Macroeconomy - The open economy

K36
1. What are net capital outflow and trade balance? What is/ are their
relationship(s)?
2. Define nominal exchange rate and real exchange rate?
3. What is the relationship between real exchange rate and trade
balance?
4. What happens to saving, investment, trade balance, interest rate and
exchange rate if the government of a small open economy increases
government purchases?
5. What is the impact of protectionist trade policies on the real exchange
rate?
6. Explain the special case of Purchasing-Power-Parity?
7. Give example: low inflation in Japan and high inflation in Vietnam.
How does this effect on the exchange rate between the Japanese Yen
and Vietnamese Dong?

1.What are net capital outflow and trade balance? What is/ are their
relationship(s)?
Net Capital Outflow (NCO) is the net flow of funds being invested
abroad by a country during a certain period of time (usually a year). NCO
is one of two major ways of characterizing the nature of a country's
financial and economic interaction with the rest of the world
Y = C + I + G + NX
Y C G = I + NX

S
SI

=
=

I + NX
NX

Net Capital outflow = Net Export

Trade Balance (Net Export) is the value of all the goods

and services we sell to other countries (exports) minus the
value of all the goods and services we buy from foreigners
(imports) is called our trade balance.
Y = C + I + G + NX
Y - C - G = I + NX

NX = Y (C+G+I)
Net Exports = Output domestic spending

S I = NX > 0 Trade surplus

S

S I = NX < 0 Trade deficit

2. Define nominal exchange rate and real exchange rate?

The exchange rate expresses the national currency's quotation in
respect to foreign ones. For example, if one US dollar is worth 10 000
Japanese Yen, then the exchange rate of dollar is 10 000 Yen. If something
costs 30 000 Yen, it automatically costs 3 US dollars as a matter of
accountancy.

Use indirect/ quantity

quotation
the exchange rate is a conversion factor, a multiplier or a
ratio, depending on the direction of conversion.

Nominal exchange rates are established on currency financial markets

called "forex markets", is the relative price of the currency of 2 countries.
For example exchange rate between Yen and Dollar is 120 Yen per Dollar
one can exchange one Dollar for 120 Yen.
Real exchange rate is the relative price of the goods of two countries. It
tells us the rate at which we can trade goods of one country for the goods of
another
Real exchange rate = Nominal exchange rate x Price of domestic goods
Price of foreign goods
= Nominal exchange rate x Ratio of price level
= Nominal exchange rate x ( P / P*)
(P = P domestic; P* = P foreign)

If real exchange rate is high foreign goods are relatively cheap

If real exchange rate is low foreign goods are relatively expensive

Base
currency/ unit
currency

Quote
currency/
Price
currency

VND / USD Exchange rate = 20.500 1 USD = 20.500 VND

Quotes using a country's home currency as the price currency

(e.g., EUR 0.735342 = USD 1.00 in the euro zone) are known as
direct quotation or price quotation (from that country's
perspective) and are used by most countries.
Quotes using a country's home currency as the unit currency
(e.g., EUR 1.00 = USD 1.35991 in the euro zone) are known as
indirect quotation or quantity quotation and are used
common in USA, EAustralia, New Zealand and the.

3. What is the relationship between real exchange rate and trade

balance?
Real exchange rate
e

NX (e)
Net exports (NX)
(Trade balance)
Real exchange rate = Nominal exchange rate x ( P /
P*)
P P / P* Asumme nominale exchange rate const Real exchange
rate
and
P (domestic inflation) Domestic goods relatively more expensive than
foreign goods Cost disadvantage for domestic goods EX and IM
NX
Real Exchange rat NX and Real exchange rate NX

4. What happens to saving, investment, trade balance, interest rate and

exchange rate if the government of a small open economy increases
government purchases?
Real exchange rate
e

2. and rises the

real exchange
rate. Domestic is
more expansive
E2
than foreign
goods

S2 I

S1 - I

1. A expansionary
fiscal policy reduces
savings and leads to
higher domestic
price and inflation

e1
NX (e)
3. and leads to
fall of Net Export

NX2

NX1

Net Export (NX)

(Trade balance)

5.What is the impact of protectionist trade policies on the real exchange

rate?
S-I
2. and rises the real
exchange rate. Because
demand for, domestic
goods domestic
goods relatively more
expensive

3. and leaves
the Net exports
unchanged,
because this policy
does not affect on
Savings or
Investment

e2

1. A protectionary
trade policy raises
the Net Exports
because it
reduces Imports

e1
NX (e)2
NX (e)1

6. Explain the special case of Purchasing-Power-Parity?

The exchange rate adjusts so that an identical good in two different
countries has the same price when expressed in the same currency
The relative version of PPP is calculated as

An economic theory that estimates the amount of adjustment

needed on the exchange rate between countries in order for the exchange
to be equivalent to each currency's purchasing power.

Also called the Big Mac index

Example (www.wikipedia.org/):
using figures in July 2008:[4]
1. the price of a Big Mac was $3.57 in the United States (Varies by store)
2. the price of a Big Mac was 2.29 in the United Kingdom (Britain)
(Varies by region)
3. the implied purchasing power parity was $1.56 to 1, that is
$3.57/2.29 = 1.56
4. this compares with an actual exchange rate of $2.00 to 1 at the time
5. [(2.00-1.56)/1.56]*100= +28%
6. the pound was thus overvalued against the dollar by 28%

7. Give example: low inflation in Japan and high inflation in Vietnam.

How does this effect on the exchange rate between the Japanese Yen
and Vietnamese Dong?

1 JPY can buy more VND

VND/JPY exchange rate = 255 1JPY = 255 VND

(direct/ price quotation)

JPY/VND exchange rate = 1/255 = 0,0039 1 VND = 0,0039 JPY

(indirect / quantity quotation)

Low inflation in Japan and high inflation in Vietnam Pvn > Pjp
Assume constant nominal exchange rate real exchange rate
Real exchange rate = Nominal exchange rate x Price of domestic goods
Price of foreign goods
const

The worth of
domestic
currency
foreign
curreny
currency

Indirect /
quantity
quotation:
1VND = x JPY