Ch 31. Open Economy Macroeconomics

.title[
# Ch 31. Open Economy Macroeconomics
]
.subtitle[
## Macroeconomics for Students of Accounting, Finance and Digital Applications
]
.author[
### Lyuben Ivanov, PhD; Georgy Ganev, PhD
]
.institute[
### Sofia University St Kliment Ohridski
]
.date[
### May 9, 2024
]

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.pull-right[
_We had to make ourselves a small but nevertheless useful part in the international system of the exchange of goods and services, of investments, banking and finance, transportation and communications..._
<hr style="background-color: black; margin: 0em 0em 0em 0em;">
<span style="float: right; font-variant: small-caps; ">Lee Kuan Yew (1996) &nbsp;</span>
]

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<hr>

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# Small Open Economy

The Bulgarian economy can be classified as a “small open
economy”.

“Open” is an economy with relatively low barriers to trade of
goods and services with the rest of the world, and for which
the flow of traded goods and services is relatively large
compared to overall economic activity.

“Small” is an economy whose internal economic processes
cannot in any way influence world terms of trade of the
respective good because its domestic volumes are
microscopically small compared to world volumes.

A small open economy takes the world prices and its internal
prices become equal to world prices, plus-minus transportation
and similar costs.

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# Trade Openness Index

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<hr>

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# Net Exports

**Net exports**<br>
The difference between exports from and
imports into a country.

**Exports**<br>
The value of factors of production, goods and services
produced inside a country but sold outside.

**Imports**<br>
The value of factors of production, goods and services
produced outside a country but sold inside.

Three possible states of net exports:
- Trade surplus
- Balanced trade
- Trade deficit

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# Bulgaria's External Trade 1991-2022

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<hr>
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# Net Capital Outflow

Every acquisition of foreign assets by Bulgarian residents
(the relevant criterion is place of residence, not
nationality) forms a **capital outflow**.

Every acquisition of Bulgarian assets by foreign residents
(residing outside Bulgaria regardless of nationality) forms
a **capital inflow**.

The flow of capital can take one of two possible forms:

- foreign direct investment – acquisition of control over real assets, e.g. a
house, land, a factory;

- foreign portfolio investment – acquisition of a financial asset –
e.g. a share in a company, a debt instrument, the country’s
currency, or a deposit in a bank in the country.

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# Identity of NX and NCO

<center> <b>Net exports &equiv; Net capital outflow </b></center>

When a country has a trade surplus more factors of production, goods and
services are produced internally and sold externally than are
produced externally and sold internally. This necessarily means
that residents of the country are on net acquiring assets, rather
than factors of production, goods and services, abroad, which is by definition
a positive net capital outflow.

When a country has a trade deficit, more factors of production, goods and
services are produced externally and sold internally than are
produced internally and sold externally. This necessarily means
that residents from abroad are on net acquiring assets, rather
than factors of production, goods and services, in the country, which is by
definition a negative net capital outflow (i.e. a net capital
inflow).

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<hr>

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# The Use of Domestic Savings
<br>
<br>

&nbsp; &nbsp; &nbsp; **GDP &equiv; C + I + G + NX**

&nbsp; &nbsp; &nbsp; **GDP - C - G &equiv; I + NX**

&nbsp; &nbsp; &nbsp; **S &equiv; I + NX**

&nbsp; &nbsp; &nbsp; **S &equiv; I + NCO**

The last identity, which is true by definition, shows
that the economic interaction of a country with the rest of the world
is linked to saving and investment (capital
formation) within the country!

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# Summary

<br>

<tr>
<th>Trade DEFICIT</th> <th> BALANCED Trade </th> <th>Trade SURPLUS</th>
</tr>

<tr>
<td>Exports < Imports</td> <td>Exports = Imports</td> <td>Exports > Imports</td>
</tr>

<tr>
<td> Net exports < 0 </td> <td> Net exports = 0 </td> <td> Net exports > 0 </td>
</tr>

</table>

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# NCO Bulgaria 1990-2022

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<hr>

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# Definitions
<br>
**Nominal exchange rate**<br>
The number of units of a foreign currency needed to by one unit of the
domestic currency.

**Real exchange rate**<br>
The number of units of a foreign good or service needed to buy one
unit of a the respective domestic good or service.

<br>
$$ \sf \text{Real exchange rate} = \frac{\text{Nominal exchange rate}\times\text{Domestic price}}{\text{Foreign price}} $$
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# Purchasing Power Parity

<br>

When there are large differences between the purchasing power of identical
nominal amounts of money in different places in the world, economic agents can
realize large profits by buying things in places they are relatively cheap and
transporting and selling them in places where they are relatively expensive.

This activity of profiting from different real prices in different places is called
“arbitrage”.

Arbitrage necessarily leads to higher quantities demanded of the currency where
the good is relatively cheap, and to higher quantities supplied of the currency where
the good is relatively expensive.

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# Purchasing Power Parity

<br>
<br>
As a consequence the currency of the country where the good was cheap
appreciates relative to the the currency of the country where the good was
expensive.

The process continues until the real exchange rate between the two currencies is
approximately 1, i.e. the same amount of either currency has approximately the
same purchasing power in both places.

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# Implications

A simple hypothesis: **Real exchange rate &approx; 1**

$$ \sf \frac{\text{Nominal exchange rate} \times \text{Domestic price level}}{\text{Foreign price level}} \approx 1$$

Implication of the simple hypothesis:

`$$\sf \%\Delta \text{ Nominal exchange rate} \approx$$`

$$\sf \%\Delta \text{ Foreign price level} - \%\Delta \text{ Domestic price level} $$
Therefore,

$$\sf \%\Delta \text{ Nominal exchange rate} > 0 $$

$$\sf \implies \%\Delta \text{ Foreign price level} > \%\Delta \text{ Domestic price level} $$
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# Implications

According to the theory of purchasing power parity the nominal
exchange rate is approximately equal to the ratio between prices (or
general price level) abroad and prices (or general price level) at home.

Thus with time the currency of a country with consistently higher
inflation than another country or the world will depreciate, while the
currency of a country with lower inflation will appreciate.

When a country’s central bank creates too much
money too fast, domestic price level will rise relatively
fast.

If this continues for a sufficiently long time, the
currency of the country will depreciate with respect to
the currencies in countries with more stable price
level.

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# The Limits of Arbitrage

Some goods, especially services, are non-tradable and
cannot be subjected to arbitrage to a degree sufficient
to lead to one price.

Even the tradable goods are subject to transportation costs
and other barriers to trade, limiting the extent to which
arbitrage can equalize prices.

The exchange rate, especially in the short run, is
determined by financial flows, and they are volatile because they
depend on expectations and financial market yields.

Nevertheless, when there is rapid increase in the money supply, resulting in 
hyperinflation, the effect described by the purchasing power parity theory
dominates all other factors (including government intervention!).

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# Prices and Exchange Rate in Bulgaria

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# Questions?

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# Thank You!

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