Econ- Chap 12

Econ- Chap 12 - Chapter 12 Chapter Define open economy...

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Unformatted text preview: Chapter 12 Chapter Define: open economy, closed economy, and Define: exports/imports. 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 flows. 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 An countries in two ways: countries 1. It buys and sells goods and services in 1. world product markets. world 2. It buys and sells capital assets in world 2. financial markets. Financial capital. financial Canada is a small, open economy with perfect Canada capital mobility. The Flow of Goods The Exports: X Are domestically produced goods that are Are sold abroad. Exports include foreign spending broad. on goods that are made domestically, shipped to, and sold in a foreign country. and The Flow of Goods The Imports: M Are foreign produced goods and services Are 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 economy. Example: Computer monitors made in Korea and wine from France are imported into Canada. into The Flow of Goods The Net Exports (NX) or Trade Balance: – – The value of exports minus the value of imports. NX =X-M NX Trade Deficit: – A situation when net exports (NX) are negative. situation negative (i.e. Exports < Imports) Trade Surplus: – A situation when net exports (NX) are positive. situation 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 NX=0 Only part of story : Value given = value received Overall accounts must balance -nothing is Overall given away. given If NX<0, we have not paid for all imports so If there must be an offsetting financial IOU there MORE TRADE: Lower tariffs MORE Factors That Influence a Country’’s s Factors Exports, Imports, and Net Exports Exports, Œ The tastes of consumers for domestic and foreign The goods. Florida OJ and French wine goods.  The prices of goods at home and abroad. Ž The exchange rates at which people can use The domestic currency to buy foreign currencies. domestic  The costs of transporting goods from country to The country. country.  The policies of the government toward The international trade. Tariffs, quotas. international Net Capital Outflow (NCO) Net NCO: difference between foreign assets difference purchased by residents and domestic assets purchased by foreigners. – Example: Canadian resident buys shares in Example: Telemex-the Mexican phone company. Increases Cdn NCO. Japanese resident buys stock in the Royal Bank. Reduces Canadian NCO. NCO. Net Capital Outflow (NCO) Net When domestic residents purchase more financial When 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 If 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 2. company—foreign portfolio investment. company—foreign For both, CDNs buy assets in ROW so both For increase Canada’s NCO increase The Flow of Capital The NCO measures the imbalance in a country’s trade in assets: assets: – When NCO > 0, “capital outflow” When NCO Domestic purchases of foreign assets exceed Domestic foreign purchases of domestic assets. foreign – When NCO < 0, “capital inflow” When NCO Foreign purchases of domestic assets exceed Foreign domestic purchases of foreign assets. Factors affecting NCO Factors NCO affected by: Real interest rates on foreign assets (return) Real interest rates on domestic assets Perceived economic and political risks Perceived abroad abroad G policies affecting foreign ownership NCO=NX NCO=NX An accounting identity: NCO = NX An NCO NX – arises because every transaction that affects arises NX also affects NCO by the same amount NX NCO (and vice versa) (and When a foreigner purchases a good When from Canada, – Canadian exports and NX increase Canadian NX – the foreigner pays with currency or assets, the 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 For balance each other so that: balance NX = NCO An increase in net exports is accompanied by An an increase in foreign exchange. an Trade imbalance is exactly offset in the capital Trade account because Value rec’d = Value given. account Saving, Investment, and International Flows of Goods & Assets of Y= C + I + G + NX Y= NX accounting identity Y – C – G = I + NX NX rearranging terms S = I + NX since S = Y – C – G NX since S = I + NCO NCO since NX = NCO since NX NCO When S > I, the excess loanable funds flow When the abroad in the form of positive net capital outflow. When S < I, foreigners are financing some of the When foreigners country’s investment, and NCO < 0. NCO S, I and NCO S, RECAP 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 Assets National Saving and Domestic Investment What makes X close to M?? What X : Demand for C$--supply of other Demand currency. currency. M: Supply of C$-demand for other. If X>M: DC$>SC$--------X rate goes UP---X If goes down and M goes up. If M>X SC$>DC$---X rate goes DOWN---X If goes up and M goes down. goes X rate is value of C$ and it adjusts to keep rate X and M close. and Real and Nominal Exchange Rates Rates International transactions are influenced by International international prices. The two most important international prices are: international – Nominal Exchange rate – Real Exchange Rate – Exchange rates are prices. The Nominal Exchange Rate The The nominal exchange rate is the rate at The which a person can trade the currency of one country for the currency of another. It is expressed in two ways: expressed 1. In units of foreign currency per one 1. Canadian dollar COMMON: 0.80US$=C$1 0.80US$=C$1 2. In units of Canadian dollars per one unit 2. of the foreign currency $1US = $1.25 C of Example Example Bank is not cheating you Assume 1C$ = US$0.80 Assume 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$125 Exchange rates both ways Exchange Nominal Exchange Rate Nominal – – – – Example: Assume the exchange rate between the Example: Mexican peso and Canadian dollar is ten to one. One Canadian dollar trades for ten pesos or one peso trades for one tenth of a dollar. If the exchange rate changes so that a dollar buys If more foreign currency, that change is called an appreciation of the dollar. The opposite is called a appreciation depreciation of the dollar. depreciation APP: C$ buys more -DEP: C$ buys less The Real Exchange Rate The The real exchange rate is the ratio at which a The 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. economy. Example: Case of German beer is twice as Example: expensive as Canadian beer. Real exchange rate is 1/2. >> 1G= 2C rate Calculating the Real Exchange Rate Rate Real exchange rates are derived from Real nominal rates. Computing the real exchange rate involves: exchange Nominal Exchange Rate Real x Domestic Price Exchange = Foreign Price Rate REXR=NXR* (Pd/Pf) The Real Exchange Rate The The real exchange rate is a key determinant The of how much a country exports and imports. of When a country’’s real exchange rate is low, s 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 The different sources. The simplest and most widely accepted theory is called PurchasingPurchasingPower Parity Theory. – Purchasing-Power Parity Theory states that “a unit Purchasing-Power 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” “Law “A good must sell for the same price in all “A locations.” locations.” This law applies in the international market This and is a common sense notion. and – – – If the law were not true, unexploited profit If 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 currency (i.e. parity) in all countries and it is the exchange rate that assures that this purchasing power is approximately equal across countries. across The nominal exchange rate between the 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 Two rates from exactly equalizing purchasing power: power: 1. Many goods are not easily traded or 1. shipped from one country to another. shipped 2. Traded goods are not always perfect 2. substitutes. substitutes. Quick quiz Quick You invent a pill allowing students to do all You studying in ½ hour studying # made-Q ATC-$ 199 199 200 200 201 201 You have made 200 doses ???╥ of making unit 201 if P=$300 Make 1 more for $300 Make # made ATC-$ 199 199 200 200 201 201 You have made 200 doses TC 39601 40000 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 good locations. locations. If the law were not true, unexploited profit If 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 Some shipped from one country to another. Limits. shipped PPP LIMITATIONS PPP Nonetheless, PPP works well in many Nonetheless, cases, especially as an explanation of longcases, run trends. For example, PPP implies: For 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 Therefore Pcw=$1.10 >>C$1 Buys 0.9 bushel US$1 buys 1 bu. C$ must fall to restore equality 1C$ = US$0.90 =9/10 bushel 1C$ SOE SOE By “small” we mean an economy that is a By “small” 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 Price and MKT for loanable funds. and Perfect Capital Mobility in a Small Open Economy Open By “perfect capital mobility” we mean that By “perfect 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 Economy 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 Net capital outflow equals domestic residents’ purchases of foreign assets minus foreigners’ purchases of domestic assets. Every international transaction involves the Every 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 Saving investment or to buy assets abroad. Thus, saving equals domestic investment plus net capital outflow. S=I+NCO outflow. Summary Summary The nominal exchange rate is the relative The price of the currency of two countries. currency The real exchange rate is the relative price The of the goods and services of the two goods 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* 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 Another A Ford Escape SUV sells for $24,000 in Canada and Ford 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 P* 30 ...
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