SOM607 Macroeconomics

Sarthak Gaurav

November 3, 2023

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 1 / 16

 Learning Objectives

Relationship between international flows of goods and assets

Nominal and Real Exchange Rate
Purchasing-power parity and exchange rates

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 2 / 16

 Factors influencing Exports

Consumers’ preferences for foreign and domestic goods

Prices of goods: Dometic and abroad
Incomes: Domestic and abroad
The exchange rates at which foreign currency trades for domestic
currency
Transportation costs
Government policies
Geopolitical factors

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 3 / 16

 Flow of Capital

Net capital outflow (NCO): also called net foreign investment

NCO= Domestic residents’ purchases of foreign assets minus
Foreigners’ purchases of domestic assets
The flow of capital abroad takes two forms: FDI and FPI
NCO measures the imbalance in a country’s trade in assets
NCO > 0, “capital outflow” i.e. Domestic purchases of foreign assets
exceed foreign purchases of domestic assets
NCO < 0, “capital inflow” Foreign purchases of domestic assets
exceed domestic purchases of foreign assets

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 4 / 16

 Factors Influencing NCO

Real interest rates paid on foreign assets

Real interest rates paid on domestic assets
Asst risks
Policies affecting asset ownership fore foreigners in home country and
vice-versa

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 5 / 16

 NX=NCO: Accounting Identity

Every transaction that affects NX also affects NCO by the same

amount (and vice versa)
When a foreigner purchases a good from India, India’s exports and NX
increase and the foreigner pays with their currency or assets
So India acquires some foreign assets. This causes NCO to rise
When an Indian citizen buys foreign goods, India’s imports rise, and
NX falls
So the Indian buyer pays with rupees or assets. The other country
acquires Indian assets. This causes India’s NCO to fall

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 6 / 16

 Saving, Investment, and NCO

When S > I, NCO > 0 : The excess loanable funds flow abroad in the
form of positive net capital outfloW
When S < I, foreigners are financing India’s investment, and NCO < 0
We discussed about the large trade deficit of US. What can you infer
about its NCO? Does ROW hold on to more US assets or US residents
hold more foreign assets? Is it linked to the debt story of US?

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 7 / 16

 Nominal Exchange Rate

Nominal exchange rate (e): the rate at which one country’s

currency trades for another
Let us express exchange rates as foreign currency per unit of domestic
currency. i.e. Dollar per Rupee and not Rupee per dollar for notation
consistency
1 INR=0.012 USD

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 8 / 16

 Appreciation (or “strengthening”): an increase in the value of a
currency as measured by the amount of foreign currency it can buy
e goes up
Depreciation (or “weakening”): a decrease in the value of a currency as
measured by the amount of foreign currency it can buy
e goes down

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 9 / 16

 Real Exchange Rate

Real exchange rate (R): the rate at which goods and services of one
country trade for the goods and services of another

e.P
R=
P∗

where
R = real exchange rate
P = domestic price
P* = foreign price (in foreign currency)
e = nominal exchange rate, i.e., foreign currency per unit of domestic
currency

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 10 / 16

 Interpreting Real Exchange Rate

A Big Mac costs 5 USD in U.S., and 500 yen in Japan

e = 150 yen per USD (From US perspective)
e.P = price in yen of a U.S. Big Mac = (150 yen per USD) x (5 USD
per Big Mac) = 750 yen per U.S. Big Mac
What is the real exchange rate, measured as Japanese Big Macs as US
Big Macs? Think of Japanese Big Macs per US Big Mac
To buy a Big Mac in the U.S., a Japanese citizen must give up an
amount that could purchase R Big Macs in Japan

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 11 / 16

 Multiple Goods and Real Exchange Rate

Price of a domestic basket of goods relative to price of a foreign basket of

goods

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 12 / 16

 Purchasing-power parity: a theory of exchange rates whereby a unit
of any currency should be able to buy the same quantity (or basket) of
goods in all countries
based on the law of one price (think of arbitrage)
nominal exchange rates adjust to equalize the price of a basket of
goods across countries
e.P=P∗
where, P= Price of Indian Big Mac in INR (or Cost of domestic basket in
domestic currency), P*=Price of US Big Mac in USD (or Cost of foreign
basked in foreign currency
eP is thus the Price of Indian Big Mac in USD (or Cost of domestic basket
in foreign currency)
Solve for e
P∗
e=
P

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 13 / 16

 PPP

PPP implies that the nominal exchange rate between two countries equals
the ratio of price levels of the two countries

If the two countries have different inflation rates, then e will change over
time:

If inflation is higher in India than in the US, then P rises faster than Pˆ, so
e falls, implying depreciation of rupee

If inflation is lower in India than in the US, then Pˆ rises faster than P, so e
rises, leading to the rupee appreciation of rupee against dollar

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 14 / 16

 Big Mac Index

https://en.wikipedia.org/wiki/BigM acI ndex

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 15 / 16
 Limitations of PPP and Big Mac Index

What could be the issues with PPP and Big Mac Index?

Issues with PPP in the real world: Domestic baskets and Foreign
baskets are not perfect substitutes ; Non-tradable goods and transportation
costs are significant

See https://www.economist.com/big-mac-index

Sarthak Gaurav (SJMSOM, IIT Bombay) SOM607 Macroeconomics November 3, 2023 16 / 16