Economics: What's my Dollar Worth in Other Countries?

In earlier chapters for simplicity we assumed that economies were closed. In reality, most economies are open economies that interact freely with foreign economies. 

Recall the definition of exports, goods/services produced domestically and sold abroad, and imports, goods/services produced produced abroad and sold domestically. Net exports is then exports - imports. Net exports is also called trade balance. If NX is positive, there is a trade surplus. If NX is negative, there is a trade deficit. If NX = 0, there is balanced trade. Factors of net exports include:

• consumer tastes of foreign/domestic goods
• domestic/foreign prices
• exchange rate of currencies
• income of consumers here and there
• costs of transportation

Net capital outflow (NCO) is purchase of foreign assets domestically - purchase of domestic assets from abroad; it's also called net foreign investment. Outflow comes in 2 forms: foreign direct investment (like opening a restaurant in Paraguay) and foreign portfolio investment (buying stock for a Bangladeshi company). The buyer has more control in the former. If NCO is negative, it's also called net capital inflow. Factors of NCO include:

• real interest rates on foreign/domestic assets
• perceived economic/political risks of holding assets abroad
• government policies that affect affect foreign ownership of domestic assets

An important identity is NCO = NX. For review, NX is the imbalance of exports over imports and NCO is the imbalance of foreign investment from domestic residents over domestic investment from foreigners. As an example, suppose you sold a computer to someone in Japan and get 10,000 yen. NX increases, and now you have the Japanese currency. Whatever you do with that money, you are investing in the Japanese economy, whether you put it in Japanese stock or give it to a bank to use; this makes NCO increase by the same amount.

Recall that Y = GDP, C = consumption, I = investment, G = gov. purchases. Y = C + I + G + NX. Then, Y - C - G = I + NX. Finally, S = I + NX where S = savings. Earlier we assumed NX = 0 in closed economies to make S = I. Now we see that S = I + NX or S = I + NCO. An economy uses saving for domestic investment and net capital outflow.

Now we move on to real and nominal exchange rates. The nominal exchange rate is the rate where one person can change a currency of one country for another. 80 yen per dollar is an example. Appreciation of a currency occurs if the currency fetches more of another currency, e.g. now it is 90 yen per dollar so the dollar appreciates. Depreciation occurs when the currency fetches less; e.g. the yen in the example scenario depreciates. The real exchange rate compares 2 goods/services of 2 countries. For example, 1 lb. of Swiss cheese for 2 lbs. of American cheese. It is calculated by nominal exchange rate * domestic price / foreign price. (Basically exchange the price of the domestic good into foreign price and divide by the actual foreign price).

Purchasing-power parity states that any unit of currency fetches the same real value everywhere. This is also called the Law of One Price. The logic behind this is that if, say, coffee is valued and priced more at Chicago than Miami, people would use arbitrage (selling the same product in different markets for profit) and move coffee from CHI to MIA. Then the price in CHI drops and the price in MIA rises to fulfill the law of supply and demand. This makes the prices equal in the end. Assuming purchasing-power parity, then nominal exchange rate equals foreign price / domestic price, and reflects the price levels of the countries.

The purchasing-power parity has limitations though. The first reason is that not all goods are easily traded. For example, if haircuts costs more in Paris, some travelers might not get haircuts in Paris and some hair cutters might move to Paris, but the differences might not be enough. Another reason is that there might be imperfect substitutes. For example, people could prefer German cars over American cars and pay more for them. Generally, the purchasing-power parity works alright and can predict nominal exchange rate pretty closely.