1. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Chapter 17 Open-Market Macroeconomics: Basic Concepts © 2002 by Nelson, a division of Thomson Canada Limited

2. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Overview  Define open economy, closed economy, and exports/imports.  Factors that influence open market transactions.  Define nominal and real exchange rates.  Calculate real exchange rates.  Examine the theory of purchasing power parity.  Learn that Canada is a small, open economy with perfect capital mobility.

3. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Open or Closed Economies  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.

4. Principles of Macroeconomics: Ch. 17 Second Canadian Edition An Open Economy  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.

5. Principles of Macroeconomics: Ch. 17 Second Canadian Edition The Flow of Goods  Exports: Are domestically produced goods that are sold abroad. Exports include foreign spending on goods that are made domestically, shipped to, and sold in a foreign country. Example: Bombardier airplanes

6. Principles of Macroeconomics: Ch. 17 Second Canadian Edition The Flow of Goods  Imports: 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 economy. Example: Computer monitors made in Korea and wine from France are imported into Canada.

7. Principles of Macroeconomics: Ch. 17 Second Canadian Edition The Flow of Goods  Net Exports (NX) or Trade Balance: – The value of exports minus the value of imports.  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)

8. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Overview Define open economy, closed economy, and exports\imports.  Factors that influence open market transactions.  Define nominal and real exchange rates.  Calculate real exchange rates.  Examine the theory of purchasing power parity.  Learn that Canada is a small, open economy with perfect capital mobility.

9. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Factors That Influence a Country’s 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.

10. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Net Foreign Investment (NFI)  Net Foreign Investment: difference between foreign assets purchased by residents and domestic assets purchased by foreigners. – Example: Canadian resident buys a car from Toyota. Mexican citizen buys stock in the Royal Bank.

11. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Net Foreign Investment (NFI)  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.

12. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Net Foreign Investment (NFI) I D > I F => NFI D

13. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Net Foreign Investment (NFI) I D > I F => NFI D I D NFI D

14. Principles of Macroeconomics: Ch. 17 Second Canadian Edition 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.

15. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Quick Quiz!  Define net exports and net foreign investment. Explain how they are related.

16. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Overview Define open economy, closed economy, and exports/imports. Factors that influence open market transactions.  Define nominal and real exchange rates.  Calculate real exchange rates.  Examine the theory of purchasing power parity.  Learn that Canada is a small, open economy with perfect capital mobility.

17. Principles of Macroeconomics: Ch. 17 Second Canadian Edition 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

18. Principles of Macroeconomics: Ch. 17 Second Canadian Edition The Nominal 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

19. Principles of Macroeconomics: Ch. 17 Second Canadian Edition The 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.

20. Principles of Macroeconomics: Ch. 17 Second Canadian Edition The Real Exchange Rate  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.

21. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Overview Define open economy, closed economy, and exports/imports. Factors that influence open market transactions. Define nominal and real exchange rates.  Calculate real exchange rates.  Examine the theory of purchasing power parity.  Learn that Canada is a small, open economy with perfect capital mobility.

22. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Calculating the Real Exchange Rate  Real exchange rates are derived from nominal rates. Computing the real exchange rate involves:

23. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Calculating the Real Exchange Rate  Real exchange rates are derived from nominal rates. Computing the real exchange rate involves: Real Exchange Rate =

24. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Calculating the Real Exchange Rate  Real exchange rates are derived from nominal rates. Computing the real exchange rate involves: Real Exchange Rate = Nominal Exchange Rate x Domestic Price

25. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Calculating the Real Exchange Rate  Real exchange rates are derived from nominal rates. Computing the real exchange rate involves: Real Exchange Rate = Nominal Exchange Rate x Domestic Price Foreign Price

26. Principles of Macroeconomics: Ch. 17 Second Canadian Edition The Real Exchange Rate  The real exchange rate is a key determinant of how much a country exports and imports.  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.

27. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Quick Quiz!  Define the nominal exchange rate and the real exchange rate, and explain how they are related.  If the nominal rate goes from 100 to 120 yen per dollar, has the dollar appreciated or depreciated?

28. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Overview Define open economy, closed economy, and exports/imports. Factors that influence open market transactions. Define nominal and real exchange rates. Calculate real exchange rates.  Examine the theory of purchasing power parity.  Learn that Canada is a small, open economy with perfect capital mobility.

29. Principles of Macroeconomics: Ch. 17 Second Canadian Edition 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. – 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

30. Principles of Macroeconomics: Ch. 17 Second Canadian Edition 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

31. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Purchasing-Power Parity  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 countries.  The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries.

32. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Limitations of The 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.

33. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Quick Quiz!  Over the past 20 years, Spain has had high inflation and Japan has had low inflation. What do you predict has happened to the number of Spanish pesetas a person can buy with a Japanese yen?

34. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Overview Define open economy, closed economy, and exports/imports. Factors that influence open market transactions. Define nominal and real exchange rates. Calculate real exchange rates. Examine the theory of purchasing power parity.  Learn that Canada is a small, open economy with perfect capital mobility.

35. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Perfect Capital Mobility in a Small Open Economy  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.

36. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Perfect Capital Mobility in a Small Open Economy  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.

37. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Perfect Captial Mobility in a Small Open Market  Implication of perfect capital mobility: The real interest rate in Canada should equal the interest rate prevailing in world financial markets.  Government policy choices can affect the size of risk and therefore Canadian interest rates relative to world interest rates.

38. Principles of Macroeconomics: Ch. 17 Second Canadian Edition Overview Define open economy, closed economy, and exports/imports. Factors that influence open market transactions. Define nominal and real exchange rates. Calculate real exchange rates. Examine the theory of purchasing power parity. Learn that Canada is a small, open economy with perfect capital mobility.