 8 yuan. • One yuan trades for 1/8 (=0.125) of a dollar.

18. Nominal Exchange Rates • If one yuan buys more foreign currency, there is an appreciation of the yuan. • If it buys less there is a depreciation of the yuan.

19. Real Exchange Rates The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies.

20. Real Exchange Rate Real Exchange Rates • The real exchange rate is a key determinant of how much a country exports and imports.

21. Real Exchange Rates • A depreciation (fall) in the Chinese real exchange rate means that Chinese goods have become cheaper relative to foreign goods. • This encourages consumers both at home and abroad to buy more Chinese goods and fewer goods from other countries.

22. Real Exchange Rates • As a result, Chinese exports rise, and Chinese imports fall, and both of these changes raise Chinese net exports. • Conversely, an appreciation in the Chinese real exchange rate means that Chinese goods have become more expensive compared to foreign goods, so Chinese net exports fall.

23. Purchasing-Power Parity • The purchasing-power parity theory(PPP theory) is the simplest and most widely accepted theory explaining the variation of currency exchange rates. • According to the purchasing-power parity theory, a unit of any given currency should be able to buy the same quantity of goods in all countries.

24. Basic Logic of Purchasing-Power Parity • The theory of purchasing-power parity is based on a principle called the law of one price. • According to the law of one price, a good must sell for the same price in all locations.

25. Basic Logic of Purchasing-Power Parity • If the law of one price were not true, unexploited profit opportunities would exist. • The process of taking advantage of differences in prices in different markets is called arbitrage.

26. Basic Logic of Purchasing-Power Parity • If arbitrage occurs, eventually prices that differed in two markets would necessarily converge. • According to the theory of purchasing-power parity, a currency must have the same purchasing power in all countries and exchange rates move to ensure that.

27. Implications of Purchasing-Power Parity • If the purchasing power of is always the same at home and abroad, then the exchange rate cannot change. • The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries.

28. Implications of Purchasing-Power Parity When the central bank prints large quantities of money, the money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.

29. Limitations of Purchasing-Power Parity • Many goods are not easily traded or shipped from one country to another. • Tradable goods are not always perfect substitutes when they are produced in different countries.

30. Fixed vs. FloatingExchange Rates • A country has a fixed exchange rate if it pegs its currency at a given exchange rate and stands ready to defend that rate. • Exchange rates which are determined by market supply and demand are called flexible exchange rates or floating exchange rates.

31. The Market forLoanable Funds • The market for loanable funds (capital market) is one in which those who want to save supply funds and those who want to borrow to invest demand funds. • It is the market in which financial resources (money, bonds, stocks) are traded.

32. The Market forLoanable Funds S = I + NFI • At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net foreign investment.

33. The Market forLoanable Funds • The supply of loanable funds comes from national saving (S). • The demand for loanable funds comes from domestic investment (I) and net foreign investment (NFI).

34. The Market forLoanable Funds • The supply and demand for loanable funds depend on the real interest rate. • A higher real interest rate encourages people to save and raises the quantity of loanable funds supplied. • The interest rate adjusts to bring the supply and demand for loanable funds into balance.

35. Real Interest Rate Supply of loanable funds (from national saving) Equilibrium real interest rate Demand for loanable funds (for domestic investment and net foreign investment) Equilibrium quantity The Market forLoanable Funds Quantity of Loanable Funds

36. The Market forLoanable Funds At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment.

37. The Market forForeign-Currency Exchange • The two sides of the foreign-currency exchange market are represented by NFIand NX. • NFI represents the imbalance between the purchases and sales of capital assets. • NX represents the imbalance between exports and imports of goods and services.

38. The Market forForeign-Currency Exchange • In the market for foreign-currency exchange, the Chinese yuan is traded for foreign currencies. • For an economy as a whole, NFI and NX must balance each other out, or: NFI = NX

39. The Market forForeign-Currency Exchange The price that balances the supply and demand for foreign-currency is thereal exchange rate.

40. The Market forForeign-Currency Exchange • The demand curve for foreign currency is downward sloping because a higher exchange rate makes domestic goods more expensive. • The supply curve is vertical because the quantity of dollars supplied for net foreign investment is unrelated to the real exchange rate.

41. Real Exchange Rate Supply of RMB (from net foreign investment) Equilibrium real exchange rate Demand for RMB (for net exports) Quantity of RMB Exchanged Equilibrium into Foreign Currency quantity The Market forForeign-Currency Exchange

42. The Market forForeign-Currency Exchange • The real exchange rate adjusts to balance the supply and demand for RMB. • At the equilibrium real exchange rate, the demand for RMB to buy net exports exactly balances the supply of RMB to be exchanged into foreign currency to buy assets abroad.

43. Marginal Propensity to Import • The marginal propensity to import (MPm) refers to the increase in the dollar value of imports resulting from each dollar increase in the value of GDP.

44. Output=Expenditure E1=C(Y) +I(r)+G E2=C(Y)+I(r)+G-IM(Y） 45° Y1 Y2 Output Determinationin Open Economy Expenditure Slope(E1 )=b C = a + bY IM = mY E2= a+I+G+(b-m)Y Slope(E2 )=b-m Output 0

45. Output=Expenditure E2=C(Y)+I(r)+G + EX(e) -IM(Y） E1=C(Y)+I(r)+G-IM(Y） 45° Y2 Y1 2. …leads to an increase in output Output Determinationin Open Economy Expenditure 1. An increase in export… Slope=b-m Output 0

46. Equilibrium Outputin Open Economy • Planned aggregate expenditure in an open economy equals: • In equilibrium:

47. The Open Economy Multiplier • b = MPC • m = MPm • 1 – b + m = 1 – MPC + MPm = MPS +MPm • The multiplier is:

48. The Open Economy Multiplier • The multiplier in the closed economy is: • The multiplier in the open economy is:

49. The Balance of Payments The balance of payment is a statement showing all of a nation’s transactions with the rest of the world for a given period. It includes purchases and sales of goods and services, gifts, government transactions, and capital movements.

50. The Balance of Payments • Suppose the initial international transaction was that a Chinese company exported a plane to the U.S. for $100 million. The Chinese central bank bought $10 million for CNY 80 million. • What was Chinese balance of payments like for that year?