İktisada Giriş II Open Economy Macro Chapter 6 Open-Economy Macroeconomics: Basic Concepts © 2007 Thomson South-WesternOpen-Economy Macroeconomics: Basic Concepts Open and Closed Economies ? A closed economy is one that does not interact ? with other economies in the world. There are no exports, no imports, and no capital ? flows for a closed economy. An open economy is one that trades goods, ? services and capital freely with other economies around the world. Open-Economy Macroeconomics: Basic Concepts 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. THE INTERNATIONAL FLOW OF GOODS AND CAPITAL The Flow of Goods: Exports, Imports, and Net ? Exports Turkey is an open economy — it imports and ? exports large quantities of goods and services. After 1980s, international trade and finance ? have become increasingly important. Trade liberalization : free flow of goods and ? services across borders. Financial liberalization : free flow of capital ? across borders. The Flow of Goods: Exports, Imports, Net Exports Net exports ( NX ) are the value of a nation’s ? exports minus the value of its imports. Net exports are also called the trade balance. ? A trade deficit is a situation in which net ? exports ( NX ) are negative. Turkey has traditionally had a trade deficit with the rest of the world. Trade deficit: Imports > Exports ?The Flow of Goods: Exports, Imports, Net Exports A trade surplus is a situation in which net ? exports ( NX ) are positive. During WW II years, Turkey had a trade surplus. Trade surplus: Exports > Imports ? Balanced trade refers to when net exports are ? zero — exports and imports are exactly equal.Turkey's foreign trade 0 10 000 000 20 000 000 30 000 000 40 000 000 50 000 000 60 000 000 70 000 000 80 000 000 90 000 000 100 000 000 110 000 000 120 000 000 130 000 000 140 000 000 150 000 000 1 9 2 3 1 9 2 7 1 9 3 1 1 9 3 5 1 9 3 9 1 9 4 3 1 9 4 7 1 9 5 1 1 9 5 5 1 9 5 9 1 9 6 3 1 9 6 7 1 9 7 1 1 9 7 5 1 9 7 9 1 9 8 3 1 9 8 7 1 9 9 1 1 9 9 5 1 9 9 9 2 0 0 3 exports imports 1000 $Turkey's Trade Deficit / GNP (%) 0.0 2.0 4.0 6.0 8.0 10.0 12.0 1 9 5 0 1 9 6 0 1 9 7 0 1 9 8 0 1 9 8 3 1 9 8 4 1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 ( 2 ) 1 9 9 7 ( 2 ) 1 9 9 8 ( 2 ) 1 9 9 9 ( 2 ) 2 0 0 0 ( 2 ) 2 0 0 1 ( 2 ) 2 0 0 2 ( 2 ) 2 0 0 3 ( 2 ) 2 0 0 4 ( 2 )Figure 1 The Internationalization of the U.S. Economy Percent of GDP 0 5 10 15 195 0 195 5 1960 1965 1970 1975 1980 1990 198 5 200 0 2005 1995 Imports ExportsThe Flow of Goods: Exports, Imports, Net Exports Factors That Affect Net Exports ? The prices of goods at home and abroad. If ? price of Turkish goods relative to other goods go up, what happens to NX? The exchange rates at which people can use ? domestic currency to buy foreign currencies. If lira appreciates, what happens to trade balance? The policies of the government toward ? international trade: tariffs and quotas on imports. İ f tariffs increase, what happens to NX?The Flow of Goods: Exports, Imports, Net Exports Factors That Affect Net Exports ? The incomes of consumers at home and ? abroad. If per capita GDP increases in Turkey relative to others, what happens to NX? The costs of transporting goods from country ? to country. İ f transportation costs decrease,.... The tastes of consumers for domestic and ? foreign goods. İ f Turks start liking Italian furniture, what happens? The Flow of Capital: Net Capital Outflow Net capital outflow (NCO) refers to the ? purchase of foreign assets (lending) by domestic residents (banks, firms, etc.) minus the purchase of domestic assets (lending) by foreigners. Two types: Foreign portfolio investment (FPI) ? and Foreign direct investment (FDI). Difference: FDI takes control of the enterprise, FPI does not. FPI is short term, FDI is long term. NCO is the opposite of Net Capital İ nflows ? (NCI): NCO = - NCI. Flow of Capital: FPI Examples: A Turkish firm buys stock in General Motors ? (+NCO) and a Mexican bank buys stocks of Vestel (-NCO). Turkish bank buys stocks of Telmex, the ? Mexican phone company, +NCO, -NCI. Japanese company buys a Turkish Treasury ? Bond, -NCO, +NCI. Turkish bank or firm borrows money from a ? foreign bank or firm (ex: Deutsche Bank), - NCO, +NCI. Akbank lends money to Albanian bank: +NCO, -NCI.Flow of Capital: FDI Examples: British company buys Migros: -NCO, +NCI. ? Bank of Greece buys Finansbank: -NCO, ? +NCI. Ko ç Holding buys Grundig: +NCO, -NCI. ?The Flow of Capital: Factors Variables that Influence NCO ? The real interest rates being paid on foreign ? assets affect FPI. How much (RIR) does the US Treasury Bond pay? (~1%) The real interest rates (RIR) being paid on ? domestic assets. How much RIR does Turkish treasury bond pay? (~13%) Currently, Turkish treasury bonds pay nominal ? 19%. İ f expected inflation is 6%, real interest rate is 13%: probably largest in the world.The Flow of Capital: Factors Variables that Influence NCO ? Risk of default (country risk) . The perceived ? economic and political risks of holding assets abroad. Russian government issued a moratorium (postponement of foreign debt repayments) in 1998. Foreign Investors pulled their money out of Russia: Capital Flight. The government policies that affect foreign ? ownership of domestic assets. Are there restrictions on foreigners buying Turkish banks, companies, land (FDI) or stocks, bonds (FPI)? The Equality of Net Exports and Net Capital Outflow For an economy as a whole, NX and NCO ? must balance each other so that: NCO = NX This holds true because every transaction that ? affects one side must also affect the other side by the same amount. Ex: When TR buys net imports of $100 worth of goods, must pay with some Turkish assets. The Equality of Net Exports and Net Capital Outflow NCO = NX Ex: Turkey’s imports exceed its exports by $ ? 52 billion in 2006. This means Turkey must sell something and receive dollars to pay for extra imports. Turkey sells stocks or bonds, i.e. ( Foreign portfolio investment ). Turkey borrows, foreigners lend. Or foreigners buy or start a company in Turkey ( foreign direct investment ). Then, NX = -$52 billion = NCO is negative, NCI is +52 billion. Saving, Investment, and Their Relationship to the International Flows Net exports is a component of GDP: ? Y = C + I + G + NX National saving is the income of the nation ? that is left after paying for current consumption and government purchases: Y – C – G = I + NXSaving, Investment, and Their Relationship to the International Flows National saving ( S ) equals Y – C – G so: ? S = I + NX or, since NX = NCO (-NCI), ? Saving Domestic Investment Net Capital Outflow = + S I NCO = +Table 1 International Flows of Goods and Capital: SummaryFigure 2: US National Saving, Domestic Investment, and Net Foreign Investment (a) National Saving and Domestic Investment (as a percentage of GDP) Percent of GDP 20 18 16 14 12 10 196 0 196 5 1995 1990 1985 1980 1975 1970 200 0 2005 National saving Domestic investmentFigure 2: US National Saving, Domestic Investment, and Net Foreign Investment (b) Net Capital Outflow (as a percentage of GDP) Percent of GDP 2 6 5 4 3 2 1 0 1 196 0 196 5 1995 1990 1985 1980 1975 197 0 200 0 2005 Net capital outflowThe Prices For International Transactions: Real And Nominal Exchange Rates International transactions are influenced by ? international prices. The two most important international prices ? are the nominal exchange rate and the real exchange rate.The nominal exchange rate is the rate at ? which a person can trade the currency of one country for the currency of another. Nominal Exchange RatesNominal Exchange Rates The nominal exchange rate is expressed in ? two ways: İ n units of TLs per one unit of the foreign ? currency (dollars): 1.34 TL/USD Or in units of foreign currency (dollars) per one ? YTL: 0.746 USD/TL Define E TL/USD as the nominal exchange rate. İ t ? shows how many TLs one can buy with 1 dollar.Nominal Exchange Rates Appreciation refers to an increase in the value ? of a currency as measured by the amount of foreign currency it can buy. Depreciation refers to a decrease in the value ? of a currency as measured by the amount of foreign currency it can buy.Nominal Exchange Rates (NER) Today, E YTL/USD = 1,28 TL/USD. If a crisis ? occurs and E YTL/USD = 1,38 TL/USD tomorrow, this means lira has appreciated or depreciated? If one lira buys less (more) dollars then there ? is a depreciation (appreciation) of the lira.How Are Exchange Rates Determined? The purchasing-power parity (PPP) theory is ? the most widely accepted theory of how exchange rates are determined in the long- run . PPP is based on the law of one price : The ? same goods must have the same price in all countries. Purchasing-Power Parity Theory 1 ton Turkish steel sold at 134 YTL is the ? same as 1 ton American steel sold for 100 dollar. So according to the law of one price, the exchange rate must be 1.34 YTL/dollar. (there is only one price of steel in the world). Assume tariffs and transportation costs are ? zero. Assume the goods produced in both countries ? are the same. Ex: Turkish steel is a perfect substitute for American steel. The Basic Logic of Purchasing- Power Parity If the law of one price were not true, then ? traders would buy from the cheap country and sell to the expensive country and make profit. This activity is called arbitrage . For example, if price of Turkish steel is 100 ? YTL and the price of American steel is 100 dollars. Then I would buy a lot of steel from Turkey and sell to the US. Everybody would do the same. The Basic Logic of Purchasing- Power Parity Then through arbitrage, price of steel in ? Turkey would increase and price of steel in US would increase and they would become equal. But in reality, many goods are not perfect ? substitutes. German tractors are not the same as Turkish tractors. Implications of Purchasing-Power Parity The nominal exchange rate between the ? currencies of two countries must reflect the different price levels in those countries: This means that if the price level increases 10 ? % in Turkey and 5 % in the US, lira will depreciate against dollar by 10-5 = 5%. US TUR USD YTL P P E ? /Implications of Purchasing-Power Parity When 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.Real Exchange Rates The real exchange rate ( RER ) is the ratio of ? prices of goods produced in Turkey and prices of goods produced in other countries. İ f law of one price and PPP theory is correct, ? then RER = 1 and constant. But real data tells us a different story.Real Exchange Rates If one Turkish tractor is 8000 euros and one ? German tractor is 10 000 euros, then the real exchange rate is 0,80 German tractor per Turkish tractor. RER GER/TUR = 0,80 German tractor/ Turkish tractor According to PPP, Real Exchange Rate must ? be equal to one because a lot of people would buy Turkish tractors and sell to Germany.Real Exchange Rates The real exchange rate depends on the ? nominal exchange rate and the prices of goods in the two countries measured in local currencies. RER US/TUR = P TUR / (E YTL/USD x P US )Real Exchange Rates Ex: Suppose price of one ton of US wheat is ? 100 dollars in US, and one ton of Turkish wheat is 145 TL in Turkey. Then RER US/TUR = = 145 TL/TRw. / (1,34 TL/USD x 100 USD/USw.) = 1,08 US wheat / Turkish wheatReal Exchange Rates RER is a key determinant of how much a ? country exports and imports. A depreciation (fall) in Turkey’s real exchange ? rate means that Turkish goods have become cheaper relative to foreign goods. This encourages consumers both at home ? and abroad to buy more Turkish goods and fewer goods from other countries. Turkish net exports increase.Real Exchange Rates As a result, Turkish exports rise, and Turkish ? imports fall, and both of these changes raise Turkish net exports. Conversely, an appreciation in the Turkish ? real exchange rate means that Turkish goods have become more expensive compared to foreign goods, so Turkish net exports fall. This is the situation these days because TL is appreciating against other currencies: E YTL/USD falling , RER US/TUR rising.Figure 3: Money, Prices, and the Nominal Exchange Rate During the German Hyperinflation 10,000,000,000 1,000,000,000,000,000 100,000 1 .00001 .0000000001 1921 1922 1923 1924 Exchange rate Money supply Price level 1925 Indexes (Jan. 1921 = 100)Critique of PPP Theory: Why PPP cannot explain NERs? Many goods are not easily traded or shipped 1. from one country to another. Ex: Haircuts, houses, etc. are nontradables . Tradable goods are not always perfect 2. substitutes when they are produced in different countries. İ s German cheese the same as Turkish cheese? Tastes are different. Tariffs and transportation costs are large. 3.