Unit 5 Open-economy macroeconomics: Basic concepts
1. Net exports are the value of exports minus the value of imports. It represent the international flow of goods and service. Net capital outflow is the home residents’ purchase of foreign assets minus the foreign residents’ purchase of domestic assets. Net exports are always equal to net capital outflow because every international transaction is an exchange.
2. An economy’s saving can either be used to invest in the domestic market or to finance the purchase of capital from another country. Thus, an open economy’s saving is equal to domestic investment plus the net capital outflow.
3. The balance of payments records the transactions of the residents of a country with the rest of the world.
4. In a nation’s balance of payments, any transaction that supplies the country’s currency in the foreign exchange market is recorded as a debit (-). Any transaction that creates a demand for the country’s currency is recorded as a credit (+).
5. The two main components of the Malaysian balance of payments are the current account, capital and the financial accounts.
6. The current account provides all international transactions in goods, services, incomes and current transfers.
7. The capital and f inancial accounts consist of two major components " the capital account and the financial account.
8. The capital account records relatively minor transactions such as migrants’ transfers, and sales and purchases of non-produced and non-financial assets.
9. The financial account records purchases of assets a country has made abroad and foreign purchases of assets in the country.
10. A nominal exchange rate is the rate at which one buys a country’s currency using another country’s currency. Your text uses the convention of writing in units of foreign currency per unit domestic currency to denote exchange rates.
11. When one unit of domestic currency buys more units of foreign currency (or when the value of the domestic currency goes up), we say the local currency appreciates against the foreign currency. When one unit of domestic currency buys fewer units of foreign currency (or when the value of the domestic currency goes down), we say the local currency depreciates against the foreign currency.
12. Under a flexible exchange rate system, the equilibrium exchange rate can be influenced by a difference in the level of income between countries, a difference in inflation rates between countries and a change in interest rates between countries.
13. Under a fixed exchange rate system, a country agrees to fix the price of its currency. The central bank of that country must then buy and sell currencies to maintain the agreed-on exchange rate.
14. A currency is overvalued if its price in terms of other currencies is above the equilibrium price.
15. A currency is undervalued if its price in terms of other currencies is below the equilibrium price.
16. Real exchange rate = Nominal exchange rate × (Domestic price / Foreign price). In symbols, the real exchange rate = e × P / P*, where e, P and P* denote the nominal exchange rate, the domestic price level and the foreign price level, respectively.
17. The real exchange rate measures the relative cost of a basket of goods and services in the home economy relative to that in the foreign country.
18. When the domestic currency appreciates in terms of the real exchange rate, the relative cost of goods and services rises in the domestic economy.
19. When the real exchange rate appreciates, domestic goods and services become more expensive relative to foreign goods and services. So, the net exports of goods and services fall. Conversely, when the real exchange rate depreciates, domestic goods and services become cheaper relative to foreign goods and services. So, the net exports of goods and services rise.
20. The law of one price says that the same good (or service) sells at the same price in all markets. The prices of the same good in different markets will converge because of the arbitrage motive.
21. Purchasing-power parity (PPP) says that a unit of any currency should have the same purchasing power in all economies.
22. By PPP, the real exchange rate of a currency equals to e × P / P* and should be 1.
23. According to PPP, the nominal exchange rate of a foreign currency should equal the relative price level in the foreign economy relative to the domestic economy (e = P* / P).
24. The main reason why PPP does not hold in most cases is that many goods and services are not tradable.
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