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ECON1000 CH. 12.docx

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ECON 1000
Nick Rowe

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Assignment #4 Posted on Webct • Due Wednesday March 14 • Chapters 11-14 Chapter 12: Open-Economy Macroeconomics • What is the difference in saving between an open and a closed economy • What are: o Nominal exchange rates o Real exchange rates • What is purchasing power parity and how it explains nominal exchange rates Open Economy: Some Definitions • Flow of goods and services defined as: o Net exports (NX) = value of exports minus value of imports • Flow of capital assets defined as: o Net capital outflow (NCO) = domestic resident's purchases of foreign assets minus foreigners' purchases of domestic assets The Equality of NX and NCO • An accounting identity: NCO = NX o It arises because every transaction that affects NX will also affect NCO by the same amount (and vice versa) • When a foreigner purchases a good from Canada: o Canadian exports and NX increase o Foreigner pays with currency or assets, so Canadian acquires some foreign assets causing NCO to rise o Therefore they both rise by the same amount • When a Canadian citizen buys foreign goods o Canadian imports rise, NX falls o Canadian buyer pays with Canadian dollars or assets, so the other country acquires Canadian assets causing Canadian NCO to fall Saving, Investment and International Flow of Goods and Assets • Y = C + I + G + NX …. (1) accounting identity Y - C - G = I + NX ….. (2) rearranging terms S = I + NX …. (3) since S = Y - C - G S = I + NCO ….. (4) since NX = NCO • Closed Economy: o S = I o National saving = Domestic investment • Open Economy: o S = I + NCO o When S > I, the excess national savings flow abroad in the form of positive net capital outflow; and therefore, Canadians are investing abroad o When S < I, foreigners are financing some of the country's investment and NCO < 0 (i.e. net capital inflow) and therefore foreigners are investing in Canada Question: Impact on NX & NCO • Suppose that Bill, a resident of Canada, buys software from a company in Japan. Explain why and in what direction this changes Canadian net exports and Canadian net capital outflow. o The purchase of a foreign good causing NX to fall. o Bill pays for the software with Canadian dollars, therefore NCO also falls as domestic assets acquired by foreign residents rises • Suppose that a country has $120 billion of national savings and $80 billion of domestic investment. Is this possible and where did the $40 billion of national savings go? o This is possible for an open economy. o The remaining $40 billion is for net capital outflow in the form of purchases of foreign assets by Canadian residents. o Canadians can save by buying Canadian assets or by buying foreign assets. o S = I + NCO • S = $120b • I = $80b • NCO = $40b Nominal Exchange Rates • Nominal exchange rates € are the rate at which a person can trade the currency of one country for the currency of another • It is expressed in two ways: o Units of foreign currency per one Canadian dollar • $0.94 US per $1 CDN • $0.70 Euros per $1 CDN o Units of Canadian dollars per one unit of the foreign currency • $1.06 CDN per $1 US • $1.43 CDN per $1 Euro o E is used as the symbol of nominal exchange rates Appreciation and Depreciation • Appreciation (or strengthening): an increase in the value of a currency o If the Canadian dollar buys more foreign currency, there is an appreciaton of the dollar • Depreciation (or weakening): a decrease in the value of a currency o If a Canadian dollar buys less foreign currency, there is a depreciation of the dollar The Real Exchange Rate • Real exchange rate is the rate at which the goods and services of one country can be traded for the goods and services of another • Real exchange rate = (e x P)/(P*) o P = domestic price o P* = foreign price (in foreign currency) o E = nominal exchange rate, i.e. foreign currency per unit of domestic currency o (e x P ) is the price of a domestic Canadian good stated in foreign currency o P* is the price of the same good in a foreign market, stated in a foreign currency Example with One Good (What is real exchange rate?) • Assume that a Big Mac costs: o $2.50 in Canada o 400 yen in Japan o E = 120 yen per CDN $ •Compute the real exchange rate. o Real exchange rate = (e x P) / (P*) •(e x P ) = price of yen of a Canadian Big Mac o = (120 yen per $) x ($2.50 per Big Mac) 300 yen per C
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