Chapter 12 Flashcards
OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS
So far, our study of macroeconomics has largely ignored the economy’s interaction with other economies around the world.
One of the ten principles of economics is that trade can make everyone better off.
The study of an open economy raises new issues.
OPEN-ECONOMY MACROECONOMICS: Open vs. Closed Economy
Closed economy is an economy that does not interact with other economies in the world.
Open economy is an economy that interacts freely with other economies around the world.
THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL
The Flow of Goods:
Exports, Imports, and Net Exports
An open economy interacts with other economies in two ways:
* It buys and sells goods and services in world product markets.
* It buys and sells capital assets such as stocks and bonds in world financial markets.
These two activities, as well as the close relationship between them, are discussed here.
THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL Part 2
Exports are goods and services that are produced domestically and sold abroad.
Imports are goods and services that are produced abroad and sold domestically.
Net exports (or trade balance) is the value of a nation’s exports minus the value of its imports. NX (X - M)
THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL: Trade Surplus, Trade Deficit, Balanced Trade
Trade surplus is an excess of exports over imports.
Trade deficit is an excess of imports over exports.
Balanced trade is a situation in which exports equal imports.
FIGURE 12.1 The Internationalization of the Canadian Economy
So the thing to look at your total imports, total exports and imports from United States and exports from the United States in relation to the Canadian economy.
It is important to note that in 2000, at least 50% of our GDP came from total exports.
(Instructor’s Note)
An important change in the Canadian economy since 1960 has been the increasing importance of international trade and finance.
The Flow of Financial Resources: Net Capital Outflow
Net capital outflow (NCO) is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
Some of the variables that influence NCO:
- Real interest rates being paid on foreign assets (Canadian more interested in 10% US interest rate than 5% CAD)
- Real interest rates being paid on domestic assets (Canadian more interested in 10% CAD interest rate than 5% US)
- Perceived economic and political risks of holding assets abroad (Some countries can promise higher returns but they could be war torn and you could never see that money)
- Government policies that affect foreign ownership of domestic assets (You never want to sell missles or essential things to foreign as they could use it against you if the time comes)
The Equality of Net Exports and Net Capital Outflow
Net exports measure an imbalance between a country’s exports and its imports.
Net capital outflow measures an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners.
NCO always equals NX:
NCO = NX
The Equality of NX and NCO Part 2: NX > 0
NX > 0: Trade Surplus
The country is selling more goods and services to foreigners than it is buying from them.
What is it doing with the foreign currency it receives from the net sale of goods and services abroad?
It must be using it to buy foreign assets.
Capital is flowing out of the country (i.e., NCO > 0).
The Equality of NX and NCO Part 3: NX < 0
NX < 0: Trade Deficit
The country is buying more goods and services from foreigners than it is selling to them.
How is it financing the net purchase of these goods and services in world markets?
It must be selling assets abroad.
Capital is flowing into the country (i.e., NCO < 0).
Trade Deficit
Export < Import
NX < 0
Y < C + I + G
S < I
NCO < 0
Balanced Trade
Export = Import
NX = 0
Y = C + I + G
S = I
NCO = 0
Trade Surplus
Export > Import
NX > 0
Y > C + I + G
S > I
NCO > 0
Saving, Investment, and Their Relationship
to the International Flows
Closed Economy: NCO = 0, S = I
Open Econony:
Y = C + I + G + NX
Y - C - G = I + NX
S = I + NX
S = I + NCO
Figure 12.2 National Saving, Domestic Investment, NCO
The graph. On the Left shows domestic investment in national saving as a percentage of GDP.
You can see that kind of move together in the same pattern. In that even at its peak for domestic investment, it only made-up 30% of GDP.
The graph on the right shows net capital outflow as a percentage of GDP.
From 1999 to 2008, net capital outflow turn positive thanks to increase in National Savings that made it possible for Canadians to not only satisfy the demand for domestic investment, but also to purchase foreign assets.
The prices for international transactions: real and nominal exchange rates.
Two important international prices are discussed here:
The nominal exchange rate. The real exchange rate.
Nominal Exchange Rate, Appreciation, Depreciation
Nominal exchange rates: The rate at which a person can trade the currency of one country for the currency of another.
* And remember, it would make sense that this is working with currency. And not real exchange rate as nominal is really looking at monetary values.
Appreciation: The increase in the value of a currency as measured by the amount of foreign currency it can buy.
* When appreciation happens, there’s a decrease in the exchange rate as now we need less money to buy the same amount.
Depreciation: the decrease in the value of a currency as measured by the amount of foreign currency it can buy.
* When depreciation happens, there is an increase in the exchange rate is now we need more money to buy the same amount.
When exchange rate rise from 80 to 90 yen per dollar. The dollar is said to appreciate as you need more yen to purschase it and the yen is said to depreciate as you need more yen to buy the same amount of dollar.
Real Exchange Rate:
The rate at which a person can trade the goods and services of one country for the goods and services of another.
It is a key determinant of how much a country exports and imports.
Real X Rate = (nom x rate * domestic price) / foreign price
Think of the bottles of wine in France to the bottles of wine in Canada. This is a good and service
Purchasing power parity (PPP)
Theory of exchange rates, whereby a unit of any given currency should be able to buy the same quantity of goods in all countries.
- Think about 1 Canadian dollar should be able to buy a loaf of bread in Japan and one Canadian dollar should be able to buy a loaf of bread in the states. 1 Canadian dollar should be able to buy a loaf of bread. In all countries.
The basic logic of purchasing power parity:
The theory of purchasing power parity is based on a principle called the law of 1 price; A good must sell for the same price in all locations.
According to the purchasing power parity theory, a currency must have the same purchasing power at all countries.
nominal exchange rate = price foregin/ price domestic
e = Pf/Pd
Figure 12.4 Real and Nominal Exhange Rates
From 1990 to 2020, real and nominal exchange rate are almost the same.
Implications of purchasing power parity
The nominal exchange rate between the currencies of two countries depends on the price levels in those countries.
If a dollar buys the same quantity of goods in Canada, where prices are measured in dollars, as in Japan where prices are measured in yen, then the number of yen per dollar must reflect the prices of goods in Canada and Japan.
For example, if a kilo of coffee costs ¥500 in Japan and $5 in Canada, then the nominal exchange rate must be ¥100 per dollar. 500/5 = 100 per dollar
Limitations of Purchasing-Power Parity
PPP provides a simple model of how exchange rates are determined.
Exchange rates do not, however, always move to ensure that a dollar has the same real value at all countries all the time.
- Many goods are not easily traded.
- Tradeable goods are not always perfect substitutes when they are in different countries.
Beer in Germany is not the same as beer in Canada. Sausage in Germany is not the same as sausage in Canada.
Deteminants of NX
Consumer tastes for domestic and foreign goods
The prices of goods at home and abroad
The exchange rates at which people can use domestic currency to buy foreign
currencies
The incomes of consumers at home and abroad
The cost of transporting goods from country to country
Government policies toward international trade
Small Open Economy
The model most economists prefer to use to explain this phenomenon is one that describes Canada as a small open economy (SOE) with perfect capital mobility.
Small open economy (SOE) is an economy that trades goods and services with other economies and, by itself, has a negligible effect on world prices and interest rates.
Perfect Capital Mobility
Perfect capital mobility means Canadians have full access to world financial markets.
The implication of perfect capital mobility for a small open economy like Canada’s is that the real interest rate in Canada should equal the real interest rate prevailing in world financial markets.
r Canada = r World
Interest rate parity
Interest rate parity is a theory of interest rate determination whereby the real interest rate on comparable financial assets should be the same in all economies with full access to world financial markets.
Limitations to Interest Rate Parity
The real interest rate in Canada is not always equal to the real interest rate in the rest of the world.
- Financial assets carry with them the possibility of default.
- Financial assets offered for sale in different countries are not necessarily perfect substitutes for one another.
