theme 7 Flashcards
Benefits of economic openness
Specialization and efficiency
Trade-related gains
Competition
Diversity of goods and services
International diversification
Financing of domestic investment by foreigners
Technology and capital by foreign direct investment
Opportunities for developing countries
Downward pressure on P
Access to more funding
Nominal exchange rate
Indirect quotation/the one we use:
How many CAD (domestic) for 1 US (foreign)
Increase: depreciation domestic
Direct quotation:
How many US (foreign) for 1 CAD (domestic)
Increase: appreciation domestic
Factors that affect e (Nominal exchange rate)
Money supply: an increase decrease the value of the currency
Political events
Sanctions
International trade
Tourism
Real exchange rate with indirect quotation
Basket price ratio (identical baskets) between 2 economies with different currencies
Price of foreign basket in domestic currency = eP*
Price of domestic basket in domestic currency = P
E = eP*/P
Real exchange rate (E) 3 possibilities
E > 1: foreign basket is more expensive than domestic basket
E = 1: basket costs the same everywhere
E < 1: foreign basket is cheaper than the domestic basket
E always > 0
Depreciation and appreciation of real E
Increase E; real depreciation
- Increase of the price of foreign basket (eP*)
- Decrease of the price of the domestic basket (P)
Decrease E; real appreciation
- Decrease of the price of foreign basket (eP*)
- Increase of the price of domestic basket (P)
Effects of changes of real exchange rate (E) on NX
Decrease in E (real appreciation):
- our goods more expensive for foreigners
- foreigners will demand less of canadian goods
- decrease of EX & NX
- foreign goods are cheaper for us; increase of demand in foreign goods; increase IM
real depreciation: increase NX
- domestic goods cheaper for foreigners (increase EX)
- foreign goods more expensive for us (decrease IM)
PPP model assumptions
- No transportation costs
- The basket is identical between economies
- No differences in taxation
- No trade barriers
- Perfect information
PPP
E = eP*/P = 1
eP* = P
e = P/P*
relative PPP
An economy with higher inflation than another economy in the LR should have a rise in e in the LR: depreciation
ge = gp - gp*
ge = domestic inflation - foreign inflation
Higher permanent LR inflation suggests higher Ms growth and thus a loss in the value of money in LR (depreciation)
Higher inflation: supposed to depreciate
Overvalued or undervalued according to the PPP?
E > 1:
If P/P* remains stable, e should decrease to decrease E (go to 1)
Currency should appreciate (decrease) in LR
Currency is undervalued (over depreciated) for now
E < 1:
e should increase to increase E (go to 1)
Currency should depreciate (increase) in the LR
Currency is overvalued (over appreciated) for now
Foreign exchange risk
If want to invest CAD in US:
1. Convert CAD to USD (e* CAD)
2. (1) * i
if e doesn’t change: return = i
if e increase: make money
if e decrease: loose money
Domestic return & foreign return
Domestic return: i
Foreign return: i* + (e**a - e)/e
Interest rate parity (IRP)
i = i*+ (e**a - e)/e
return domestic = return foreign
e and the expected return on foreign deposits go in opposite directions; the better return (R), the lower the e
return on domestic deposits: e doesn’t affect your return
IRP condition is met when the 2 curves cross each other
AD-AS in open economy
Increase of i:
decrease C & I; decrease AD
effect of exchange rate: appreciation (e decrease); NX decrease
AD is moving more in an open economy
Increase of Ms:
lower interest rate
increase C & I; AD increases
effect of exchange rate: depreciation (e increases); NX increases
AD is increasing even more
Balance of payments
An accounting framework that records the inflow and outflow of financial capital between the domestic economy and the rest of the world over a given period of time.
Receive financial capital from the rest of the world: +
Sends financial capital from the rest of the world: -
BoP = 0
BoP = CA + CFA = 0
Current account (CA)
EX: +
IM: -
Net asset income (NAI) = Dividends, interest, rents, and other payments RECEIVED from the rest of the world - PAID
Net transfers: development aid, money sent to family abroad or received from his family abroad
Capital and financial account (CFA)
CAHF: Canadian assets hold by foreigners
foreigners are sending financial capital to domestic economy to buy canadian assets : +
foreigners are selling their canadian assets and withdrawing their financial capital from our economy: -
FAHC: Foreign assets held by Canadians
canadians are sending financial capital to the foreign economy to purchase foreign assets : -
canadians are divesting their foreign assets and repatriating their fiancial capital to Canada: +
RES: Official foreign currency reserves
CB buys foreign currency with CAD, we are acquiring foreign assets (foreign currency): -
CB sells foreign currencies, we dispose of foreign assets and repatriates its CAD here: +
Come in: +
Come out: -
BoP when export from Canada to US
- CA increase:
increase EX
If American pays with CAD:
2. CAFH decrease: CFA decrease
If American pays with USD:
2. FAHC increase: CFA decrease
If Canadian change USD to CAD:
3. FAHC decrease: CFA increase
4. CAHF decrease: CFA decrease (take back CAD to Canada)
Net 0 effect when currency exchange
S > I
Has a surplus of internal savings
Will buy assets abroad
NX > 0: Net exporter
Will buy more foreign assets than foreigners buy at home: net lending capacity
Accumulates foreign assets each year
CFA - : sends capital to the rest of the world
CA +:
NAI + : receives net income from assets
NX +
S < I
Has a shortage of internal savings
Foreigners will buy assets in this economy
NX < 0: Net importer
Will buy less foreign assets than foreigners buy at home: net borrowing position
Accumulate domestic assets more than residents accumulate foreign assets
CFA + : acquisition of domestic assets by foreigners. receives financial capital from the rest of the worls
CA -:
NAI - : mut pay net asset income
NX: -
Getting richer with CA > 0
CA > 0, CFA <0:
Economy accumulates foreign assets and receive a piece of the pie of the rest of the world’s production
Purchasing power
Getting richer with CA < 0
CA < 0, CFA > 0:
Economy accumulates capital
Capital accumulation is partly financed by the rest of the world
Increase in K = increase in standard of living (Solow)
Purchasing power
US economy
US BoP: CA < 0 and CFA > 0
Absorbs more funds (CFA > 0) than all other economies in the world that are also in a CFA > 0 position, combined
International net position
What residents of the economy hold in foreign assets - what foreigners hold in domestic assets
Each year that CA < 0 and CFA > 0: foreigners accumulate more domestic assets holdings than the domestic economy accumulates in foreign assets and the net international debt increases
Each year that CA > 0 and CFA < 0: domestic economy buys more foreign assets than foreigners buy in domestic assets, net international debt decreases
BoP crises
net international debt is growing faster than GDP
Increase in net international; debt/GDP ratio
If panic takes hold of the world markets all at once, a capital flight ensues:
foreigners no longer want domestic assets and there is a massive sale of all the assets of the economy, including the currency
Economy collapses
