Chap 31

c

Copyright © 2001 by Harcourt, Inc.
All rights reserved. Requests for permission to make copies of any part of the
work should be mailed to:
Permissions Department, Harcourt College Publishers,
6277 Sea Harbor Drive, Orlando, Florida 32887-6777.
c
º closed economy is one that does not

interact with other economies in the
world.
º There are no exports, no imports, and
no capital flows.
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
c
n open economy is one that

interacts freely with other
economies around the world.
c
ºn open economy interacts with other

countries in two ways.
º It buys and sells goods and services in world
product markets.
º It buys and sells capital assets in world
financial markets.
c
ºThe U.S. is a very large and open

economy ± it imports and exports huge
quantities of goods and services.
ºOver the past four decades, international
trade and finance have become
increasingly important.
Ñ

º|xports are domestically produced

goods and services that are sold
abroad.
ºImports are foreign produced goods
and services that are sold domestically.
Ñ

ºDet exports r are the value of a

nation¶s exports minus the value of its
imports.
ºDet exports are also called the trade
balance.
Ñ

º trade deficit is a situation in which net
exports (D are negative.

º trade surplus is a situation in which net
exports (D are positive.

º Ôalanced trade refers to when net exports are
zero ± exports and imports are exactly equal.
Ñ

º The tastes of consumers for domestic and

foreign goods.
º The prices of goods at home and abroad.
º The exchange rates at which people can
use domestic currency to buy foreign
currencies.
Ñ

º The incomes of consumers at home and

abroad.
º The costs of transporting goods from
country to country.
º The policies of the government toward
international trade.
Ñ !"#"
ë

ë

Ñ
$ %
ºDet foreign investment refers to the

purchase of foreign assets by domestic
residents minus the purchase of domestic
assets by foreigners.
º U.S. resident buys stock in the Toyota
corporation and a Mexican buys stock in the
Ford Motor corporation.
Ñ
$ %
º hen a U.S. resident buys stock in
Telmex, the Mexican phone company, the
purchase raises U.S. net foreign
investment.
º hen a Japanese residents buys a bond
issued by the U.S. government, the
purchase reduces the U.S. net foreign
investment.
ë & '
$ %
º The real interest rates being paid on
foreign assets.
º The real interest rates being paid on
domestic assets.
º The perceived economic and political
risks of holding assets abroad.
º The government policies that affect
foreign ownership of domestic assets.
Ñ ('
$ %
º Det exports (D and net foreign
investment (DFI are closely linked.
º For an economy as a whole, D and DFI
must balance each other so that:

º This holds true because every transaction
that affects one side must also affect the other
side by the same amount.
#% $ % Ñ
)

º Det exports is a component of GDP:
£
º Dational saving is the income of the
nation that is left after paying for current
consumption and government purchases:
£
#% $ % Ñ
)

º Dational saving (S equals Y-C-G so:
G

G

#% $ * %
$ %
r G

r
ë
ë

ë

#% $ * %
$ %
r r
ë
ë

ë

) $
)
º International transactions are

influenced by international prices.
º The two most important international
prices are the nominal exchange rate
and the real exchange rate.
$ )
º The nominal exchange rate is the rate

at which a person can trade the
currency of one country for the
currency of another.
$ )
º The nominal exchange rate is

expressed in two ways:
º In units of foreign currency per one U.S.
dollar.
º nd in units of U.S. dollars per one unit of
the foreign currency.
$ )
º ssume the exchange rate between the

Japanese yen and U.S. dollar is 80 yen to
one dollar.
º One U.S. dollar trades for eighty yen.
º One yen trades for 1/80 (=0.0125 of a dollar.
$ )
ºIf a dollar buys more foreign currency,

there is an appreciation of the dollar.
ºIf it buys less there is a depreciation of
the dollar.
) $ )
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.
) $ )
ºThe real exchange rate compares the

prices of domestic goods and foreign
goods in the domestic economy.
º If a case of German beer is twice as
expensive as merican beer, the real
exchange rate is 1/2 case of German beer per
case of merican beer.
) $ )
The real exchange rate depends on

the nominal exchange rate and the
prices of goods in the two countries
measured in local currencies.
) $ )

A

ºThe real exchange rate is a key

determinant of how much a
country exports and imports.
) $ )
º depreciation (fall in the U.S. real

exchange rate means that U.S. goods
have become cheaper relative to foreign
goods.
º This encourages consumers both at home
and abroad to buy more U.S. goods and
fewer goods from other countries.
) $ )
º s a result, U.S. exports rise, and U.S.

imports fall, and both of these changes
raise U.S. net exports.
º Conversely, an appreciation in the U.S.
real exchange rate means that U.S. goods
have become more expensive compared
to foreign goods, so U.S. net exports fall.
' $+ +
ºThe purchasing-power parity theory is

the simplest and most widely accepted
theory explaining the variation of
currency exchange rates.
+' $+ +
º ccording 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.
,$
+' $+ +
º The theory of purchasing-power parity

is based on a principle called the law of
one price.
º ccording to the law of one pricej a
good must sell for the same price in all
locations.
,$
+' $+ +
º Ifthe law of one price were not true,

unexploited profit opportunities would
exist.
º The process of taking advantage of
differences in prices in different
markets is called arbitrage.
,$
+' $+ +
º Ifarbitrage occurs, eventually prices that

differed in two markets would necessarily
converge.
º ccording 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.

+' $+ +
º Ifthe purchasing power of the dollar is

always the same at home and abroad,
then the exchange rate cannot change.
º The nominal exchange rate between the
currencies of two countries must reflect
the different price levels in those countries.

+' $+ +
º hen 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.

+ $ )
*' $ .

r "
---------------
#
!!!
ë

!
"

"

,
+' $+ +
ºMany goods are not easily traded or

shipped from one country to another.
ºTradable goods are not always perfect
substitutes when they are produced in
different countries.
#'
º Det exports are the value of domestic goods

and services sold abroad minus the value of
foreign goods and services sold domestically.
º Det foreign investment is the acquisition of
foreign assets by domestic residents minus
the acquisition of domestic assets by
foreigners.
#'
º n economy¶s net foreign investment

always equals its net exports.
º n economy¶s saving can be used to
either finance investment at home or
to buy assets abroad.
#'
º The nominal exchange rate is the relative

price of the currency of two countries.
º The real exchange rate is the relative
price of the goods and services of two
countries.
#'
º hen the nominal exchange rate changes
so that each dollar buys more foreign
currency, the dollar is said to appreciate
or strengthen.
º hen the nominal exchange rate changes
so that each dollar buys less foreign
currency, the dollar is said to depreciate
or weaken.
#'
º ccording to the theory or purchasing-
power parity, a unit of currency should
buy the same quantity of goods in all
countries.
º The nominal exchange rate between the
currencies of two countries should reflect
the countries¶ price levels in those
countries.
Graphical
Review
Ñ !"#"
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ë

#% $ * %
$ %
r G

r
ë
ë

ë

#% $ * %
$ %
r r
ë
ë

ë


+ $ )
*' $ .

r "
---------------
#
!!!
ë

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"

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Chap 31

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c 

Copyright © 2001 by Harcourt, Inc.

º closed economy is one that does not

n open economy is one that

ºn open economy interacts with other

ºThe U.S. is a very large and open

º|xports are domestically produced

ºDet exports r are the value of a

º The tastes of consumers for domestic and

º The incomes of consumers at home and

ºDet foreign investment refers to the

    

º International transactions are

º The nominal exchange rate is the rate

º The nominal exchange rate is

º ssume the exchange rate between the

ºIf a dollar buys more foreign currency,

The real exchange rate is the rate at

ºThe real exchange rate compares the

The real exchange rate depends on

ºThe real exchange rate is a key

º depreciation (fall in the U.S. real

º s a result, U.S. exports rise, and U.S.

ºThe purchasing-power parity theory is

º ccording to the purchasing-power

º The theory of purchasing-power parity

º Ifthe law of one price were not true,

º Ifarbitrage occurs, eventually prices that

º Ifthe purchasing power of the dollar is

º hen the central bank prints large

ºMany goods are not easily traded or

º Det exports are the value of domestic goods

º n economy¶s net foreign investment

º The nominal exchange rate is the relative

    

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c

º closed economy is one that does not

n open economy is one that

ºn open economy interacts with other

º ssume the exchange rate between the

º depreciation (fall in the U.S. real

º s a result, U.S. exports rise, and U.S.

º ccording to the purchasing-power

º n economy¶s net foreign investment