Open-Economy Macroeconomics:

Basic Concepts

Course Instructor:
Dr. Amarendu Nandy
Assistant Professor
Indian Institute of Management, Ranchi

Closed vs. Open Economies

A closed economy does not interact with other economies in

the world.
There are no exports, no imports, and no capital flows.
An open economy interacts freely with other economies

around the world.

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.

Closed vs. Open Economies

Openness of an economy covers three important aspects:

Goods Market Openness refers to free exchange of commodities across national

borders. This has been growing as many LDCs have moved towards a policy of greater
integration with global markets.

Capital Market Openness relates to international trade in financial assets (Capital

refers to financial, not physical, capital). Investors today have more freedom to choose
between domestic and foreign assets. It is now much easier for foreigners to acquire
assets in India (share of an Indian company, GoI bond). Indian firms have greater
ability to raise to finance abroad due to relaxation of capital controls.

Factor Market Openness refers to the ease with which factors of production can
move across geographical boundaries without facing serious restrictions.

Closed vs. Open Economies

Degree of Openness

Total foreign trade (export + import) as a proportion of GDP

India 8 percent in 1970 to 47 percent in 2010

Value of import duties as a proportion of value of imports

reduction implies greater openness (lower import restrictions)

53 percent in 1987; 46 percent in 1991 to approx. 20 percent in

recent years.

Macroeconomic Variable Determination in an Open

Economy

The important macroeconomic variables of an open

economy include:

net exports (NX)

net capital outflow (NCO)
nominal exchange rates (e)
real exchange rates (eP/P*)
real interest rates (r)
Loanable funds (LF=I=S)

The values of these variables are determined through the interaction of:

the Loanable Funds Market, the Net Foreign Investment Market, and
the Market for Foreign-Currency Exchange.

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

The Flow of Goods & Services

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

zeroexports and imports are exactly equal.

Variables that affect NX

What do you think would happen to Indias net
exports if:
A. U.S. experiences a recession
(falling incomes, rising unemployment)

B. Indian consumers decide to be patriotic and

buy more products Made in India

C. Prices of goods produced in U.S. rise faster than prices of

goods produced in the India

Answers
A. U.S. experiences a recession
(falling incomes, rising unemployment)

Indias net exports would fall

due to a fall in U.S. consumers purchases
of Indian exports
B. Indian consumers decide to be patriotic and
buy more products Made in India

Indias net exports would rise

due to a fall in imports

Answers
C. Prices of U.S. goods rise faster than prices of
Indian goods

This makes Indian goods more attractive

relative to U.S. goods.
Exports to U.S. increase, imports from U.S.
decrease,
So Indias net exports increase.

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 towards

international trade

The Flow of Capital

Net capital outflow (NCO):

purchase of foreign assets by domestic residents

minus
the purchase of domestic assets by foreigners

E.g. An Indian resident buys stock in the Toyota Corporation and (-) a
Malaysian buys stock in Infosys.

NCO is also called net foreign investment (NFI).

Alternatively, NCO is the net flow of funds being invested abroad

by a country during a certain period of time. A positive NCO

means that the country invests outside more than the world invests
in it; a negative one, that the world invests in the country more
than the country invests in the world.

The Flow of Capital

The flow of capital abroad takes two forms:

Foreign direct investment:

Domestic residents actively manage the foreign
investment, e.g., Nirulas opens a fast-food outlet in
New York.

Foreign portfolio investment:

Domestic residents purchase foreign stocks or bonds,
supplying loanable funds to a foreign firm.

The Flow of Capital

NCO measures the imbalance in a countrys 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.

Variables that Influence NCO

Real interest rates paid on foreign assets
Real interest rates paid on domestic assets
Perceived economic and political risks of holding

foreign assets
Govt. policies affecting foreign ownership of
domestic assets

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 India,

Indias

exports and NX increase

the foreigner pays with currency or assets,
so India acquires some foreign assets, causing
NCO to rise.

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 an Indian citizen buys foreign goods,

Indias

imports rise, NX falls

The Indian buyer pays with Indian rupees or
assets, so the other country acquires Indian assets,
causing Indias NCO to fall.

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

S = I + NCO

since S = Y C G

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 countrys

investment, and NCO < 0.

International Flows of Goods and

Capital: Summary

Case Study: The U.S. Trade Deficit

Is the U.S. trade deficit a problem?
The extra capital stock from the 90s investment boom has
yielded reasonable returns.
The fall in saving of the 80s and 00s, while not desirable, at
least did not depress domestic investment, as 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.

Case Study: The U.S. Trade Deficit

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

would become a drain on U.S. income.

The Nominal Exchange Rate

Nominal exchange rate: the rate at which

one countrys currency trades for another. It is thus

a bilateral concept.
We express all exchange rates as foreign currency

per unit of domestic currency.

Effective Exchange Rate

It is the weighted average of nominal rates, the weights being the shares

of the respective countries in the trade of the country (either export or

import) for which the EER is being calculated.
Example: suppose India trades only with the USA (share 60%) and

Japan (share 40%) & NERs of the rupee are 50 for the dollar & 10 for
the yen.
EER = 0.6(50) + 0.4(10) = 34
Interpretation: For Rs. 34 one can buy a basket consisting of 0.6 dollar

and 0.4 yen.

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

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

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
P*

300 yen per U.S. Big Mac

400 yen per Japanese Big Mac

= 0.75 Japanese Big Macs per US Big Mac

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.

The Real Exchange Rate With Many Goods

P = Indian price level, e.g., Wholesale/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
RER is often taken as a measure of the countrys international

competitiveness.
If Indian real exchange rate appreciates, Indian goods become more

expensive relative to foreign goods.

Real Effective Exchange Rate

This is the overall RER for the economy. It is the weighted average of

the RERs for all its trade partners, the weights being the share of the
respective countries in its foreign trade.
Example: assume India has a single trading partner-the USA. So, EER

= NER & REER = RER;

e = nominal exchange rate = 40, P* = $4 & P = Rs.10, hence RER = 16.

16 units of the home good are needed to buy 1 unit of USA good.

Indias REER (Base: 1993-4 = 100)

YEAR

6-Currency NEER

6-Currency REER

2003-04

69.97

99.17

2004-05

69.58

101.78

2005-06

72.28

107.30

2006-07

69.49

105.57

2007-08

74.76

114.23

2008-09

65.07

104.34

2009-10

62.87

104.56

Source: Economic Survey 2010-11

Spot Exchange Rate

The spot rate of exchange between two countries is

the rate applicable for immediate delivery (within 2

days).
Example: Price PC = $100;

e = 30 & the domestic price (fixed) Rs. 40,000.

Profit = Rs. 37,000
Rupee depreciate e = 40; profit = Rs. 36,000.

Forward Exchange Rate

The forward exchange rate applies to agreements for an exchange of

two currencies at an agreed date in future.

The date of exchange as well as the rate of exchange are fixed in

advance at the time of writing the contract.

The chief utility of forward rate is that it provides protection against

exchange rate risk created by possible future variation in the spot rate.
30 day forward contract ef = 35; Guaranteed profit = Rs.36,500 (minus

the fee charged by the bank.)

Nominal Depreciation and Real Depreciation

Example: e = 40 ($1=Rs. 40), price of refrigerator made in India = Rs. 40,000 Will sell
for $1000 in the USA.

Rupee depreciates so that e = 50. Refrigerator becomes cheaper in dollars ($800) and
thus more competitive with refrigerators from other countries to the US market and its
demand (our exports) will increase.

However, if along with the depreciation of the rupee our price level (P) also rises to the
same extent, there may not be any change in the RER and export will not rise.

Consider this: If e = 50, and domestic price of refrigerator is now = Rs. 50,000, the dollar
price stays the same as before ($1000), and there will be no effect on competitiveness and
sales.

The nominal depreciation (rise in e) has failed to generate real depreciation.

Exports will not change. For real depreciation to take place, nominal
depreciation must not be offset by domestic inflation (rise in P).

The Law of One Price

Law of one price (LOOP): the notion that a good

should sell for the same price in all markets

Suppose coffee sells for Rs. 400/kg in Kochi and Rs.

700/kg in Ranchi, and can be costlessly transported.

There is an opportunity for arbitrage, making a quick

profit by buying coffee in Kochi and selling it in Ranchi.

Such arbitrage drives up the price in Kochi and drives

down the price in Ranchi, until the two prices are equal.

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 (LOOP)

implies that nominal exchange rates adjust

to equalize the price of a basket of goods across countries

Purchasing-Power Parity (PPP)

Example: The basket contains a Big Mac.
P = price of US 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 US
Big Mac, in yen

Solve for e:

P*
e =
P

price of Japanese Big

Mac, in yen

PPP and Its Implications

PPP implies that the nominal exchange rate between

two countries should equal the ratio of price levels.

P*
e =
P
If the two countries have different inflation rates, then

e will change over time:

If inflation is higher in U.S. than in the India, then P* rises

faster than P, so e rises
the rupee appreciates against the dollar.

If inflation is higher in India than in U.S., then P rises faster

than P*, so e falls
the rupee depreciates against the dollar.

Exchange Rates
Purchasing Power Parity
When PPP doesnt hold, we can decompose changes in the real
exchange rate into parts
e/e = enom/enom + P/P PFor/PFor

This can be rearranged as

enom/enom = e/e + For

Exchange Rates
Purchasing Power Parity
Thus a nominal appreciation is due to a real appreciation or a
lower rate of inflation than in the foreign country

Exchange Rates
Purchasing Power Parity
In the special case in which the real exchange rate doesnt
change, so that e/e = 0, the resulting equation is called
relative purchasing power parity, since nominal exchangerate movements reflect only changes in inflation

Relative purchasing power parity works well as a description of

exchange-rate movements in high-inflation countries, since in
those countries, movements in relative inflation rates are much
larger than movements in real exchange rates

Implications of Purchasing-Power Parity

If the purchasing power of the rupee is always the same at

home and abroad, then the exchange rate would be

constant.

The nominal exchange rate between the currencies of two

countries must reflect the different price levels in those

countries and the real exchange rate would be equal to 1.

Therefore, if a central bank prints large quantities of

money, the price level rises and its value in buying goods
and services and other currencies falls.

Money, Prices, and the Nominal Exchange Rate During

the German Hyperinflation
Indexes
(Jan. 1921 5 100)

1,000,000,000,000,000

Money supply

10,000,000,000
Price level

100,000

Exchange rate

.00001

.0000000001
1921

1922

1923

1924

1925

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 Indian consumers may prefer Toyotas over Tatas, or

vice versa
Price differences reflect taste differences

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 countrys inflation rate,

the faster its currency should depreciate
(relative to a low-inflation country like the US).
The data support this prediction

Inflation & Depreciation in a Cross-Section

of 31 Countries

10,000.0

Ukraine

1,000.0
Avg annual
depreciation 100.0
relative to
10.0
US dollar
1993-2003
1.0
(log scale)

Romania

Brazil

Argentina
Mexico
Canada
Kenya
Japan

0.1

0.1

1.0

10.0

100.0 1,000.0

Avg annual CPI inflation

1993-2003 (log scale)

Exchange rate pass-through

Exchange rate pass-through (ERPT) is the percentage change in local currency import prices
resulting from a one percent change in the exchange rate between the exporting and importing
countries

The transmission mechanism of pass-through works in two stages.

In the first stage, a depreciation increases prices of imported consumption and intermediate goods.
In the second stage, it affects prices of domestically produced goods through supply and demand channels.

By affecting the price of intermediate goods, it affects the cost of production and hence prices of
domestically produced goods.

Because of rise in import prices, demand shifts to domestically produced goods, leading to
further increase in domestic prices.

Degree and timing of pass-through is important for forecasting inflation.

Setting of effective monetary policy in response to inflation shocks require knowledge about
ERPT.

Interest Rate Parity

Interest rate parity is the asset

equivalent of PPP. It states that

all assets should be expected to
earn the same return
For example, suppose that the
interest rate in the US is 5%,
the interest rate in Europe is
7%,, the current exchange rate
is $1.15/E and the anticipated
exchange rate in a year is
$1.10/E

Interest Rate Parity

Interest rate parity is the asset

equivalent of PPP. It states that

all assets should be expected to
earn the same return
For example, suppose that the
interest rate in the US is 5%,
the interest rate in Europe is
7%,, the current exchange rate
is $1.15/E and the anticipated
exchange rate in a year is
$1.10/E

Each $1 invested in the US will

be worth $1.05 in a year. How

about each $ invested in
Europe?

Interest Rate Parity

Interest rate parity is the asset

Each $1 invested in the US will

equivalent of PPP. It states that

all assets should be expected to
earn the same return
For example, suppose that the
interest rate in the US is 5%,
the interest rate in Europe is
7%,, the current exchange rate
is $1.15/E and the anticipated
exchange rate in a year is
$1.10/E

be worth $1.05 in a year. How

about each $1 invested in
Europe?
$1 = (1/1.15) = .87E
.87E(1.07) = .93E
.93E ($1.10/E) = $1.02

Interest Rate Parity

Interest rate parity is the asset

Each $1 invested in the US will

equivalent of PPP. It states that

all assets should be expected to
earn the same return
For example, suppose that the
interest rate in the US is 5%,
the interest rate in Europe is
7%,, the current exchange rate
is $1.15/E and the anticipated
exchange rate in a year is
$1.10/E

be worth $1.05 in a year. How

about each $1 invested in
Europe?
$1 = (1/1.15) = .87E
.87E(1.07) = .93E
.93E ($1.10/E) = $1.02
Even with the higher return in
Europe, the 5% appreciation of
the dollar makes the US asset a
better investment. Therefore,
funds will flow to the US.

Interest Rate Parity

Interest parity states that exchange rates should be

expected to adjust such that assets pay equal returns

across countries
(1+i) = (1+i*)(e/e)

Interest Rate Parity

Interest parity states that exchange rates should be

expected to adjust such that assets pay equal returns across

countries
(1+i) = (1+i*)(e/e)

A more useful form is

i i* = % change in e
For example, if the interest rate in the US is 5% and the
interest rate in Japan is 2%, the dollar should depreciate by
3% against the Yen

Interest Rate Parity

Interest parity states that exchange rates should be

expected to adjust such that assets pay equal returns across

countries
(1+i) = (1+i*)(e/e)

A more useful form is

i i* = % change in e
For example, if the interest rate in the US is 5% and the
interest rate in Japan is 2%, the dollar should depreciate by
3% against the Yen
Interest rate parity fails just as badly as PPP.

Interest Rate Parity & PPP

Recall that PPP gives the following:

% change in e = Inflation Inflation*

Interest Rate Parity & PPP

Recall that PPP gives the following:

% change in e = Inflation Inflation*

Interest Parity gives the following:
i i* = % change in e

Interest Rate Parity & PPP

Recall that PPP gives the following:

% change in e = Inflation Inflation*

Interest Parity gives the following:
i i* = % change in e
Combining them gives us
i i* = Inflation Inflation*

Interest Rate Parity & PPP

Recall that PPP gives the following:

% change in e = Inflation Inflation*

Interest Parity gives the following:
i i* = % change in e
Combining them gives us
i i* = Inflation Inflation*
i Inflation = i* - Inflation*

Interest Rate Parity & PPP

Recall that PPP gives the following:

% change in e = Inflation Inflation*

Interest Parity gives the following:
i i* = % change in e
Combining them gives us
i i* = Inflation Inflation*
i Inflation = i* - Inflation*
r = r*