Open-Economy Macroeconomics

Basic Concepts

Outline: Closed versus open economy Key macroeconomic variables in an

open economy Understanding and interpretation of

data

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

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 nation’s exports minus the value of its imports

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

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

Increasing openness of Canadian economy: Reasons

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

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.

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

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

Exports > Imports + NX

Canadian resident

Purchases foreign stock

+ NFI

Foreign resident

Purchases Canadian stock - NFI

+ NX

+ NFI

USA

Canada USA

Good is exported

Pays in USD

Canada

Invest in US bonds

Imports US goods No change in NX

and NFI

NX=NFI

+ NX=+ NFI

Conclusion:

Value of asset= value of goods and services sold

NFI=NX International flow of goods=

international flow of capital

Saving= domestic investment+ net foreign investment

Saving, Investment, and international flows

Savings in Canadian economy

Investment in the

Canadian economy

Canadian NFI

Exports and Imports: Canada

0

100000

200000

300000

400000

500000

600000

Year Q1

Exp

ort

s, Im

po

rts

Exports

Imports

Relation between saving, investment, and NFI: Canada’s experience

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

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

Real Exchange rate

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.

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.

                                     

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

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

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 :

• 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 • Harrod’s of London sells stock to the Ontario Teachers’

Pension Plan • Macey’s in NY is selling Roots T-shirts

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