N.

Gregory Mankiw

Economics
Principles of

Sixth Edition

31
Open-Economy
Premium
Macroeconomics: PowerPoint
Slides by
Basic Concepts Ron Cronovich
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2012 UPDATE
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 In this chapter,
look for the answers to these questions:
• How are international flows of goods and assets
related?
• What’s the difference between the real and
nominal exchange rate?
• What is “purchasing-power parity,” and how does
it explain nominal exchange rates?

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 Introduction
▪ One of the Ten Principles of Economics
from Chapter 1:
Trade can make everyone better off.
▪ This chapter introduces basic concepts of
international macroeconomics:
▪ The trade balance (trade deficits, surpluses)
▪ International flows of assets
▪ Exchange rates

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 Closed vs. Open Economies
▪ A closed economy
does not interact with
other economies in
the world.

▪ An open economy
interacts freely with
other economies
around the world.

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 The Flow of Goods & Services
▪ Exports:
domestically-produced g&s sold abroad
▪ Imports:
foreign-produced g&s sold domestically
▪ Net exports (NX), aka the trade balance
= value of exports – value of imports

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 China's total exports
In September 2024, China's total exports amounted to USD 303.712 billion,
representing a year-on-year increase of 2.40%. According to the average
forecast of institutions compiled by Wind, total exports in October 2024 are
expected to grow by 10.00% year-on-year.

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返回根目录
数据来源:Wind
 China's total imports
In September 2024, China's total imports amounted to USD 222.002 billion,
marking a year-on-year increase of 0.30%.

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进口商品总额:当月值 亿美元 进口商品总额：当月同比增长 % （右）
返回根目录 数据来源:Wind
 ACTIVE LEARNING 1
Variables that affect NX
What do you think would happen to
U.S. net exports if:
A. Canada experiences a recession
(falling incomes, rising unemployment)
B. U.S. consumers decide to be patriotic and
buy more products “Made in the U.S.A.”
C. Prices of goods produced in Mexico rise faster
than prices of goods produced in the U.S.

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 ACTIVE LEARNING 1
Answers
A. Canada experiences a recession
(falling incomes, rising unemployment)
U.S. net exports would fall
due to a fall in Canadian consumers’
purchases of U.S. exports
B. U.S. consumers decide to be patriotic and
buy more products “Made in the U.S.A.”
U.S. net exports would rise
due to a fall in imports

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 ACTIVE LEARNING 1
Answers
C. Prices of Mexican goods rise faster than prices
of U.S. goods
This makes U.S. goods more attractive
relative to Mexico’s goods.
Exports to Mexico increase,
imports from Mexico decrease,
so U.S. net exports increase.

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 Variables that Influence Net Exports
▪ Consumers’ preferences for foreign and
domestic goods
▪ Prices of goods at home and abroad
▪ Incomes of consumers at home and abroad
▪ The exchange rates at which foreign currency
trades for domestic currency
▪ Transportation costs
▪ Govt policies

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 Trade Surpluses & Deficits
NX measures the imbalance in a country’s trade in
goods and services.
▪ Trade deficit:
an excess of imports over exports
▪ Trade surplus:
an excess of exports over imports
▪ Balanced trade:
when exports = imports

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 China's trade surplus
In September 2024, the trade surplus was USD 81.711 billion, a decrease of
USD 9.290 billion compared to the previous month, and an increase of 8.77%
year-on-year.

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数据来源:Wind
返回根目录
 China's major export destinations
As of the end of September 2024, China's cumulative exports to the United
States amounted to USD 381.137 billion, to the European Union to USD
384.627 billion, and to Japan to USD 111.546 billion.
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返回根目录 美 国 :出口额:累计值 万美元 欧 洲 联盟:出口额:累计值 万 美元 日 本 :出口额:累计值 万美元
数据来源:Wind
 Mid semester thesis
▪ "What changes have occurred in China's cross-
border trade since 2024, Please provide some
analysis to explain the reasons for the changes.
▪ More than 500 words；Submit the paper version
(with clear name and student ID) before class on
December 5th.

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 Figure 1 The Internationalization of the U.S. Economy

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 The nominal US dollar index and the US trade
deficit
The U.S. Department of Commerce announced that the nominal U.S. Dollar
Index was 122.13 in September 2024, a decrease of 0.75 from the previous
month. The trade deficit in August was -70.431billion,comparedto−78.918
billion in the previous month.
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返回根目录 数据来源:Wind

美国:贸易差额:季节调整 右 亿美元 名义美元指数:广义 2006年1月=100

 The Flow of Capital
▪ Net capital outflow (NCO):
domestic residents’ purchases of foreign assets
minus
foreigners’ purchases of domestic assets
▪ NCO is also called net foreign investment.

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 The Flow of Capital
The flow of capital abroad takes two forms:
▪ Foreign direct investment:
Domestic residents actively manage the foreign
investment, e.g., McDonalds opens a fast-food
outlet in Moscow.
▪ Foreign portfolio investment:
Domestic residents purchase foreign stocks or
bonds, supplying “loanable funds” to a foreign
firm.

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 The Flow of Capital
NCO measures the imbalance in a country’s trade
in assets:
▪ When NCO > 0, “capital outflow”
Domestic purchases of foreign assets exceed
foreign purchases of domestic assets.
▪ When NCO < 0, “capital inflow”
Foreign purchases of domestic assets exceed
domestic purchases of foreign assets.

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 Variables that Influence NCO
▪ Real interest rates paid on foreign assets
▪ Real interest rates paid on domestic assets
▪ Perceived risks of holding foreign assets
▪ Govt policies affecting foreign ownership of
domestic assets

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 The Equality of NX and NCO
▪ An accounting identity: NCO = NX
▪ arises because every transaction that affects
NX also affects NCO by the same amount
(and vice versa)
▪ When a foreigner purchases a good
from the U.S.,
▪ U.S. exports and NX increase
▪ the foreigner pays with currency or assets,
so the U.S. acquires some foreign assets,
causing NCO to rise.
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 The Equality of NX and NCO
▪ An accounting identity: NCO = NX
▪ arises because every transaction that affects
NX also affects NCO by the same amount
(and vice versa)
▪ When a U.S. citizen buys foreign goods,
▪ U.S. imports rise, NX falls
▪ the U.S. buyer pays with U.S. dollars or
assets, so the other country acquires
U.S. assets, causing U.S. NCO to fall.

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 Saving, Investment, and International
Flows of Goods & Assets
Y = C + I + G + NX accounting identity
Y – C – G = I + NX rearranging terms
S = I + NX since S = Y – C – G
S = I + NCO since NX = NCO
▪ When S > I, the excess loanable funds flow
abroad in the form of positive net capital outflow.
▪ When S < I, foreigners are financing some of the
country’s investment, and NCO < 0.
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 Case Study: The U.S. Trade Deficit
▪ The U.S. trade deficit reached record levels in
2006 and remained high in 2007–2008.
▪ Recall, NX = S – I = NCO.
A trade deficit means I > S,
so the nation borrows the difference
from foreigners.
▪ In 2007, foreign purchases of U.S. assets
exceeded U.S. purchases of foreign assets by
$775 million.
▪ Such deficits have been the norm since 1980…
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25
Figure 2 National Saving, Domestic Investment,
and Net Capital Outflow, Part 1

▪Panel (a) shows national saving and domestic investment as a percentage of GDP. You can
see from the figure that national saving has been lower since 1980 than it was before 1980. This
fall in national saving has been reflected primarily in reduced net capital outflow rather than in
reduced domestic investment.

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26
Figure 2 National Saving, Domestic Investment,
and Net Capital Outflow, Part 2

▪Panel (b) shows net capital outflow as a percentage of GDP. You can see from the figure that national
saving has been lower since 1980 than it was before 1980. This fall in national saving has been
reflected primarily in reduced net capital outflow rather than in reduced domestic investment.

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 International Capital Flows and Market Interest
Rates
In September 2024, the average yield on one-year U.S. Treasury bonds was
3.87%. In August, the net inflow of international capital amounted to USD
119.119 billion.
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美国月度国际资本流动:净额:2期移动平均值 亿美元(右)
返回根目录 数据来源:Wind
 Case Study: The U.S. Trade Deficit
Why U.S. saving has been less than investment:
▪ In the 1980s and early 2000s,
huge govt budget deficits and low private saving
depressed national saving.
▪ In the 1990s,
national saving increased as the economy grew,
but domestic investment increased even faster
due to the information technology boom.

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 Case Study: The U.S. Trade Deficit
▪ Is the U.S. trade deficit a problem?
▪ The extra capital stock from the ’90s investment
boom may well yield large returns.
▪ The fall in saving of the ’80s and ’00s,
while not desirable, at least did not depress
domestic investment, since firms could borrow
from abroad.
▪ A country, like a person, can go into debt
for good reasons or bad ones.
A trade deficit is not necessarily a problem,
but might be a symptom of a problem.
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 Case Study: The U.S. Trade Deficit
as of 6-30-2024
People abroad owned $ 58.52 trillion in U.S. assets.
U.S. residents owned $ 36.00 trillion in foreign assets.
U.S.’ net indebtedness to other countries = $22.52
trillion.
Higher than every other country’s net indebtedness,
hence, U.S. is “the world’s biggest debtor nation.”
▪ So far, the U.S. earns higher interest rates on foreign
assets than it pays on its debts to foreigners.
▪ But if U.S. debt continues to grow, foreigners may
demand higher interest rates, and servicing the debt
may become a drain on U.S. income.
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 Foreign investors hold U.S. Treasury bonds
In August 2024, overseas investors collectively held U.S. Treasury bonds totaling
USD 8,503.380 billion, an increase of USD 164.840 billion compared to the
previous month. Among them, China held USD 774.614 billion, with a decline in
holdings; while Japan held USD 1,129.183 billion, with an increase in holdings.

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合计（右） 中国 日本 英国
返回根目录 数据来源:Wind
 Real and Nominal Exchange Rates
The Nominal Exchange Rate
▪ Nominal exchange rate: the rate at which
one country’s currency trades for another
▪ We express all exchange rates as foreign
currency per unit of domestic currency.
▪ Some exchange rates as of 5 Dec 2024,
all per US$
▪ Canadian dollar: 1.4069
▪ Euro: 0.9499
Japanese yen: 149.75
Rmb: 7.2674
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 Appreciation and Depreciation
▪ Appreciation (or “strengthening”):
an increase in the value of a currency
as measured by the amount of foreign currency it
can buy
▪ Depreciation (or “weakening”):
a decrease in the value of a currency
as measured by the amount of foreign currency it
can buy
▪ Examples:
▪ Since October 2024.,
▪ the U.S. dollar…
▪ appreciated against
▪ the RMB
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 Appreciate ??Depreciate??

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 Appreciate ??Depreciate??

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 Appreciate ??Depreciate??

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 Appreciate ??Depreciate??

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 The Real Exchange Rate
▪ Real exchange rate: the rate at which the g&s
of one country trade for the g&s of another
exP
▪ Real exchange rate =
P*
where
P = domestic price
P* = foreign price (in foreign currency)
e = nominal exchange rate, i.e., foreign
currency per unit of domestic currency

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 Example With One Good
▪ A Big Mac costs $2.50 in U.S., 400 yen in Japan
▪ e = 120 yen per $
▪ e x P = price in yen of a U.S. Big Mac
= (120 yen per $) x ($2.50 per Big Mac)
= 300 yen per U.S. Big Mac
▪ Compute the real exchange rate:
exP 300 yen per U.S. Big Mac
=
P* 400 yen per Japanese Big Mac
= 0.75 Japanese Big Macs per U.S. Big Mac
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Interpreting the Real Exchange Rate
“The real exchange rate =
0.75 Japanese Big Macs per U.S. Big Mac”
Correct interpretation:
To buy a Big Mac in the U.S.,
a Japanese citizen must sacrifice
an amount that could purchase
0.75 Big Macs in Japan.

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 ACTIVE LEARNING 2
Compute a real exchange rate
e = 10 pesos per $
price of a tall Starbucks Latte
P = $3 in U.S., P* = 24 pesos in Mexico
A. What is the price of a U.S. latte measured in
pesos?
B. Calculate the real exchange rate,
measured as Mexican lattes per U.S. latte.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 2
Answers
e = 10 pesos per $
price of a tall Starbucks Latte
P = $3 in U.S., P* = 24 pesos in Mexico
A. What is the price of a U.S. latte in pesos?
e x P = (10 pesos per $) x (3 $ per U.S. latte)
= 30 pesos per U.S. latte
B. Calculate the real exchange rate.
exP 30 pesos per U.S. latte
=
P* 24 pesos per Mexican latte
= 1.25 Mexican lattes per U.S. latte
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The Real Exchange Rate With Many Goods
P = U.S. price level, e.g., Consumer Price Index,
measures the price of a basket of goods
P* = foreign price level
Real exchange rate
= (e x P)/P*
= price of a domestic basket of goods relative to
price of a foreign basket of goods
▪ If U.S. real exchange rate appreciates,
U.S. goods become more expensive relative to
foreign goods.
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 The Law of One Price
▪ Law of one price: the notion that a good should
sell for the same price in all markets
▪ Suppose coffee sells for $4/pound in Seattle
and $5/pound in Boston,
and can be costlessly transported.
▪ There is an opportunity for arbitrage,
making a quick profit by buying coffee in
Seattle and selling it in Boston.
▪ Such arbitrage drives up the price in Seattle
and drives down the price in Boston, until the
two prices are equal.
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 Purchasing-Power Parity (PPP)
▪ Purchasing-power parity:
a theory of exchange rates whereby a unit of
any currency should be able to buy the same
quantity of goods in all countries
▪ based on the law of one price
▪ implies that nominal exchange rates adjust
to equalize the price of a basket of goods
across countries
Purchasing-Power Parity ,how to use it to compute the nominal exchange
rate?

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 Purchasing-Power Parity (PPP)
▪ Example: The “basket” contains a Big Mac.
P = price of U.S. Big Mac (in dollars)
P* = price of Japanese Big Mac (in yen)
e = exchange rate, yen per dollar
▪ According to PPP, e x P = P*

price of U.S. price of Japanese

Big Mac, in yen Big Mac, in yen

P*
▪ Solve for e: e =
P
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 PPP and Its Implications
▪ PPP implies that the nominal
P*
exchange rate between two countries e =
P
should equal the ratio of price levels.
▪ If the two countries have different inflation rates,
then e will change over time:
▪ If inflation is higher in Mexico than in the U.S.,
then P* rises faster than P, so e rises—
the dollar appreciates against the peso.
▪ If inflation is higher in the U.S. than in Japan,
then P rises faster than P*, so e falls—
the dollar depreciates against the yen.
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Purchasing-Power Parity (PPP)

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 【The Big Mac Index】
▪ https://www.statista.com/statistics/274326/big-
mac-index-global-prices-for-a-big-mac/

▪ 【The Big Mac Index】

https://www.bilibili.com/video/BV1ox411r75i/?sha
re_source=copy_web

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 Big Mac index worldwide 2024

▪ At 8.07 U.S. dollars, Switzerland has the most expensive Big Macs
in the world, according to the July 2024 Big Mac index.
Concurrently, the cost of a Big Mac was 5.69 dollars in the U.S.,
and 6.06 U.S. dollars in the Euro area.
▪ What is the Big Mac index?
▪ The Big Mac index, published by The Economist, is a novel way of
measuring whether the market exchange rates for different
countries’ currencies are overvalued or undervalued. It does this
by measuring each currency against a common standard – the
Big Mac hamburger sold by McDonald’s restaurants all over the
world. Twice a year the Economist converts the average national
price of a Big Mac into U.S. dollars using the exchange rate at
that point in time. As a Big Mac is a completely standardized
product across the world, the argument goes that it should have
the same relative cost in every country. Differences in the cost of
a Big Mac expressed as U.S. dollars therefore reflect differences
in the purchasing power of each currency.

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 Big Mac index worldwide 2024

Is the Big Mac index a good measure of purchasing power

parity?
▪ Purchasing power parity (PPP) is the idea that items should cost
the same in different countries, based on the exchange rate at
that time. This relationship does not hold in practice. Factors like
tax rates, wage regulations, whether components need to be
imported, and the level of market competition all contribute to
price variations between countries. The Big Mac index does
measure this basic point – that one U.S. dollar can buy more in
some countries than others. There are more accurate ways to
measure differences in PPP though, which convert a larger range
of products into their dollar price. Adjusting for PPP can have a
massive effect on how we understand a country’s economy.
The country with the largest GDP adjusted for PPP is China, but
when looking at the unadjusted GDP of different countries, the
U.S. has the largest economy.

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 Limitations of PPP Theory
Two reasons why exchange rates do not always
adjust to equalize prices across countries:
▪ Many goods cannot easily be traded
▪ Examples: haircuts, going to the movies
▪ Price differences on such goods cannot be
arbitraged away
▪ Foreign, domestic goods not perfect substitutes
▪ E.g., some U.S. consumers prefer Toyotas over
Chevys, or vice versa
▪ Price differences reflect taste differences

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 Limitations of PPP Theory
▪ Nonetheless, PPP works well in many cases,
especially as an explanation of long-run trends.
▪ For example, PPP implies:
the greater a country’s inflation rate,
the faster its currency should depreciate
(relative to a low-inflation country like the US).
▪ The data support this prediction…

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 ACTIVE LEARNING 3
Chapter review questions
1. Which of the following statements about a country
with a trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving
D. Y < C + I + G

2. A Ford Escape SUV sells for $24,000 in the U.S.

and 720,000 rubles in Russia.
If purchasing-power parity holds, what is the
nominal exchange rate (rubles per dollar)?
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 ACTIVE LEARNING 3
Answers
1. Which of the following statements about a country
with a trade deficit is not true?
A. Exports < imports
B. Net capital outflow < 0
C. Investment < saving not true
D. Y < C + I + G

A trade deficit means NX < 0.

Since NX = S – I,
a trade deficit implies I > S.

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 ACTIVE LEARNING 3
Answers
2. A Ford Escape SUV sells for $24,000 in the U.S.
and 720,000 rubles in Russia.
If purchasing-power parity holds, what is the
nominal exchange rate (rubles per dollar)?
P* = 720,000 rubles
P = $24,000
e = P*/P = 720000/24000 = 30 rubles per dollar

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 questions will be like this
After-class exercises
▪ Assuming the price of a bottle of French
perfume is 100 euros, a similar perfume in
China costs 700 Chinese yuan, and 1 euro can
be exchanged for 7.5 Chinese yuan.
▪ 1、What is the nominal exchange rate of the
euro? According to the theory of purchasing
power parity, what should the nominal
exchange rate of the euro be?
▪ 2、If the price of the French perfume
increases to 120 euros, while the price in China
remains unchanged, will the nominal exchange
rate of the euro appreciate or depreciate?
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 SU MMA RY

• Net exports equal exports minus imports.

Net capital outflow equals domestic residents’
purchases of foreign assets minus foreigners’
purchases of domestic assets.
• Every international transaction involves the
exchange of an asset for a good or service,
so net exports equal net capital outflow.

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 SU MMA RY

• Saving can be used to finance domestic

investment or to buy assets abroad. Thus,
saving equals domestic investment plus net
capital outflow.
• The nominal exchange rate is the relative price
of the currency of two countries.
• The real exchange rate is the relative price of
the goods and services of the two countries.

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 SU MMA RY

• According to the theory of purchasing-power

parity, a unit of any country’s currency should be
able to buy the same quantity of goods in all
countries.
• This theory implies that the nominal exchange
rate between two countries should equal the
ratio of the price levels in the two countries.
• It also implies that countries with high inflation
should have depreciating currencies.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.