Question 2

EC 100
Open Economy
Question 1
Define “exports” and “imports”. When do purchases
by LSE students of LSE housing accommodation
services constitute UK exports?
Question 1
• So basically, money earned abroad that is spent on
British products is an export.
• Even if it is spent in the UK!
• Hence, if you spend money earned abroad on UK
housing, it counts as an export.
Question 2
• When China’s economy runs a trade surplus, it
also experiences net capital outflows.
Describe how
Question 2
• Exports – imports = trade balance
– UK and US have large trade deficits, i.e.
– So their trade balance is negative
– China’s is positive
Trade balance, % of GDP
% of GDP
Source: World Bank World Development Indicators
Question 2
• So how do UK and US pay for this?!
• Capital inflows – Capital outflows = Capital flows
– Capital inflows are foreigners buying UK assets
– Outflows are UK citizens buying foreign assets
– So capital here means ownership of assets, not
physical capital
• Trade balance + capital flows = 0 (always!)
– This = 0 because trade balance and capital flows
always cancel each other out
– If you have a trade deficit, capital inflows must be
greater than capital outflows!
Question 2
So this is how UK and US pay for it!
Foreigners are buying UK assets.
We have net capital inflows.
This enables us to pay for the excess imports
we buy.
Britons have a huge demand for foreign goods—
on a broad measure the country imports far
more than it exports. So where does the U.K. find
the money to buy all this stuff?
Increasingly, an examination of fund-flow data
shows the answer is property. Foreigners
snapping up U.K. real estate have become a vital
source of cash. Simply put, the U.K. is selling
Belgravia to buy BMWs and swapping Islington
for iPods.
Question 2
• China is the “opposite” case
• It is running a trade surplus
– i.e. Exports>Imports
– Instead of needing (net) capital inflows to finance
excessive spending – like the UK and US do – it has
excessive saving
– It is consuming less than it is producing
– It puts this “excess saving” abroad
– Hence it has net capital outflows
– (Note: these net capital outflows are what enable
the UK and US to run trade deficits!).
Question 2
NCO and Exchange Rates
Y= C + I + G + EX - IM
Savings need not equal investment, as part of the
savings may be invested elsewhere. The
difference between savings and investment is
called net capital outflow. This equals the
country‘s trade balance!
Some of China‘s savings are being invested in the
UK and US
Question 3
• When China’s economy runs a trade surplus, it also experiences net
capital outflows. What does the phrase "capital flowing uphill"
• Chinese Trade Surplus means positive capital outflows; the Chinese
capital is flowing out of China to places with higher returns.
• Phenomenon of global capital flowing “uphill” means capital is
flowing from poorer to richer countries.
• This is the opposite of what traditional economic theory predicts!!
• One reason: China’s demand for assets cannot be met – in terms of
both quantity and quality – in China, so they deploy part of their
savings to countries like the US, which can offer a more diverse
array of quality assets.
• Alternative: specialization due to comparative advantage;
developing countries specialize on labour intensive goods, while
developed countries specialize in capital intensive goods. This
implies that returns to capital in developed countries are higher
than in less developed countries, explaining the observed capital
Question 4
• The Real Exchange Rate takes into account the
different price levels in countries.
• This is sensible, e.g. suppose you are soon going
to New York, and thinking of doing some
• You would want to know:
– The nominal exchange rate: so you can determine
how many dollars you will have to spend.
– The relative prices: so you can determine whether
clothes are cheaper in New York or London.
Question 4
• Hence:
• As UK price levels go up, the real exchange
rate appreciates.
• This implies UK goods become more expensive
relative to other goods (you need more USD
to purchase the same amount of UK goods
and services).
• This reduces export demand and increases
import demand
Question 5
• What would a government seek to regulate
the flow of goods and services across national
Question 6
• See class.
• In words:
Increasing money supply shifts LM curve to right.
This reduces r below “world equilibrium” level.
Hence large capital outflows (NCO).
This increases the supply of £, hence depreciates the
currency. (Prices may increase, which offsets this
effect on the RER, but assume this effect is smaller).
– This increases net exports. IS curve shifts to right.
– Hence, monetary policy highly effective under a
flexible exchange rate.
– Fiscal policy less effective than in closed economy.

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