2 Outline: Closed versus open economy Key macroeconomic variables in an open economyUnderstanding and interpretation of data
3 Closed versus openClosed economy is an economy that does not interact with other economies in the worldOpen economy is an economy that interacts freely with other economies in the world
4 International flows of goods Exports: goods and services that are produced domestically and sold abroadImports: goods and services that are produced abroad and sold domesticallyNet exports: the value of a nation’s exports minus the value of its imports
5 International flows of goods Trade balance: also called as net exportsTrade surplus: an excess of exports over imports, i.e. net exports are positiveTrade deficit: an excess of imports over exports, i.e. net exports are negativeBalanced trade: Exports and imports are equal, i.e. net exports are zero
6 Factors affecting international trade in goods and services Tastes of consumers for domestic and foreign goodsPrices of goods at home and abroadExchange rate of domestic currencyIncome of consumers at home and abroadCost of transportationPolicies of government towards trade
7 Increasing openness of Canadian economy: Reasons Improvements in transportationAdvances in telecommunicationsTechnological progressFree Trade Agreement in 1989NAFTA in 1993
8 International flow of capital Net foreign investment: the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreignersForeign Direct Investment (FDI): is investment that gives foreign investor management control of the domestic firm in which the investment is madeForeign Portfolio Investment: are foreign holdings of government and private sector debt (bonds and shares) and involves no legal control.
9 Variables influencing net foreign investment Real interest rates paid on foreign assetsReal interest rates paid on domestic assetsPerceived risk of holding assets abroadGovernment policies that affect foreign ownership of domestic assets
10 Net Exports (NX)= Net Foreign Investment (NFI) Exports > ImportsPurchases foreign stockCanadian resident+ NFIPurchases Canadian stockForeign resident- NFI
11 + NX NX=NFI + NFI + NX=+ NFI No change in NX and NFI Good is exported+ NXUSACanadaNX=NFIPays in USD+ NFIInvest in US bonds+ NX=+ NFIUSACanadaImports US goodsNo change in NX and NFI
12 Conclusion:Value of asset= value of goods and services soldNFI=NXInternational flow of goods= international flow of capital
13 Saving, Investment, and international flows Saving= domestic investment+ net foreign investmentInvestment in the Canadian economySavings in Canadian economyCanadian NFI
16 Relation between saving, investment, and NFI: Canada’s experience Refer transparencies for slides or pp. 382 of the text book.
17 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 anotherAppreciation: An increase in the value of a currency as measured by the amount of foreign currency it can buyDepreciation: A decrease in the value of a currency as measured by the amount of foreign currency it can buy
19 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.
20 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 substitutesConclusion: 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.
22 Interest rate determination Assumptions:Small open economyPerfect capital mobilityInterest 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 defaultFinancial assets are imperfect substitutesDifferences in default risk and in tax treatments
23 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 steelQuantity of steel producedQuantity of steel consumedQuantity of steel exportedConsumer surplusProducer surplusGovernment revenueTotal surplus
24 How would the following transactions affect Canada's imports, exports, net exports, and net foreign investment?A Canadian spends his summer in EuropeStudents in Paris come to watch whales in Victoria, BCA Canadian cellular phone co establishes an office in the USATD mutual fund sells its Volkswagen stock to a French investorYour uncle buys a new VolvoA Canadian citizen shops at a store in NY to avoid Canadian sales taxHarrod’s of London sells stock to the Ontario Teachers’ Pension PlanMacey’s in NY is selling Roots T-shirts