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 Purchases foreign stock Canadian resident + NFI Purchases Canadian stock Foreign resident - NFI

+ NX NX=NFI + NFI + NX=+ NFI No change in NX and NFI Good is exported + NX USA Canada NX=NFI Pays in USD + NFI Invest in US bonds + NX=+ NFI USA Canada Imports US goods No change in NX and NFI

Conclusion: Value of asset= value of goods and services sold NFI=NX International flow of goods= international flow of capital

Saving, Investment, and international flows Saving= domestic investment+ net foreign investment Investment in the Canadian economy Savings in Canadian economy Canadian NFI

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

Consider a small country that exports steel 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 : Domestic price of steel Quantity of steel produced Quantity of steel consumed Quantity of steel exported Consumer surplus Producer surplus Government revenue Total surplus

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