Unformatted text preview: Chapter 12
Chapter Define: open economy, closed economy, and
exports/imports. Factors that influence open economy transactions. NX = NCO Define nominal and real exchange rates. Calculate real exchange rates. Examine the theory of purchasing power parity.
Examine Canada is a small, open economy (SOE) with
perfect capital mobility. Here financial capital
flows-interest rates trigger flows rw Open & Closed Economies
Open Closed Economy:
There are no economic relations with other
countries. No exports, no imports, and no
capital Open Economy:
An economy that interacts freely with other
economies around the world. Goods
markets AND financial markets.
markets An Open Economy
An An open economy interacts with other
countries in two ways:
1. It buys and sells goods and services in
world product markets.
2. It buys and sells capital assets in world
financial markets. Financial capital.
financial Canada is a small, open economy with perfect
capital mobility. The Flow of Goods
The Exports: X
Are domestically produced goods that are
abroad. Exports include foreign spending
goods that are made domestically, shipped
and sold in a foreign country.
and The Flow of Goods
The Imports: M
Are foreign produced goods and services
that are sold to residents of the domestic
country. Imports include domestic
spending on goods that are made abroad,
shipped to, and sold in the domestic
Example: Computer monitors made in
Korea and wine from France are imported
into The Flow of Goods
The Net Exports (NX) or Trade Balance:
– The value of exports minus the value of imports.
NX Trade Deficit:
– A situation when net exports (NX) are negative.
(i.e. Exports < Imports) Trade Surplus:
– A situation when net exports (NX) are positive.
(i.e. Exports > Imports)
(i.e. Trade imbalance
Trade Trade Deficit: X< M
Trade Surplus: X>M
Trade balance: X=M NX<0
NX=0 Only part of story : Value given = value received Overall accounts must balance -nothing is
given If NX<0, we have not paid for all imports so
there must be an offsetting financial IOU
there MORE TRADE: Lower tariffs
MORE Factors That Influence a Country’’s
Exports, Imports, and Net Exports
The tastes of consumers for domestic and foreign
goods. Florida OJ and French wine
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
The policies of the government toward
international trade. Tariffs, quotas.
international Net Capital Outflow (NCO)
Net NCO: difference between foreign assets
purchased by residents and domestic
assets purchased by foreigners.
– Example: Canadian resident buys shares in
Telemex-the Mexican phone company.
Increases Cdn NCO. Japanese resident buys
stock in the Royal Bank. Reduces Canadian
NCO. Net Capital Outflow (NCO)
Net 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. NCO>0
outflow 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. NCO<0
inflow Financial capital flows : NCO
Financial Two forms of capital flow: 1. Tim Horton’s opens restaurant in Russiaforeign direct investment. 2. A Canadian buys shares in a Russian
company—foreign portfolio investment.
company—foreign For both, CDNs buy assets in ROW so both
increase Canada’s NCO
increase The Flow of Capital
NCO measures the imbalance in a country’s trade in
– When NCO > 0, “capital outflow”
Domestic purchases of foreign assets exceed
foreign purchases of domestic assets.
– When NCO < 0, “capital inflow”
Foreign purchases of domestic assets exceed
domestic purchases of foreign assets. Factors affecting NCO
NCO affected by:
Real interest rates on foreign assets (return)
Real interest rates on domestic assets
Perceived economic and political risks
G policies affecting foreign ownership NCO=NX
NCO=NX An accounting identity: NCO = NX
– arises because every transaction that affects
NX also affects NCO by the same amount
(and vice versa)
(and When a foreigner purchases a good
– Canadian exports and NX increase
– the foreigner pays with currency or assets,
so the Canadian acquires some foreign assets,
causing NCO to rise.
NCO The Equality of Net Exports and
Net Capital Outflow
Net For an economy as a whole, NX and NCO
balance each other so that:
balance NX = NCO An increase in net exports is accompanied by
an increase in foreign exchange.
an Trade imbalance is exactly offset in the capital
account because Value rec’d = Value given.
account Saving, Investment, and International Flows
of Goods & Assets
Y= C + I + G + NX
NX accounting identity Y – C – G = I + NX
NX rearranging terms S = I + NX since S = Y – C – G
S = I + NCO
NCO since NX = NCO
since NX NCO When S > I, the excess loanable funds flow
abroad in the form of positive net capital outflow. When S < I, foreigners are financing some of the
country’s investment, and NCO < 0.
NCO S, I and NCO
Y= C+I+G+NX RE-WRITE
Y-C-G = I+NX
National Saving S= I+NX
Domestic saving= Domestic I + NCO
S = I+ NCO
Because NCO =NX International Flows of Goods &
Assets National Saving and Domestic
Investment What makes X close to M??
What X : Demand for C$--supply of other
currency. M: Supply of C$-demand for other. If X>M: DC$>SC$--------X rate goes UP---X
goes down and M goes up. If M>X SC$>DC$---X rate goes DOWN---X
goes up and M goes down.
goes X rate is value of C$ and it adjusts to keep
X and M close.
and 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
– Exchange rates are prices. The Nominal Exchange Rate
The 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 COMMON:
2. In units of Canadian dollars per one unit
of the foreign currency $1US = $1.25 C
Example Bank is not cheating you
Assume 1C$ = US$0.80
Go to bank –buy US$100
What should you pay? 20% difference>> pay $120?? US/C
US/C If US$0.80 = C$1
>> US$0.80/0.80 =C$1/.80
US$1 = C$1.25
C$120 buys 120*.80 =$96
US$100 costs 100/.80= C$125 Exchange rates both ways
Exchange Nominal Exchange Rate
– – –
– Example: Assume the exchange rate between the
Mexican peso and Canadian dollar is ten to one.
One Canadian dollar trades for ten pesos or one
peso trades for one tenth of a dollar.
If the exchange rate changes so that a dollar buys
more foreign currency, that change is called an
appreciation of the dollar. The opposite is called a
depreciation of the dollar.
APP: C$ buys more
-DEP: C$ buys less The Real Exchange Rate
The 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. Example: Case of German beer is twice as
expensive as Canadian beer. Real exchange
rate is 1/2.
>> 1G= 2C
rate Calculating the Real Exchange
Rate Real exchange rates are derived from
nominal rates. Computing the real
exchange rate involves:
Nominal Exchange Rate
x Domestic Price
Rate REXR=NXR* (Pd/Pf) The Real Exchange Rate
The The real exchange rate is a key determinant
of how much a country exports and imports.
of When a country’’s 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 country’s
goods and fewer foreign produced goods.
goods Purchasing-Power Parity
Purchasing-Power The variation of currency exchange rates has
different sources. The simplest and most
widely accepted theory is called PurchasingPurchasingPower Parity Theory.
– 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.”
goods Based upon The Law of One Price Goods means real. The “Law of One Price”
“A good must sell for the same price in all
locations.” This law applies in the international market
and is a common sense notion.
– 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
Internal and external price. Purchasing-Power Parity
Purchasing-Power A currency must have the same buying power
(i.e. parity) in all countries and it is the
exchange rate that assures that this
purchasing power is approximately equal
across The nominal exchange rate between the
currencies of two countries must reflect the
different price levels in those countries.
different Limitations of Purchasing-Power Parity
Limitations Two things may keep nominal exchange
rates from exactly equalizing purchasing
1. Many goods are not easily traded or
shipped from one country to another.
2. Traded goods are not always perfect
substitutes. Quick quiz
Quick You invent a pill allowing students to do all
studying in ½ hour
studying # made-Q ATC-$ 199
201 You have made 200 doses ???╥ of making unit 201 if P=$300 Make 1 more for $300
Make # made
You have made 200 doses TC
40401 ???╥ of making unit 201 if P=$300
-$101 P<MC PPP-Law of 1 price
PPP-Law A good must sell for the same price in all
locations. 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. Called arbitrage. Some goods are not easily traded or
shipped from one country to another. Limits.
shipped PPP LIMITATIONS
PPP Nonetheless, PPP works well in many
cases, especially as an explanation of longcases,
run trends. For example, PPP implies:
the greater a country’s inflation rate,
the faster its currency should depreciate
(relative to a low-inflation countries like
Canada and the US).
Canada PPP example
PPP Assume C$1=US$1 =1 bushel of wheat
This is PPP: equal real value of money
Assume PdotC= 10% US=0
>>C$1 Buys 0.9 bushel US$1 buys 1 bu.
C$ must fall to restore equality
1C$ = US$0.90 =9/10 bushel
SOE By “small” we mean an economy that is a
small part of the world economy. By itself it
will have only a negligible effect on the
prices of goods and services and interest
rates in the rest of the world.
rates Price taker—particularly with interest rates
and MKT for loanable funds.
and Perfect Capital Mobility in a Small
Open By “perfect capital mobility” we mean that
Canadians have full access to world
financial markets and people in the rest of
the world have full access to the Canadian
financial market. LF
financial Perfect Capital Mobility in a Small
Open Implication of perfect capital mobility:
The real interest rate in Canada should
equal the interest rate prevailing in world
financial markets. Rc=Rw
financial Government policy choices can affect the
size of risk and therefore Canadian interest
rates relative to world interest rates. CHAPTER SUMMARY
CHAPTER Net exports equal exports minus imports.
Net capital outflow equals domestic residents’
purchases of foreign assets minus foreigners’
purchases of domestic assets. Every international transaction involves the
exchange of an asset for a good or service,
so net exports equal net capital outflow. NX=NCO
so Saving can be used to finance domestic
investment or to buy assets abroad. Thus, saving
equals domestic investment plus net capital
Summary The nominal exchange rate is the relative
price of the currency of two countries.
currency The real exchange rate is the relative price
of the goods and services of the two
countries. Real x rate = e*P/P*
Real P= domestic price
P*= foreign price
e = nominal x rate
Real=nominal if P=P*
Consider PPP again
Same product—same price everywhere.
e x P = P*
Cdn price*e= foreign price
OR e=P/P* PPP-Big Mac Index
PPP-Big PPP—1 good
PPP—1 A Big Mac costs C$3.00 but 250 yen in Japan PPP implies x rate is P/P* Nominal
3.00/250= 83 (inverse to get yen rate)
Implied PPP rate is 83 yen per C$
Actual rate is 84 yen
Big Mac gives good estimate Another example
A Ford Escape SUV sells for $24,000 in Canada and
720,000 rubles in Russia.
If purchasing-power parity holds, what is the
nominal exchange rate (rubles per dollar)?
nominal P* = 720,000 rubles
P = $24,000
e = P*/P = 720000/24000 = 30 rubles per dollar
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