Chapter 12

Question 1

What are the 2 ways that an open economy can interact with other economies in the word?

Answer 1

1. buys and sells goods and services

2. buys and sells capital assets (stocks and bonds) in world financial markets

Question 2

What is a trade deficit?

Answer 2

an excess of imports over exports

bringing in more than putting out

Question 3

What are the (6) factors that influence exports and imports?

Answer 3

1. consumer tastes for domestic and foreign goods
2. prices of goods at home and abroad
3. exchange rates at which people can use domestic currency to buy foreign currencies
4. incomes of consumers at home and abroad
5. cost of transporting goods
6. government policies towards international trade

Question 4

what is net capital outflow?

Answer 4

the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners; positive when domestic residents are buying more foreign assets; capital is flowing OUT of the country

Question 5

What are the factors that influence net capital outflow?

Answer 5

1. real interest rates being paid on foreign assets
2. real interest rates being paid on domestic assets
3. perceived economic and political risks of holding assets abroad
4. government polices that affect foreign ownership of domestic assets

Question 6

NCO = NX

Answer 6

.

Question 7

S = I + NCO 
saving = domestic investment + net capital outflow

Answer 7

when a nations saving exceeds its domestic investment, its net capital outflow is positive, indicating that the nation is using some of its saving to buy assets abroad

Question 8

What is a nominal exchange rate?

Answer 8

the rate at which a person can trade the currency of one country for the currency of another

Question 9

What is appreciation?

Answer 9

an increase in the value of a currency as measured by the amount of foreign currency it can buy

Question 10

What is depreciation?

Answer 10

a decrease in the value of a currency as measured by the amount of foreign currency it can buy

Question 11

what is a real exchange rate?

Answer 11

the rate at which a person can trade the goods and services of one country for the goods and services of another (units of the foreign item)

Question 12

What is the equation for real exchange rate?

Answer 12

real exchange rate = (e x P)/ P*

e: nominal exchange rate between CAD and foreign currencies
P: price index for Canadian basket
P*: price index for foreign basket

Question 13

Is depreciation in Canada’s real exchange rate good or bad?

Answer 13

Canadian goods become cheaper relative to foreign goods, encourages consumers at home and abroad to buy more Canadian goods, Canada’s exports raise, imports fall, raise NX, so good.

Question 14

What is the purchasing power parity?

Answer 14

the theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries (because of the law of one price)

Question 15

Define arbitrage?

Answer 15

taking advantage of differences in prices in different markets

Question 16

Why might the purchasing power parity not always hold in practice?

Answer 16

1. many goods are not easily traded (haircuts)

2. trade-able goods are not always perfect substitutes when they are produced in different countries

Question 17

What does it mean when Canada is a small open economy with perfect capital mobility?

Answer 17

it trades goods and services with other economies, and by itself, has a negligible effect on world prices and interest rates, and has full access to world financial markets
Canadian real Interest rate = world real interest rate

Question 18

What is the interest rate parity?

Answer 18

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

Question 19

What are the limitations to the interest rate parity?

Answer 19

1. financial assets carry the possibility of default (higher the credit risk, higher the interest rate buyers demand; may not represent an arbitrage opportunity)
2. financial assets offered for sale in different companies are not necessarily perfect substitutes for one another (may have different after tax returns)