Chapter 12 Flashcards
What is an open economy?
An economy that interacts freely with other economies by trading goods, services, and financial assets internationally.
What is a closed economy?
An economy that does not interact with other economies in terms of trade or financial exchanges.
What are net exports (NX), and how are they calculated?
Net exports (NX) measure a country’s trade balance and are calculated as: NX = Value of Exports - Value of Imports. NX > 0 → Trade surplus (more exports than imports). NX < 0 → Trade deficit (more imports than exports). NX = 0 → Balanced trade.
What is net capital outflow (NCO), and how is it calculated?
Net capital outflow (NCO) measures the net flow of financial capital between countries and is calculated as: NCO = Purchases of Foreign Assets by Domestic Residents - Purchases of Domestic Assets by Foreigners. NCO > 0 → More capital is flowing out of the country. NCO < 0 → More capital is flowing into the country.
How are net exports (NX) and net capital outflow (NCO) related?
They are always equal by an accounting identity: NX = NCO. This happens because every transaction that affects the trade balance also affects capital flows.
What is the relationship between saving, domestic investment, and net foreign investment?
S = I + NCO. If NCO > 0, the country is lending abroad. If NCO < 0, the country is borrowing from abroad.
What factors influence net capital outflow (NCO)?
Real interest rates on domestic vs. foreign assets. Economic and political risks of holding foreign assets. Government policies that affect foreign ownership of domestic assets.
What is the nominal exchange rate?
The rate at which one currency is exchanged for another (e.g., 1 CAD = 0.75 USD).
What is the real exchange rate, and how is it calculated?
The real exchange rate measures the relative price of goods between two countries: Real Exchange Rate = Nominal Exchange Rate × Domestic Price Level / Foreign Price Level. If the real exchange rate rises, domestic goods become more expensive, and exports decline. If the real exchange rate falls, domestic goods become cheaper, and exports increase.
If the nominal exchange rate is 120 yen per Canadian dollar, the price of a Big Mac in Canada is $6, and in Japan, it’s 600 yen, what is the real exchange rate?
Real Exchange Rate = (120 yen per CAD) × (6 CAD per Big Mac) / 600 yen per Big Mac = 1.2. So, 1.2 Japanese Big Macs per Canadian Big Mac.
What does the Purchasing-Power Parity (PPP) Theory state?
The theory states that a unit of any currency should buy the same amount of goods in all countries, leading to: e = P* / P, where e = nominal exchange rate, P* = foreign price level, P = domestic price level.
Why does PPP not always hold in reality?
Some goods are not easily traded (e.g., real estate, services). Consumer preferences differ, meaning identical goods are not always perfect substitutes.
Scenario: A Canadian firm buys a factory in Mexico. How does this transaction affect Canada’s net capital outflow (NCO)?
NCO increases because Canada is investing abroad (Foreign Direct Investment).
Scenario: The Canadian dollar depreciates relative to the US dollar. What happens to Canada’s exports and imports?
Exports increase (Canadian goods become cheaper for Americans). Imports decrease (Foreign goods become more expensive in Canada).
Scenario: A Canadian investor buys US stocks, and an American investor buys Canadian government bonds. How do these transactions affect Canada’s net capital outflow (NCO)?
Canadian investor buying US stocks → NCO increases. American investor buying Canadian bonds → NCO decreases. If equal, NCO remains unchanged.
What happens to the Canadian exchange rate if inflation in Canada is higher than in the US?
The Canadian dollar depreciates because its purchasing power falls relative to the US dollar.
Why do trade deficits require borrowing from foreign countries?
A trade deficit (NX < 0) means the country is buying more from abroad than it is selling, which must be financed by selling assets to foreigners (NCO < 0).
If a country has $50 million in net exports and $70 million in saving, what must be its net capital outflow (NCO) and domestic investment (I)?
S = I + NCO. 70M = I + 50M. I = 20M. Thus, Net Capital Outflow = $50M, and Domestic Investment = $20M.
How is the inflation rate calculated in an international trade context?
Inflation Rate = (CPI in current year - CPI in previous year) / CPI in previous year × 100.
What is the difference between anticipated and unanticipated inflation?
Anticipated inflation – Expected price increases, allowing wages and contracts to adjust accordingly. Unanticipated inflation – Unexpected price increases that redistribute wealth between borrowers and lenders.
How does wage indexation help workers during inflation?
Wage indexation links wages to inflation, ensuring that salaries automatically rise with price levels to maintain purchasing power.
What is the relationship between inflation and real GDP growth in the short run?
If inflation is moderate and stable, it can stimulate economic growth. If inflation is too high or unpredictable, it leads to economic uncertainty and lower growth.
Why do governments prefer moderate inflation over deflation?
Moderate inflation reduces real debt burdens and prevents wage rigidity. Deflation discourages spending, increases real debt burdens, and can lead to a recession.
