ECON 1BB3 Lecture Notes - Foreign Portfolio Investment, Capital Outflow, Exchange Rate

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taupemacaw43

7 Feb 2013

School

McMaster University

Department

Economics

Course

ECON 1BB3

Professor

Bridget O' Shaughnessy

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ECON 1BB3 Full Course Notes

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Net exports measure international flow of goods and services. How net foreign investment measure international flow of capital. Why net exports must always = net foreign investment. How savings, domestic investment and net foreign investment are related. Meaning of nominal exchange rate and real exchange rate. Purchasing power parity: theory of how exchange rates are determined. Canada is a small open economy and the implication of perfect capital mobility. Benefits of international trade: produce what they do best and consume great variety of goods and services produced aborund the world. International trade raise living standards in all countries by specialization when it has comparative advantage. Closed economy: economy that does not interact with other economies in the world. Open economy: economy that interact freely with other economies around the world. Buys and sells goods and services in world product markets. Buys and sells capital assets (stocks and bonds) in world financial markets.

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5. Saving and net flows of capital and goods In a closed economy, saving and investment must be equal, but this is not the case in an open economy. In the following problem, you will explore how saving and investment are connected to the international flow of capital and goods in an economy. Before delving into the relationship between these various components of an economy, you will be asked to recall some relationships between aggregate variables that will be useful in your analysis. Recall the components that make up GDP. National income (Y) equals total expenditure on the economy's output of goods and services. Thus, where C = consumption, I = investment, G = government purchases, X = exports, M = imports, and NX = net exports: Y = Also, national saving is the income of the nation that is left after paying for . Therefore, national saving (S) is defined as: S = Rearranging the previous equation and solving for Y yields Y = . Plugging this into the original equation showing the various components of GDP results in the following relationship: S = This is equivalent to S = , since net exports must equal net capital outflow (NCO, also known as net foreign investment). Now suppose that a country is experiencing balanced trade. Determine the relationships between the entries in the following table, and enter these relationships using the following symbols: > (greater than), < (less than), or = (equal to). Outcomes of Balanced Trade Imports Exports 0 Net Exports Y C+I+G Investment Saving Net Capital Outflow 0

ochreduck773

With the heavy focus on trade with China, it may be surprising to discover that Canada is the USA's largest trading partner. Perhaps it is not the amount of trade between the US and China that is such a great concern as much as the growth of the trade, the corresponding imbalances, and China's currency valuations.

The yuan renminbi is the official currency of China. It has been historically fixed and controlled by the Chinese government, but that may be changing. As China becomes a greater global exporter and economic powerhouse, critics are claiming that the currency is being undervalued and manipulated in an attempt to protect domestic markets. There are additional levels of complexity impacting China as the nation must deal not only with the economic competition but also internal political and social pressures. As China continues to loosen capital controls, there is fear that the government may lose control of inflation and interest rates, thereby causing a great deal of labor and social unrest, while negatively impacting China's competitive advantages. There are currently platforms in place to increase the circulation of the yuan, but those platforms are currently limited and severely restricted.

China is a leader in international world trade, a major exporter, and currently holds the largest foreign exchange reserve in the world. The nation has one of the highest GDPs in the world and is increasing its economic power. Is it fair for China to fix its currency by undervaluing it on the market? How does keeping its exchange rate undervalued give it a favorable position in international trade? What about from the viewpoint of consumers?

Why is the Chinese government hesitant to open the yuan to market forces to determine its value (floating exchange rate) inside and outside of China?

We often talk about manufacturing and goods related to trade with China. What information can you find on trade in services between the two countries?

ochrecrow336

(Exercise 3.3, Capital controls, optional) Consider a two-period model of a small open economy with a single good each period and no investment. Let preferences of the representative household be described by the utility function U(C1, C2) = â(C_1 ) + ï¢â(C_2 ) The parameter ï¢ is known as the subjective discount factor. It measures the consumerâs degree of impatience in the sense that the smaller is ï¢, the higher is the weight the consumer assigns to present consumption relative to future consumption. Assume that ï¢ = 1/1.1. The representative household has initial net foreign wealth of (1 + r0) B_0^* = 1, with r0 = 0.1, and is endowed with Q1 = 5 units of goods in period 1 and Q2 = 10 units in period 2. The world interest rate paid on assets held from period 1 to period 2, r* = 10% (i.e., r* = 0.1) and there is free international capital mobility. Calculate the equilibrium levels of consumption in period 1, C1, consumption in period 2, C2, the trade balance in period 1, TB1, and the current account balance in period 1, CA1. Suppose now that the government imposes capital controls that require that the countryâs net foreign asset position at the end of period 1 be nonnegative (B_1^* â¥ 0). Compute the equilibrium value of the domestic interest rate, r1, consumption in periods 1 and 2, and the trade and current account balances in period 1. Evaluate the effect of capital controls on welfare. Specifically, find the level of utility under capital controls and compare it to the level of utility obtained under free capital mobility. For this question and the next, suppose that the country experiences a temporary increase in the endowment of period 1 to Q1 = 9, with period 2 endowment unchanged. Calculate the effect of this output shock on C1, C2, TB1, CA1, and r1 in the case that capital is freely mobile across countries. Finally, suppose that the capital controls described in part (b) are in place. Will they still be binding (i.e., affect household behavior)?

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ECON 1BB3 Lecture Notes - Foreign Portfolio Investment, Capital Outflow, Exchange Rate

ECON 1BB3 Full Course Notes

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