chapter 13 (A Macroeconomic Theory of the Small Open Economy) Flashcards
More recently, attention has focused on
the Trans-Pacific Partnership (TPP), an agreement involving Canada and 11 other countries intended to lower barriers to trade.
Like all trade agreements, the TPP raises concerns about what it means for employment, prices, and the viability of certain industries in the Canadian economy.
In addition to concerns about international trade in goods and services, Canadians have also often expressed concern about the purchase of Canadian assets by foreigners.
1) As a result, many firms located in Canada are owned by foreigners.
2) During that ten-year period, Canadians were buying more foreign assets than foreigners were buying Canadian assets. To some, this situation is also indicative of economic problems: Canadians’ savings are going abroad to purchase foreign assets.
The preceding chapter also described Canada as a “small” open economy
an open economy for which the world interest rate and the world price of goods and services are unaffected by what happens in Canada.
To develop this macroeconomic model of a small open economy, we build on our previous analysis in three important ways.
First, the model takes the economy’s GDP as given. We assume that the economy’s output of goods and services, as measured by real GDP, is determined by the supplies of the factors of production and by the available production technology that turns these inputs into output. Second, the model takes the economy’s price level as given. We assume that the
price level adjusts to bring the supply and demand for money into balance. Third, the model takes the real interest rate as given. The real interest rate is assumed to equal the world interest rate because of perfect capital mobility. In other words, this chapter takes as a starting point the lessons learned in previous chapters about the determination of the economy’s output, interest rate, and price level.
The goal of the model in this chapter is to highlight the forces that determine the economy’s trade balance and exchange rate.
In one sense, the model is simple: It applies the tools of supply and demand to an open economy. Yet the model is also more complicated than others we have seen because it involves looking simultaneously at two related markets—the market for loanable funds and the
market for foreign-currency exchange.
net capital outflow
the market for loanable funds, which coordinates the economy’s saving, investment, abroad
The second is the market for foreign-currency
exchange,
which coordinates people who want to exchange the domestic currency for the currency of other countries.
identity for loanable funds
S = I + NCO Saving = Domestic investment + Net capital outflow
market for loanable funds
All savers go to this market to deposit their saving, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.
This identity emphasizes that in an open economy the amount that a nation saves does not have to equal the amount it spends to purchase domestic capital.
If the amount of national saving exceeds the amount needed to finance the purchase of domestic capital, the amount left over can be used to finance the purchase of an asset abroad. In this case, net capital outflow (NCO) is a positive number.
If national saving is insufficient to finance the purchase of domestic capital, the shortfall can be met by the savings of foreigners.
In this case, NCO is a negative number
In Canada, the supply of loanable funds from national saving (S) has at times not been sufficient to satisfy the demand for loanable funds for domestic investment (/), so we have had S < I
In those cases, the shortfall has been met by
the savings of foreigners and net capital outflow has been negative.
At other times in Canada, the supply of loanable funds from national saving (S) has been more than sufficient to satisfy the demand for loanable funds for domestic investment (I), so S > I
In those cases, Canadian savings have been used to purchase foreign assets and NCO has been positive.
We found that in a small open economy with perfect capital mobility, like Canada
if we ignore differences in tax treatments and default risk, the domestic interest rate will equal the world interest rate
As in our earlier analysis of the financial system, the demand curve for loanable funds slopes downward because a higher real interest rate makes borrowing to finance capital projects more costly;
thus, it discourages investment and reduces the quantity of loanable funds demanded
