The international flows of goods and capital
The prices for international transactions: Real and nominal exchange rates
A first theory of exchange-rate determination: Purchasing-power parity
The prices for international transactions: Real and nominal exchange rates
A first theory of exchange-rate determination: Purchasing-power parity
Introduction
Earlier in the text, we learned that people gain from trade because they can specialise in the production of goods for which they have a comparative advantage and trade for other people's production. However, until now, most of our study of macroeconomics has been based on a closed economy: one that does not interact with other economies. We now begin the study of macroeconomics in an open economy: an economy that interacts with other economies.
The international flows of goods and capital
An open economy interacts with other economies in two ways: it buys and sells goods and services in world product markets; and it buys and sells capital assets in world financial markets.
Exports are domestically-produced goods and services sold abroad, while imports are foreign-produced goods and services sold domestically. Net exports (NX) are the value of a country's exports minus the value of its imports. Net exports are also called the trade balance. If exports exceed imports, net exports are positive and the country is said to have a trade surplus. If imports exceed exports, net exports are negative and the country is said to have a trade deficit. If imports equal exports, net exports are zero and there is balanced trade.
Net exports are influenced by the tastes of consumers for domestic versus foreign goods, the relative prices of foreign and domestic goods, exchange rates, foreign and domestic incomes, international transportation costs and government policies toward trade. These factors will be addressed in the following chapter.
The Australian economy has engaged in an increasing amount of international trade during the last four decades for the following reasons: (1) improved transportation such as larger cargo ships; (2) advances in telecommunications which allow for better overseas communication; (3) changes in the types of goods produced - technologically-advanced goods such as consumer electronics have a lower weight per dollar value and are easier to transport; and (4) governments around the world look more favourably on trade, as evidenced by their support of the North American Free Trade Agreement (NAFTA) and the General Agreement on Tariffs and Trade (GATT).
Net foreign investment (also known as net capital outflow) is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. When a domestic resident buys and controls capital in a foreign country, it is known as foreign direct investment. When a domestic resident buys stock in a foreign corporation but has no direct control of the company, it is known as foreign portfolio investment.
Net foreign investment is influenced by the relative real interest rates paid on foreign versus domestic assets, the relative economic and political risks, and government policies that affect ownership of foreign assets. These factors will be addressed in the following chapter.
Interaction in an open economy occurs in two ways - in world markets for goods and services, and in world financial markets. The current account measures net exports plus flows of net income (NY) and net transfer payments (NT). Income flows come from the receipt of income earned by Australian residents from overseas sources such as overseas companies. Overseas residents also earn income from Australian sources. Net income measures the difference in overseas payments and receipts. Transfer payments include aid payments made to overseas countries and pensions paid to foreign citizens who reside in Australia. The current account balance (CAB) can be shown by the following equation:
The capital account measures financial flows in terms of net foreign investment. For an economy as a whole, NFI always equals the current account balance:
NFI = CABThis equation is an identity because every international transaction is an exchange. When Fosters sells beer to a New Zealand resident, Fosters receives NZ dollars. NX has increased and NFI has increased because Fosters is now holding additional foreign assets (NZ dollars). If Fosters chooses not to hold the NZ dollars, any subsequent transaction undertaken by Fosters preserves the equality of NX and NFI. For example, Fosters could use the NZ dollars to purchase New Zealand goods of equal value, reversing the transaction so that NX and NFI return to their original values. Alternatively, Fosters could use the NZ dollars to buy other New Zealand assets (stocks etc.), maintaining the increase in NX and NFI. Finally, Fosters could exchange the NZ dollars for AUS dollars. The new owners of the NZ dollars could buy New Zealand assets, maintaining the increase in NX and NFI, or they could buy New Zealand goods, reducing NX and NFI to their original levels. Simply put, when someone exports goods and receives foreign currency, the foreign currency will either be held, used to buy goods from the importing country or used to buy assets from the importing country. In each case, NX = NFI is maintained.
When all transactions are included, the net value of goods and services sold, plus the net income earned from overseas (CAB), must equal the net value of assets acquired (NFI).
Saving and investment are important for growth. Saving is the income of a nation that is left over after paying for consumption and government purchases. Recall, gross domestic product (Y) is the sum of consumption (C), investment (I), government purchases (G) and net exports (NX). When we include earnings from overseas investments, we can define gross national disposable income (GNDY) as:
GNDY = GDP + NY + NTNational savings in the amount of income remaining after deducting consumption and government expenditure. Hence gross national saving (S) can be written as:
(S) = GDNY - C - G.Substituting the definition of GDNY into the equation:
S = C + I + G + NX + NY + NT - C - GS = I + NX + NY + NTS = I + CAB.Since CAB = NFI, we can write:
S = I + NFI.Thus, in an open economy, when the Australian economy saves a dollar, it can invest in domestic capital (I) or foreign capital (NFI). It does not have to invest only in domestic capital (I).
In summary, if a country runs a trade surplus, net exports (NX) are positive, domestic saving is greater than domestic investment and net foreign investment (NFI) is positive. If a country runs a trade deficit, net exports (NX) are negative, domestic saving is less than domestic investment and net foreign investment (NFI) is negative. If a country has balanced trade, net exports (NX) are zero, domestic saving is equal to domestic investment and net foreign investment (NFI) is zero.
The prices for international transactions: Real and nominal exchange rates
The nominal exchange rate is the rate at which people can trade one currency for another currency. An exchange rate between dollars and any foreign currency can be expressed in two ways: foreign currency per dollar; or dollars per unit of foreign currency. For example, if 80 yen are equal to 1 dollar, the nominal exchange rate is 80 yen per dollar or .0125 (which is 1/80) dollars per yen. Here we will always express exchange rates as foreign currency per dollar. When the dollar buys more foreign currency, there has been an appreciation of the dollar. When the dollar buys less foreign currency, there has been a depreciation of the dollar.
Because there are so many currencies in the world, the dollar exchange rate is often expressed by an exchange rate index that compares a group of currencies to the dollar.
The real exchange rate is the rate at which people can trade the goods and services of one country for the goods and services of another. Two things are considered when we directly compare the value of goods in one country to those in another: the relative values of the currencies (nominal exchange rate); and the relative prices of the goods to be traded. The real exchange rate is defined as:
real exchange rate = (nominal exchange rate domestic price)/foreign priceJust as the nominal exchange rate is expressed as units of foreign currency per unit of domestic currency, the real exchange rate is expressed as units of foreign goods per unit of domestic goods. For example: suppose that a case of Mexican beer is 20 pesos while a case of Australian beer is $10, and the nominal exchange rate is 4 pesos per dollar. The real exchange rate of Mexican beer to Australian beer is:
real exchange rate = [(4 pesos/1 dollar) x ($10/case Australian beer)]/(20 pesos/case Mexican beer)= (40 pesos/case Australian beer)/(20 pesos/case Mexican beer)
= 2 cases Mexican beer/1 case Australian beer
The real exchange rate is the true relative cost of goods across borders.
Since macroeconomists are concerned with the economy as a whole, they are concerned with overall prices rather than individual prices. Therefore, instead of using the price of beer to compute the real exchange rate, macroeconomists use each country's price index:
real exchange rate = (e x P)/P*where e is the nominal exchange rate, P is a domestic price index and P* is a foreign price index.
When this measure of the real exchange rate rises, Australian goods are more expensive relative to foreign goods and net exports fall. When this measure of the real exchange rate falls, Australian goods are cheaper relative to foreign goods and net exports rise.
A first theory of exchange-rate determination: Purchasing-power parity
The simplest explanation of why an exchange rate takes on a particular value is called purchasing-power parity. This theory says that a unit of any given currency should buy the same quantity of goods in all countries. The logic of this theory is based on the law of one price. The law of one price says that a good must sell for the same price in all locations because, if there were different prices for the same good, people would buy the good where it is cheap and sell it where it is expensive. This behavior will continue to drive up the price where it was low and drive down the price where it was high until the prices are equalised. This process is called arbitrage. Thus, a dollar should buy the same amount of beer in Mexico as it buys in Australia. If it did not, there would be opportunities for profit and traders would buy where it is cheap and sell where it is expensive.
If purchasing-power parity is true, the nominal exchange rate between two country's currencies depends on the price levels in those two countries. For example, if beer in Mexico is 20 pesos per case while beer in Australia is $10 per case, then the exchange rate should be 20 pesos per $10, or 2 pesos/dollar so that one dollar buys the same amount of beer in both countries. Notice, the nominal exchange rate of 2 pesos/dollar is simply the ratio of the prices in the two countries.
To put this concept into a formula, suppose P is the Australian price level, P* is the foreign price level and e is the exchange rate in terms of foreign currency per dollar. A dollar can buy 1/P units in Australia and e/P* units in the foreign country. Purchasing-power parity suggests that a dollar should buy the same amount in each country.
1/P = e/P*Solving for e,
e = P*/P.
Thus, if purchasing-power parity holds, the nominal exchange rate is the ratio of the foreign price level to the domestic price level.
Recall, a country's price level depends on how much money its central bank creates. If a central bank creates more money, its currency will buy fewer goods and services and fewer units of other currencies. That is, its currency will depreciate.
Purchasing-power parity is most likely to hold in the long run. However, even in the long run, the theory of purchasing-power parity is not completely accurate because (1) some goods are not easily traded (such as services) and (2) even tradable goods are not always perfect substitutes.