Chapter 17 Openeconomy Macroeconomics: Basic Concepts

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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

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• 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.

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• 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

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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

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• 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.

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• 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

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• 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.

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• 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.

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• 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.

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• 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)

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.