OpenEconomy Macroeconomics

1
Open-Economy Macroeconomics

• Basic Concepts

2
Outline

• Closed versus open economy
• Key macroeconomic variables in an open economy
• Understanding and interpretation of data

3
Closed versus open

• Closed economy is an economy that does not
  interact with other economies in the world
• Open economy is an economy that interacts freely
  with other economies in the world

4
International flows of goods

• Exports goods and services that are produced
  domestically and sold abroad
• Imports goods and services that are produced
  abroad and sold domestically
• Net exports the value of a nations exports
  minus the value of its imports

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International flows of goods

• Trade balance also called as net exports
• Trade surplus an excess of exports over imports,
  i.e. net exports are positive
• Trade deficit an excess of imports over exports,
  i.e. net exports are negative
• Balanced trade Exports and imports are equal,
  i.e. net exports are zero

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Factors affecting international trade in goods
and services

• Tastes of consumers for domestic and foreign
  goods
• Prices of goods at home and abroad
• Exchange rate of domestic currency
• Income of consumers at home and abroad
• Cost of transportation
• Policies of government towards trade

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Increasing openness of Canadian economy Reasons

• Improvements in transportation
• Advances in telecommunications
• Technological progress
• Free Trade Agreement in 1989
• NAFTA in 1993

8
International flow of capital

• Net foreign investment the purchase of foreign
  assets by domestic residents minus the purchase
  of domestic assets by foreigners
• Foreign Direct Investment (FDI) is investment
  that gives foreign investor management control of
  the domestic firm in which the investment is made
  
• Foreign Portfolio Investment are foreign
  holdings of government and private sector debt
  (bonds and shares) and involves no legal control.
  

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Variables influencing net foreign investment

• Real interest rates paid on foreign assets
• Real interest rates paid on domestic assets
• Perceived risk of holding assets abroad
• Government policies that affect foreign ownership
  of domestic assets

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Net Exports (NX) Net Foreign Investment (NFI)
NX

• Exports gt Imports

Purchases foreign stock
Canadian resident
NFI
Purchases Canadian stock
Foreign resident
- NFI
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Good is exported
NX
USA
Canada
NXNFI
Pays in USD
NFI
Invest in US bonds
NX NFI
USA
Canada
Imports US goods
No change in NX and NFI
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• Conclusion
• Value of asset value of goods and services sold
• NFINX
• International flow of goods international flow
  of capital

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Saving, Investment, and international flows

• Saving domestic investment net foreign
  investment

Investment in the Canadian economy
Savings in Canadian economy
Canadian NFI
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Relation between saving, investment, and NFI
Canadas experience

• Refer transparencies for slides or pp. 382 of the
  text book.

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Prices for international transactions Exchange
Rates

• Nominal exchange rate Rate at which a person can
  trade the currency of one country for the
  currency of another
• Appreciation An increase in the value of a
  currency as measured by the amount of foreign
  currency it can buy
• Depreciation A decrease in the value of a
  currency as measured by the amount of foreign
  currency it can buy

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Real Exchange rate
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Exchange rate determination PPP

• PPP is a theory of exchange rate whereby a unit
  of any given currency should be able to buy the
  same quantity of goods in all countries, i.e., a
  unit of all currencies must have the same real
  value in every country.
• Implications
• Nominal exchange rate between the currencies of
  the two countries depends on the price levels in
  those countries.
• Nominal exchange rates change when the price
  levels change.
• Increase in the supply of money lowers value of
  money and depreciates the nominal exchange rate
  of the currency as well.

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PPP Theory Limitations

• Many goods are not easily traded between
  countries limiting the arbitrage that can be
  gained from difference in prices.
• Tradable goods are not perfect substitutes
• Conclusion Changes in the real exchange rate are
  often small and temporary. Large changes in
  nominal exchange rates reflect changes in price
  levels at home and abroad.

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Interest rate determination

• Assumptions
• Small open economy
• Perfect capital mobility
• Interest parity is a 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.
• Limitations
• Possibility of default
• Financial assets are imperfect substitutes
• Differences in default risk and in tax treatments
  

23

Consider a small country that exports steel.
Suppose that a pro-trade government decides to
subsidize steel by paying a certain amount for
each ton of steel sold abroad. What are the
effects of the export subsidy on

• Domestic price of steel
• Quantity of steel produced
• Quantity of steel consumed
• Quantity of steel exported
• Consumer surplus
• Producer surplus
• Government revenue
• Total surplus

24

How would the following transactions affect
Canada's imports, exports, net exports, and net
foreign investment?

• A Canadian spends his summer in Europe
• Students in Paris come to watch whales in
  Victoria, BC
• A Canadian cellular phone co establishes an
  office in the USA
• TD mutual fund sells its Volkswagen stock to a
  French investor
• Your uncle buys a new Volvo
• A Canadian citizen shops at a store in NY to
  avoid Canadian sales tax
• Harrods of London sells stock to the Ontario
  Teachers Pension Plan
• Maceys in NY is selling Roots T-shirts