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econ chap 12 notes.docx

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Bridget O' Shaughnessy

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Chapter 12: Open-economy macroeconomics: basic concepts Objectives:  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  Trade makes everyone better off  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  Interacts with other economies in two ways  Buys and sells goods and services in world product markets  Buys and sells capital assets (stocks and bonds) in world financial markets Trade balance: the value of a nation’s exports minus the value of its imports; also called net exports Trade surplus: excess of exports over imports Trade deficit: an excess of imports over exports Balanced trade: a situation in which exports equal imports Factors that influence imports, exports, net exports:  Tastes of consumers for domestic and foreign goods  Prices of goods at home and abroad  Exchange rates at which people can use domestic currency to buy foreign currencies  Incomes of consumers at home and abroad  Cost of transporting goods from country to country  Government policies towards international trade Chapter 12: Open-economy macroeconomics: basic concepts The increasing openness of the Canadian economy  Total value of goods and services exported inclined averaging more o Nearly 50% of GDP are exports  Increase in international trade  Goods that once had to be produced locally can now be traded around the world  Telecommunications influenced international trades  Technology progress fostered international trade Net capital outflow: purchase of foreign assets by domestic residents minus  Net capital outflow = purchase of foreign assets by domestic residents – purchase of domestic assets by foreigners  Ex. Canadian resident buys stock in Mexican phone company, the purchase increases Canadian net capital outflow  Foreign direct investment: ex. Tim Hortons open outlet in Russia (actively managing investment)  Foreign portfolio investment: ex. Canadian buys stock in Russian corporation (passively managing investment) Net capital outflow net foreign investment can be positive or negative  Positive: domestic residents are buying more foreign assets than foreigners are buying domestic assets o Capital is flowing out of the country (Capital outflow))  Negative: domestic residents are buying less foreign assets than foreigners are buying domestic assets o Capital is flowing into the country (capital inflow) Variables that influence net capital outflow:  Real interest rates being paid on foreign assets  Real interest rate being paid on domestic assets  Perceived economic and political risks of holding assets abroad  Government policies that effect foreign ownership of domestic assets Default on debt: not pay investors interest when it is due Government policies: restrictions might have been impose or will be imposed, on foreign investors in foreign countries The equality of net exports and net capital outflow  Open economy interacts with rest of the world in two ways: o world markets for goods and services or world financial markets Chapter 12: Open-economy macroeconomics: basic concepts Net exports measure an imbalance between a country’s exports and its imports Net capital outflow measures an imbalance between the amunt of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners These two imbalances must offset each other: NCO must always equal NX NCO = NX Ex. Canadian producer sells planes to Japanese airline,  gives planes to Japanese company JP company gives yen to Canadian company  sales increase net exportsNet exports, and increased foreign assets (the yens) net capital outflow 1. Canadian company might not hold onto the yen exchange yen for dollars with Canadian mutual fund that wants yen to buy stock in Sony corporation o Net exports of planes = mutual fund’s net capital outflow in Sony stock  NX =NCO 2. Canadian company might exchange yen for dollars with another Canadian company that wants to buy computers from Toshibacanada’s exports (of computers) exactly offset Canada’s exports (of planes) o Sales of Canadian plane company and Toshiba together neither increase nor decrease Canadian net capital outflow  NX = NCO (same as before transactions took place) Trade surplus = (NX > 0)  selling more goods to foreigners than buying from them.--> more currency receiveduse it to buy foreign assetscapital is flowing out of country (NCO > 0) Trade deficit = (NX < 0)  buying more goods from foreigners than selling to them--> to finance net purchase in world markets  must sell assets abroad  capital is flowing into the country (NCO < 0) Saving, investment, and their relationship to the international flows  Nation’s saving and investment are crucial to long-run economic growth  related to international flows of goods and capital as measured by net exports and net capital outflow SAVINGS IS THE INCOME OF NATIONS THAT IS LEFT AFTER CURRENT CONSUMPTOIONS AND PURCHASES S = Y – C – G Chapter 12: Open-economy macroeconomics: basic concepts Y – C – G = I + NX S = I + NX N = NCO S = I + NCO Saving = domestic investment + Net capital outflow  equation shows a nation’s saving must equal its domestic investment plus its net capital outflow  when Canadians save a dollar of their income for the future, dollar can be used to finance accumulations of domestic capital or can be used to finance purchase of capital abroad  before S = I because NCO = 0 in closed economy  now S = I + NCO because NCO >0 or NCO < 0 in open economy o open economy has two uses for savings: net capital outflow and investment  ex. Savings used to build new research laboratory domestically, and savings used to buy stock abroad o S = I + NCO  If S > I, NCO > 0  if S < I, NCO < 0 Ex: NCO is negative because fall in savings--.nation is putting away less of income to provide for futurenational savings fall resulting trade deficitsinvestment fall  if Canadian saving declined, it is better to have foreigners invest in economy than no one at all Ex: NCO is negative because investment boomborrowing from abroad to buy new capital goodsadditional capital gives higher production repay debts  but, if investment project fails to get favourable results, debts will increase Prices for international transactions: real and nominal exchange rates  measure prices in any market is important for coordinating buyers and sellers  international prices help coordinating decisions of consumers and producers as they interact in world markets  nominal exchange rate: rate at which a person can trade currency of one country for the currency of another  appreciation: increase in value of a currency as measure by the amount of foreign currency it can buy o ex. Exchange rates change
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