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Economics: Macroeconomics

Explain why net exports and net capital outflow are always equal

There are two fundamental platforms on which an open economy interacts with the world -- the world financial market and the world product market. Net capital outflow (NCO) measures the imbalance in the product market -- it is the difference between the value of domestic assets purchased by foreigners, and the foreign assets purchased by a country's residents. Net exports (NE), on the other hand, is the difference between a country's imports and its exports (Mankiw, 2014). The two must always be equal (NCO=NE) because any transaction that affects the product market affects the financial market by the very same amount.

Illustration: we can take the example of a software programmer resident in the U.S., who develops a computer program and sells it to a consumer in Japan for 20,000 yen. The transfer of the program to the Japanese customer is an export to the U.S., and it causes an increase in the country's net export (NE) level. So, what then does the computer programmer do with the 20,000 yen he receive from the Japanese client? We could consider three different options -- first, that he just stores the same in his home-made savings, in which case he (a domestic resident) will have acquired a foreign product/asset (the Yen), thereby using his income to make an investment in Japan's economy (capital outflow), and causing an equal increase in America's net capital outflow. Similarly, he could invest the same directly in the Japanese economy by purchasing a Japanese government bond for the full value of the amount received from the sale of software. In the two cases above, the amount of capital invested in the Japanese economy in the form of assets or stocks is equal to the increase in the NE level acquired from the sale of software. More realistically, he could use the Yen to purchase a car manufactured in Japan (import to the U.S.), in which case there would be a balanced trade (increase in exports equal to increase in imports) such that the net export level remains unchanged and there is no effect on net capital outflow as the foreign asset acquired by the domestic resident and the domestic asset acquired by the foreigner cancel out.

1. Explain why higher real interest rates lead to lower net capital outflow

The real interest rate basically refers to nominal interest rate that has been adjusted for inflation. It is calculated as: nominal interest rate -- inflation. Just as is the case in a closed economy, the real interest rate in an open economy is determined by the demand for and supply of loanable funds in the economy, which are in turn determined by the level of NCO and domestic investment and the level of savings, respectively. Equilibrium is achieved at that rate of real interest at which the amount of savings (supply of loanable funds) balances that which people require for investment purposes, and using which they can either invest in foreign assets or in domestic capital (demand for loanable funds) (quadrant a).

Net capital outflow = domestic assets purchased by foreigners -- foreign assets purchased by residents

When the real interest rate is higher, domestic assets become more attractive than foreign assets; and when people invest more in domestic assets, the level of outgoing capital (net capital outflow) falls, as shown in fig 1 below.

(a) the market for loanable funds (b) net capital outflow r Dd0 SS1 SS0 r

R1 E1 R1

Re Re

SS1 E0

NCO

SS0 Dd0

L1 Le NCO

The market is in equilibrium at interest rate r0 and at NCO level Le. Following a decline in the level of savings in the economy, there is less money to lend out to borrowers, as indicated by the inward shift of the loanable funds supply curve from S0S0 to S1S1. The demand for loanable funds is, however, not affected, and a new equilibrium is created at E1, in which case the new supply curve S1S1 crosscuts the demand curve D1D1. The new equilibrium is associated with a higher real interest rate r1, meant to discourage borrowers from seeking out loans; and consequently, the level of net capital outflow falls from Le to L1.

2. What is the implication for the real exchange rate if the PPP condition holds? Under what circumstances does the PPP theory Explain how exchange rates are determined, and why is it not completely accurate all the time?

The PPP theory holds that equilibrium between two currencies is achieved when the exchange rate between the two is equal to "the ratio of the countries' price levels" (Reinert, et al., 2009, p. 941). At the PPP exchange rate, therefore, the purchasing power of one unit of currency in one country is essentially similar to that in the other country. In other words, goods cost the same in the two countries, and the individual currencies work more or less like a common currency. The PPP is based on the 'law of one price', which suggests that in the absence of transaction costs such as transportation, the price of a commodity in one country would equal that in another as long as the prices are expressed in a common currency (Reinert, et al., 2009). There are two versions of PPP- relative PPP and absolute PPP (Reinert, et al., 2009). PPP theory is mainly associated with the absolute version, which is given by;

S= p -- p* where'd is the PPP exchange rate; and "p and p* are the domestic and foreign price indices respectively" (Reinert, et al., 2009). If the domestic price index rises above the foreign price index, the domestic/local currency depreciates, and vice versa. Towards this end, if absolute PPP is to hold, movements in p - p* must be matched by equal movements in the exchange rate. The relative price (p -- p*) is used in making adjustments to the nominal exchange rate so as to obtain the real exchange rate, which is the "nominal exchange adjusted for relative price differences" (Reinert, et al., 2009). When PPP holds, "the real exchange rate is constant," and any movements in the rate can then be rightly interpreted as deviations from the PPP exchange rate (Reinert, et al., 2009, p. 943).

It is, however, almost impossible to have a constant exchange rate in reality. PPP has been found to be reasonably accurate in determining the exchange rate when used in the long-run, because then the rate of exchange as well as the relative prices will have had enough time to readjust, correct deviations from parity, and restore equilibrium (Reinert, et al., 2009).

PPP, however, has two major weaknesses that impede on its ability to accurately predict exchange rates. First, not all goods are easily tradeable, and secondly, even those goods that are easily tradeable may not always act as perfect substitutes when produced in different economies; and as such, price relativity and price comparisons may be impractical.

3. Describe whether each of the following groups will be happy or unhappy if the U.S. dollar depreciates:

i) The People's Bank of China, which holds U.S. government bonds

The Central Bank of China, in this case a lender to the U.S. government, would be unhappy if the dollar depreciates because that would mean that its value would fall relative to the Chinese Yuan, and consequently, the value of their holdings (U.S. governments bonds in this case) would fall. In the end, the Chinese government would obtain lower yields in the form of interest on their Treasury securities than they would have otherwise gained if the dollar had remained stable or appreciated.

ii) The U.S. manufacturing industry

The manufacturing industry would be happy if the dollar depreciates. Depreciation of the dollar represents a loss of value in the currency and any securities (bonds or stocks pegged on the dollar) held by both domestic and foreign investors. This would basically mean that domestic bonds would become less attractive in terms of potential returns; and as a result, investors will want to reduce their holdings of domestic securities and either increase their investment in foreign securities or hold their money in cash. This would cause an increase in money supply (money circulating in the economy), and interest rates would fall as a result. The U.S. manufacturing industry would benefit from the lower interest rates as borrowing will be cheaper.

iii) Mainland Chinese tourists planning a trip to the U.S.

This group would be disadvantaged if the dollar depreciates. To begin with, such depreciation would mean that the value of the dollar would fall relative to that of the Yuan, and a result, the tourists are deemed to obtain less in terms of U.S. dollars than they otherwise would have when they trade in their Yuans for dollars during their trip. Moreover, the tourists will have to deal with inflation occasioned by high levels of money supply and falling rates of interest in the U.S. economy; and this… [END OF PREVIEW]

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