Chapter 17 Openeconomy Macroeconomics: Basic Concepts presentation

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Title: Chapter 17 Openeconomy Macroeconomics: Basic Concepts

1
Chapter 17 Open-economy Macroeconomics Basic
Concepts

The International Flows of Goods and Capital
The Prices for International Transactions Real
and Nominal Exchange Rates
Interest Rate Determination in a Small Open
Economy with Perfect Capital Mobility

Closed Economy
There are no economic relations with other
countries. No exports, no imports, and no
capital flows.
Open Economy
An economy that interacts freely with other
economies around the world.
The International Flows of Goods and Capital
An open economy interacts with other countries in
two ways
? It buys and sells goods and services in world
product markets.
? It buys and sells capital assets in world
financial markets.
Canada is a small, open economy with perfect
capital mobility.

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
Ex Bombardier, the Canadian aircraft
manufacturer, builds a plane and sells it to New
Zealand Airline, the sale is an export for Canada
and an import for New Zealand.
Net Exports (NX) the value of a nations exports
minus the value of its imports, also called the
trade balance. Ex the Bombardier sale raises
Canadas net exports however, decreases New
Zealands net exports.
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

Factors That Influence a Countrys Exports,
Imports, and Net Exports
The tastes of consumers for domestic and foreign
goods.
The prices of goods at home and abroad.
The exchange rates at which people can use
domestic currency to buy foreign currencies.
The costs of transporting goods from country to
country.
The policies of the government toward
international trade.
The increasing openness of the Canadian Economy
See Figure 17-1. In the 1960s, exports of goods
and services averaged less than 20 of GDP. Today
they are more than twice that level and still
rising. Imports of goods and services have risen
by a similar amount.

The Flow of Capital Net Foreign Investment (NFI)
Net foreign investment the purchase of foreign
assets by domestic residents minus the purchase
of domestic assets by foreigners.
Example Canadian resident buys a car from
Toyota. Mexican citizen buys stock in the Royal
Bank.
When domestic residents purchase more financial
assets in foreign economies than foreigners
purchase of domestic assets, there is a net
capital outflow from the domestic economy.
If foreigners purchase more Canadian financial
assets than Canadian residents spend on foreign
financial assets, then there will be a net
capital inflow into Canada.
Foreign investment takes two forms foreign
direct investment and foreign portfolio
investment.

foreign direct investment
Example Tim Hortons opens up a fast food outlet
in Russia.
The Canadian owner is actively managing the
investment.
foreign portfolio investment
Example A Canadian buys stock in a Russian
Corporation.
The Canadian owner has a more passive role.
In both cases, Canadian residents are buying
assets located in another country, so both
purchases increase Canadian net foreign
investment.
The Equality of Net Exports and Net Foreign
Investment
For an economy as a whole, NX and NFI balance
each other so that
NX NFI
An increase in exports is accompanied by an
increase in foreign exchange.

Y C I G NX
where Y is GDP, C is consumption, I is
investment, G is government purchases and NX is
net exports.
National Saving (S) Y-C-G
And Y-C-G I NX so S I NX
Because NX NFI, we can write this equation as
S I NFI
Saving Domestic Investment Net Foreign
investment
In a closed economy, NFI0, so Saving equals
Investment.
Saving, Investment and net foreign investment of
Canada
See Figure 17-2. In all but three years from 1961
to 1999, net foreign investment has been
negative. This indicates that foreigners
typically purchase more Canadian assets than
Canadians purchase foreign assets.

The Prices for International Transactions Real
and Nominal Exchange Rates
International transactions are influenced by
international prices. The two most important
international prices are
Nominal Exchange rate
Real Exchange Rate
The nominal exchange rate is the rate at which a
person can trade the currency of one country for
the currency of another. It is expressed in two
ways
1. In units of foreign currency per one Canadian
dollar
2. In units of Canadian dollars per one unit of
the foreign currency
Example Assume the exchange rate between the
Mexican peso and Canadian dollar is ten to one.
One Canadian dollar trades for ten pesos or one
peso trades for one tenth of a dollar.

If the exchange rate changes so that a dollar
buys more foreign currency, that change is called
an appreciation of the dollar. The opposite is
called a depreciation of the dollar.
The real exchange rate is the ratio at which a
person can trade the goods and services of one
country for the goods and services of another.
Compare the prices of the domestic goods and
foreign goods in the domestic economy.
The real exchange rate is a key determinant of
how much a country exports and imports.
We can summarize this calculation for the real
exchange rate with the following formula
Real Exchange rate
Nominal Exchange Rate Domestic price / foreign
price

When a countrys real exchange rate is low, its
goods are cheap relative to foreign goods, so
consumers both at home and abroad tend to buy
more of that countrys goods and fewer foreign
produced goods.
Example A tonne of Canadian wheat sells for
200 Canadian dollars and a tonne of French wheat
sells for 1600 Francs. Assume nominal exchange
rate is 4 francs per Canadian dollar. Then Real
Exchange rate
Nominal Exchange Rate Domestic price / foreign
price
4 francs per dollar 200 per tonne of
Canadian wheat/
1600 francs per tonne of French wheat
1/2 tonne of French wheat per tonne of Canadian
wheat.
Thus, the real exchange rate depends on the
nominal exchange rate and on the prices of goods
in the two countries measured in the local
currencies.

When studying an economy as a whole,
macroeconomists focus on overall prices rather
than the prices of individual items. That is, to
measure the real exchange rate, they use price
indexes, such as consumer price index, which
measure the price of a basket of goods and
services.
Suppose that P is the price of a basket of goods
in Canada ( measured in dollars), P is the price
of a basket of goods in Japan (measured in yen),
and e is the nominal exchange rate ( the number
of yen a Canadian dollar can buy).
We can compute the overall real exchange rate
between Canada and other countries as follows
Real exchange rate (e x P)/ P
See Figure 17-3 the value of Canadian dollar

A First Theory of Exchange-Rate Determination
Purchasing-Power Parity
The variation of currency exchange rates has
different sources. The simplest and most widely
accepted theory is called Purchasing-Power Parity
Theory.
Parity means equality,and purchasing power refers
to the value of money.
Purchasing-Power Parity Theory states that a
unit of any given currency should be able to buy
the same quantity of goods in all countries.
Based upon The Law of One Price A good must
sell for the same price in all locations.
Otherwise, opportunities for profit would be left
unexploited.
Example Buying coffee in Vancouver for, say, 4
a pound and then sell it in Victoria for 5 a
pound, making a profit of 1 per pound from the
difference in price.

The process of taking advantage of differences in
prices in different markets is called arbitrage.
This process would increase the demand for coffee
in Vancouver and increase the supply for coffee
in Victoria. So, the price in Vancouver would
rise and the price in Victoria would decrease.
This process would continue until, eventually,
the price were the same in the two markets.
This law applies in the international market.
If the law were not true, unexploited profit
opportunities would exist, allowing someone to
earn riskless profits by purchasing low in one
market and selling high in another.
Example Buying coffee in Canada or Japan
The process of price adjustment is the same as
our previous example.

In the end, the law of one price tells us that a
dollar must buy the same amount of coffee in all
countries.
Implication of Purchasing-power parity
What does the theory of purchasing-power parity
say about exchange rates? It tells us that the
nominal exchange rate between the currencies of
two countries depends on the price level in those
countries. e P/P
If a dollar buys the same quantity of goods in
Canada ( where prices are measured in dollars) as
in Japan ( where prices are measured in yen),
then the number of yen per dollar must reflect
the prices of goods in Canada and Japan.
Example If a pound of coffee costs 500 yen in
Japan and 5 in Canada, then the nominal exchange
rate must be 100 yen per dollar. Otherwise, the
purchasing power of the dollar would not be the
same in the two countries.

Suppose that P is the price of a basket of goods
in Canada ( measured in dollars), P is the price
of a basket of goods in Japan (measured in yen),
and e is the nominal exchange rate ( the number
of yen a Canadian dollar can buy).
Now consider the quantity of goods a dollar can
buy at home and abroad.
At home, the price level is P,so the purchasing
power of 1 at home is 1/P
At abroad, a Canadian dollar can be exchanged
into e units of foreign currency, which in turn
have purchasing power e/P
For the purchasing power of a dollar to be the
same in two countries, it must be the case that
1/P e/P
With arrangement, this equation becomes 1ep/P
The left hand side is a constant, 1, and the
right-hand side is the real exchange rate. ( see
slide 11)

Thus, if the purchasing power of the dollar is
always the same at home and abroad, then the real
exchange rate, the relative price of domestic and
foreign goods, cannot change.
Rearrange the equation, we can get e P/P. That
is, the nominal exchange rate equals the ratio of
the foreign price level to the domestic price
level.
According to the theory of purchasing-power
parity, the nominal exchange rate between the
currencies of two countries must reflect the
different price levels in these countries.
A key implication of this theory is that nominal
exchange rates change when price levels change.
As we saw in Chapter 16, the price level in any
country adjusts to bring the quantity of money
supplied and the quantity of money demanded into
balance.

Because the nominal exchange rate depends on the
price levels, it also depends on the money supply
and money demand in each country.
Therefore, when the central bank prints large
quantities of money, the money loses value both
in terms of the goods and services it can buy and
in terms of the amount of other currencies it can
buy.
See Figure 17-4. Consider the German
hyperinflation of the early 1920s. Notice that
these series move closely together. When the
supply of money starts growing quickly, the price
level also takes off, and the German mark
depreciates.
When the money supply stabilizes, so does the
price level and the exchange rate.

Limitations of Purchasing-Power Parity
Two things may keep nominal exchange rates from
exactly equalizing purchasing power
1. Many goods are not easily traded or shipped
from one country to another.
2. Traded goods are not always perfect
substitutes.

Interest Rate Determination in a Small Open
Economy with Perfect Capital Mobility
Small open economy an economy that trades goods
and services with other economies and by itself,
has a negligible effect on world prices and
interest rates
Perfect Capital Mobility full access to world
financial markets.
Implication of perfect capital mobility
The real interest rate in Canada, r, should
equal the interest rate prevailing in world
financial markets, rw.
The theory that the real interest rate in Canada
should equal that in the rest of world is known
as interest rate parity.
Limitations to interest rate parity The real
interest rate in Canada is not always equal to
the real interest rate in the rest of world, for
two key reasons.

First, financial assets carry with them the
possibility of default. That is, while the seller
of a financial asset promises to repay the buyer
as some future date, the possibility always
exists that the seller may not do so.
In this case, buyers of financial assets are
therefore said to incur a default risk.
The higher the default risk, the higher the
interest rate asset buyers demand from asset
sellers.
Second, financial assets offered for sale in
different countries are not necessarily perfect
substitutes for one another. For example, while
similar assets in tow countries may pay the same
rate of pre-tax return, different tax regimes in
these two countries may result in different
after- tax returns.

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