Chapter 12: Open Economy Macro-Economic Basic ...
Chapter 12: Open Economy Macro-Economic Basic Concepts Closed Economy: an economy that does not interact with other economies in the world Open Economy: an economy that interacts freely with other economies around the world. The International Flow of Goods and Capital Economy interacts with others in two ways: Buys/Sells Goods and Services and Buys/Sells Capital Assets such as stocks and bonds
The Flow of Goods: Exports, Imports, and Net Exports Exports: goods and services that are produced domestically and sold abroad Imports: goods and services that are produced abroad and sold domestically Net Exports/Trade Balance: the value of a nation’s exports minus the value of its imports. If net exports are positive, exports are greater than imports indicating that the country sells more goods abroad than it buys from other countries Trade Surplus: an excess of exports over imports Trade Deficit: an excess of imports over exports Balanced Trade: a situation in which exports equal imports Example: What do you think would happen to Canadian net exports if: A: The US experiences a recession (falling incomes, rising unemployment) Answer: Canadian net exports would fall due to a fall in American consumer’s purchase of Canadian exports B. Canadian consumers decide to be patriotic and buy more products made in Canada Answer: Canadian exports would rise due to a fall in imports C. Prices of goods produced in Mexico rise faster than prices of goods produced in Canada Answer: This makes Canadian goods more attractive relative to Mexico’s good. Exports to Mexico increase, imports from Mexico decrease, so Canadian net exports increase
The Flow of Financial Resources: Net Capital Outflow Net Capital Outflow (Net Foreign Investment): the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Example, when Canadian resident buys stocks in Mexican company, the purchase raises Canadian net capital flow. When Japanese resident buys a bond issued by Canadian government, the purchase reduces Canadian net capital flow. Flow of Capital Abroad takes Two Forms: 1) Foreign Direct Investment: domestic residents actively manage the foreign investment. Example, Tim Horton opens a fast food outlet in Russia 2) Foreign Portfolio Investment: domestic resident purchase foreign stocks or bonds, supplying “loanable funds: to a foreign firm. Example, Canadians buy stocks in Russia corporation -In both cases, Canadian residents are buying assets located in another country, so both purchases increase Canadian net capital outflow Net Capital Outflow measures the imbalance in a country’s trade in assets: Capital Outflow= positive, domestic residents are buying more foreign assets than foreign are buying domestic assets. Capital is said to be flowing out of the country
Capital Inflow= negative, domestic residents are buying less foreign assets than foreigners are buying domestic assets. Capital is flowing into the country Variables that Influence NCO: real interest rates paid on foreign assets, domestic assets, perceived risks of holding foreign assets, government policies affecting foreign ownership of domestic assets
The Equality of Net Exports and Net Capital Outflow Accounting Identity= Net Capital Outflow (NCO) = Net Exports (NX) -arises because every transaction that affects NX also affects NCO by the same amount and vice versa -When a seller country transfers a good or service to a buyer country, the buyer country gives up some assert to pay for this. The value of the asset equals the value of the good and service sold. When we add everything up, the net value of goods/service sold by a country (NX) must equal the net value of asset acquired (NCO). Example: When a foreigner purchase goods from Canada. Canadian exports and NX increase, the foreigner pays with currency or assets, so the Canadian acquire some foreign assets, causing NCO to rise. When a Canadian citizen buys foreign goods, Canadian import rises, NX falls, the Canadian buyer pays with Canadian dollars or assets, so the country acquires Canadian assets, causing Canadian NCO to fall
Saving, Investment, and International Flows of Goods and Assets GDP (Y)= Consumption (C) + Investment (I) + Government Purchase (G) + Net Exports (NX) Savings: national saving is the income of the nation that is left after paying for current consumption and government purchases. National Saving (S)= Y- C – G Rearranged Equation: Y – C – G = I + NX Rearranged Equation: S = I + NX Because net exports (NX) also equals net capital outflow (NCO): S = I + NCO = Savings = Domestic Investment + Net Capital Outflow -When Savings exceed Domestic Investment, its net capital outflow is positive, indicating that the nation is using some of its savings to buy assets abroad -When Domestic Investment exceeds Savings, its net capital outflow is negative, indicating that foreigners are financing some of this investment by purchasing domestic assets Therefore, a nations saving must equal its domestic investment plus its net capital outflow. Three Possible Outcomes for an Open Economy:
Trade Deficit: the value of export is less than value of imports. Because net exports are exports minus imports, net exports (NX) are negative. Thus Income (Y= C + I + G + NX) must be less than domestic spending (C + I + G). But if Y is less than C + I + G, then Y – C – G must be less than I. That is, saving must be less than investment = net capital outflow must be negative. Trade Surplus: value of exports exceeds the value of imports. Because net exports are exports minus imports, net exports (NX) are greater than zero. As a result, income (Y= C + I+G+NX) must be greater than domestic spending (C + I + G). But if Y is more than C + I + G, then Y – C – G must be more than I. That is, saving (S= Y – C – G) must exceed investment. Because the country is saving more than its investing, it must be sending some of its saving abroad = net capital outflow must be greater than 0
The Prices for International Transactions: Real and Nominal Exchange Rates -International transactions are influenced by international prices. The two most important international prices are the nominal exchange rate and the real exchange rate.
Nominal Exchange Rates Nominal Exchange Rate: the rate at which a person can trade the currency of one country for the currency of another Expressed in Two Ways: In units of foreign currency per one Canadian dollar. Example, 80 yen per dollar In units of Canadian dollars per unit of the foreign currency. Example, one dollar per 80 yen Appreciation (strengthening): an increase in the value of a currency as measured by the amount of foreign currency it can buy. Example, if exchange rate rises from 80 to 90 yen per dollar, the DOLLAR is said to appreciate. At the same time, because a Japanese yen now buys less of the Canadian currency, the yen is said to depreciate. An appreciation (rise) in Canada’s real exchange rate means that Canadian goods have become more expensive compared to foreign goods, so Canada’s net exports falls. Depreciation (weakening): a decrease in the value of currency as measured by the amount of foreign currency it can buy. Example, when exchange rate falls from 80 to 70 yen per dollar, the dollar is said to depreciate, and then yen is said to appreciate. A depreciation (fall) in Canada’s real exchange rate means that Canadians goods have become cheaper relative to foreign goods. As a result, Canada’s export rise and Canada’s imports fall, and both of these changes raises NX.
Real Exchange Rates 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 : Real Exchange Rate = Nominal exchange rate x Domestic Price/Foreign Price P= domestic price, P*= foreign price (in foreign currency), e= nominal exchange rate (foreign currency per unit of domestic currency) Example: Big Mac costs $2.50 but 400 yen in Japan e (exchange rate)= 120 yen per $, e x P= price in yen of a Canadian Big Mac =(120 yen per $) x (2.50 per Big Mac) =300 yen per Canadian Big Mac
Compute the Real Exchange Rate: e x P/P* = 300 yen per CDN Big Mac/400 yen per Japanese Big Mac = 0.75 Japanese BM per CDA BM Example 2: e= 10 pesos per $, price of Starbucks latter: P=$3 in CDA, P*=24 pesos in Mexico A: What is the price of a Canadian latte measured in pesos? Answer: e x P = (10 pesos per $) x (3 $ per US latte) = 30 pesos per CDA latter B: Calculate the real exchange rate, measured as Mexican lattes per Canadian latter Answer: e x P/P* = 30 pesos per CDA latter/24 pesos per Mexican latter = 1.25 Mexican latte per CDA latte
A First Theory of Exchange-Rate Determination: Purchasing-Power Parity Law of One Price: the notion that a good should sell for the same price in all markets. Suppose coffee sells for $4/pound in Toronto and $5/pound in Montreal, and can be transported without cost. -there is an opportunity of arbitrage, making a quick profit by buying coffee in Toronto and selling it in Montreal. Such arbitrage drives up the price in Toronto and drives down the price in Montreal, until the two prices are equal Purchasing Power Parity: a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries. Based on the law of one prices, implies that nominal exchange rates between the currencies of two countries depends on the price levels in those countries. Implications of Purchasing-Power Parity e=P*/P -The nominal exchange rate equals the ratio of the foreign price level (measured in units of the foreign currency) to the domestic price level (measured in units of domestic currency). According to the theory of PPP, the nominal exchange rate between the currencies of two countries must reflect the different price level in those countries If the two countries have different inflation rates, then e will change over time. -If inflation is higher in Mexico than in Canada, then P* rises faster than P, so e rises – the dollar appreciates against the peso -If inflation is higher in Canada than in Japan, then P rises faster than P*, so e falls- the dollar depreciates against the yen Limitations of Purchasing-Power Parity Two reasons why exchange rates do not always adjust to equalize prices across countries: -Many goods cannot be easily traded such as haircuts, going to the movies, price differences on such goods cannot be arbitraged way -Foreign, domestic goods not perfect substitutes. Example, some Canadian consumers prefer Toyotas over Chevys. Price differences reflect taste differences -Nonetheless, PPP works well in many cases especially in long-run trends. PPP implies that the greater a countries inflation rate, the faster its currency should depreciate
Exercise 1 1: Which of the following statements about a country with a trade deficit is not true? A: Exports < Imports B: Net capital outflow
The Flow of Goods: Exports, Imports, and Net Exports Exports: goods and services that are produced domestically and sold abroad Imports: goods and services that are produced abroad and sold domestically Net Exports/Trade Balance: the value of a nation’s exports minus the value of its imports. If net exports are positive, exports are greater than imports indicating that the country sells more goods abroad than it buys from other countries Trade Surplus: an excess of exports over imports Trade Deficit: an excess of imports over exports Balanced Trade: a situation in which exports equal imports Example: What do you think would happen to Canadian net exports if: A: The US experiences a recession (falling incomes, rising unemployment) Answer: Canadian net exports would fall due to a fall in American consumer’s purchase of Canadian exports B. Canadian consumers decide to be patriotic and buy more products made in Canada Answer: Canadian exports would rise due to a fall in imports C. Prices of goods produced in Mexico rise faster than prices of goods produced in Canada Answer: This makes Canadian goods more attractive relative to Mexico’s good. Exports to Mexico increase, imports from Mexico decrease, so Canadian net exports increase
The Flow of Financial Resources: Net Capital Outflow Net Capital Outflow (Net Foreign Investment): the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Example, when Canadian resident buys stocks in Mexican company, the purchase raises Canadian net capital flow. When Japanese resident buys a bond issued by Canadian government, the purchase reduces Canadian net capital flow. Flow of Capital Abroad takes Two Forms: 1) Foreign Direct Investment: domestic residents actively manage the foreign investment. Example, Tim Horton opens a fast food outlet in Russia 2) Foreign Portfolio Investment: domestic resident purchase foreign stocks or bonds, supplying “loanable funds: to a foreign firm. Example, Canadians buy stocks in Russia corporation -In both cases, Canadian residents are buying assets located in another country, so both purchases increase Canadian net capital outflow Net Capital Outflow measures the imbalance in a country’s trade in assets: Capital Outflow= positive, domestic residents are buying more foreign assets than foreign are buying domestic assets. Capital is said to be flowing out of the country
Capital Inflow= negative, domestic residents are buying less foreign assets than foreigners are buying domestic assets. Capital is flowing into the country Variables that Influence NCO: real interest rates paid on foreign assets, domestic assets, perceived risks of holding foreign assets, government policies affecting foreign ownership of domestic assets
The Equality of Net Exports and Net Capital Outflow Accounting Identity= Net Capital Outflow (NCO) = Net Exports (NX) -arises because every transaction that affects NX also affects NCO by the same amount and vice versa -When a seller country transfers a good or service to a buyer country, the buyer country gives up some assert to pay for this. The value of the asset equals the value of the good and service sold. When we add everything up, the net value of goods/service sold by a country (NX) must equal the net value of asset acquired (NCO). Example: When a foreigner purchase goods from Canada. Canadian exports and NX increase, the foreigner pays with currency or assets, so the Canadian acquire some foreign assets, causing NCO to rise. When a Canadian citizen buys foreign goods, Canadian import rises, NX falls, the Canadian buyer pays with Canadian dollars or assets, so the country acquires Canadian assets, causing Canadian NCO to fall
Saving, Investment, and International Flows of Goods and Assets GDP (Y)= Consumption (C) + Investment (I) + Government Purchase (G) + Net Exports (NX) Savings: national saving is the income of the nation that is left after paying for current consumption and government purchases. National Saving (S)= Y- C – G Rearranged Equation: Y – C – G = I + NX Rearranged Equation: S = I + NX Because net exports (NX) also equals net capital outflow (NCO): S = I + NCO = Savings = Domestic Investment + Net Capital Outflow -When Savings exceed Domestic Investment, its net capital outflow is positive, indicating that the nation is using some of its savings to buy assets abroad -When Domestic Investment exceeds Savings, its net capital outflow is negative, indicating that foreigners are financing some of this investment by purchasing domestic assets Therefore, a nations saving must equal its domestic investment plus its net capital outflow. Three Possible Outcomes for an Open Economy:
Trade Deficit: the value of export is less than value of imports. Because net exports are exports minus imports, net exports (NX) are negative. Thus Income (Y= C + I + G + NX) must be less than domestic spending (C + I + G). But if Y is less than C + I + G, then Y – C – G must be less than I. That is, saving must be less than investment = net capital outflow must be negative. Trade Surplus: value of exports exceeds the value of imports. Because net exports are exports minus imports, net exports (NX) are greater than zero. As a result, income (Y= C + I+G+NX) must be greater than domestic spending (C + I + G). But if Y is more than C + I + G, then Y – C – G must be more than I. That is, saving (S= Y – C – G) must exceed investment. Because the country is saving more than its investing, it must be sending some of its saving abroad = net capital outflow must be greater than 0
The Prices for International Transactions: Real and Nominal Exchange Rates -International transactions are influenced by international prices. The two most important international prices are the nominal exchange rate and the real exchange rate.
Nominal Exchange Rates Nominal Exchange Rate: the rate at which a person can trade the currency of one country for the currency of another Expressed in Two Ways: In units of foreign currency per one Canadian dollar. Example, 80 yen per dollar In units of Canadian dollars per unit of the foreign currency. Example, one dollar per 80 yen Appreciation (strengthening): an increase in the value of a currency as measured by the amount of foreign currency it can buy. Example, if exchange rate rises from 80 to 90 yen per dollar, the DOLLAR is said to appreciate. At the same time, because a Japanese yen now buys less of the Canadian currency, the yen is said to depreciate. An appreciation (rise) in Canada’s real exchange rate means that Canadian goods have become more expensive compared to foreign goods, so Canada’s net exports falls. Depreciation (weakening): a decrease in the value of currency as measured by the amount of foreign currency it can buy. Example, when exchange rate falls from 80 to 70 yen per dollar, the dollar is said to depreciate, and then yen is said to appreciate. A depreciation (fall) in Canada’s real exchange rate means that Canadians goods have become cheaper relative to foreign goods. As a result, Canada’s export rise and Canada’s imports fall, and both of these changes raises NX.
Real Exchange Rates 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 : Real Exchange Rate = Nominal exchange rate x Domestic Price/Foreign Price P= domestic price, P*= foreign price (in foreign currency), e= nominal exchange rate (foreign currency per unit of domestic currency) Example: Big Mac costs $2.50 but 400 yen in Japan e (exchange rate)= 120 yen per $, e x P= price in yen of a Canadian Big Mac =(120 yen per $) x (2.50 per Big Mac) =300 yen per Canadian Big Mac
Compute the Real Exchange Rate: e x P/P* = 300 yen per CDN Big Mac/400 yen per Japanese Big Mac = 0.75 Japanese BM per CDA BM Example 2: e= 10 pesos per $, price of Starbucks latter: P=$3 in CDA, P*=24 pesos in Mexico A: What is the price of a Canadian latte measured in pesos? Answer: e x P = (10 pesos per $) x (3 $ per US latte) = 30 pesos per CDA latter B: Calculate the real exchange rate, measured as Mexican lattes per Canadian latter Answer: e x P/P* = 30 pesos per CDA latter/24 pesos per Mexican latter = 1.25 Mexican latte per CDA latte
A First Theory of Exchange-Rate Determination: Purchasing-Power Parity Law of One Price: the notion that a good should sell for the same price in all markets. Suppose coffee sells for $4/pound in Toronto and $5/pound in Montreal, and can be transported without cost. -there is an opportunity of arbitrage, making a quick profit by buying coffee in Toronto and selling it in Montreal. Such arbitrage drives up the price in Toronto and drives down the price in Montreal, until the two prices are equal Purchasing Power Parity: a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries. Based on the law of one prices, implies that nominal exchange rates between the currencies of two countries depends on the price levels in those countries. Implications of Purchasing-Power Parity e=P*/P -The nominal exchange rate equals the ratio of the foreign price level (measured in units of the foreign currency) to the domestic price level (measured in units of domestic currency). According to the theory of PPP, the nominal exchange rate between the currencies of two countries must reflect the different price level in those countries If the two countries have different inflation rates, then e will change over time. -If inflation is higher in Mexico than in Canada, then P* rises faster than P, so e rises – the dollar appreciates against the peso -If inflation is higher in Canada than in Japan, then P rises faster than P*, so e falls- the dollar depreciates against the yen Limitations of Purchasing-Power Parity Two reasons why exchange rates do not always adjust to equalize prices across countries: -Many goods cannot be easily traded such as haircuts, going to the movies, price differences on such goods cannot be arbitraged way -Foreign, domestic goods not perfect substitutes. Example, some Canadian consumers prefer Toyotas over Chevys. Price differences reflect taste differences -Nonetheless, PPP works well in many cases especially in long-run trends. PPP implies that the greater a countries inflation rate, the faster its currency should depreciate
Exercise 1 1: Which of the following statements about a country with a trade deficit is not true? A: Exports < Imports B: Net capital outflow
