Summary of Lecture Notes from Chapter 13 and practice questions
1. Net exports are the value of domestic goods and services sold abroad minus the value of foreign
goods and services sold domestically. Net capital outflow is the acquisition of foreign assets by
domestic residents minus the acquisition of domestic assets by foreigners. Because every
international transaction involves an exchange of an asset for a good or service, an economy’s net
capital outflow always equals its net exports.
2. An economy’s saving can be used to finance investment at home or to buy assets abroad. Thus,
national saving equals domestic investment plus net capital outflow.
3. The nominal exchange rate is the relative price of the currency of two countries, and the real
exchange rate is the relative price of the goods and services of two countries. When the nominal
exchange rate changes so that each dollar buys more foreign currency, the dollar is said to
appreciate or strengthen. When the nominal exchange rate changes so that each dollar buys less
foreign currency, the dollar is said toepreciate or weaken.
4. According to the theory of purchasing-power parity, a dollar (or a unit of any other currency) should
be able to buy the same quantity of goods in all countries. This theory implies that the nominal
exchange rate between the currencies of two countries should reflect the price levels in those two
countries. As a result, countries with relatively high inflation should have depreciating currencies,
and countries with relatively low inflation should have appreciating currencies.
5. Most economists prefer to use a model that describes Canada as a small open economy with perfect
capital mobility. In such economies, interest rate parity is expected to hold. Interest rate parity is a
theory that predicts interest rates in Canada will equal those in the rest of the world. Due to
differences in tax rates and concerns about default risk, interest rates in Canada are not expected to
exactly equal those in the rest of the world, but we do expect Canadian interest rates to rise and fall
with increases and decreases in world interest rates.
I. We will no longer be assuming that the economy is a closed economy.
A. Definition of closed economy : an economy that does not interact with other
economies in the world.
B. Definition of open economy: an economy that interacts freely with other
economies around the world.
II. The International Flows of Goods and Capital
A. The Flow of Goods: Exports, Imports, and Net Exports
1. Definition of exports: goods and services that are produced domestically
and sold abroad.
2. Definition of imports: goods and services that are produced abroad and
1 2 ☞ Chapter 13/Open-Economy Macroeconomics: Basic Concepts
3. Definition of net exports: the value of a nation’s exports minus the value
of its imports, also called the trade balance.
NX = Exports - Imports
4. Definition of trade balance : the value of a nation’s exports minus the
value of its imports; also called net exports.
5. Definition of trade surplus: an excess of exports over imports.
6. Definition of trade deficit : an excess of imports over exports.
7. Definition of balanced trade: a situation in which exports equal imports.
8. Factors that Influence a Country’s Exports, Imports, and Net Exports
a. The tastes of consumers for domestic and foreign goods.
b. The prices of goods at home and abroad.
c. The exchange rates at which people can use domestic currency to buy
d. The incomes of consumers at home and abroad.
e. The cost of transporting goods from country to country.
f. The policies of the government toward international trade.
9. Case Study: The Increasing Openness of Canadian Economy
a. Figure 13.1 shows the total value of Canada’s exports and imports
(expressed as a percentage of GDP) since 1960.
b. Advances in transportation, telecommunications, and technological
progress are some of the reasons why international trade has increased
over time. Chapter 13/Open-Economy Macroeconomics: Basic Concepts ☞ 3
c. Policymakers around the world have also become more accepting of free
trade over time.
B. The Flow of Financial Resources: Net Capital Outflow
1. Definition of net capital outflow: the purchase of foreign assets by
domestic residents minus the purchase of domestic assets by
NCO = purchasesof foreign assets - purchasesof domesticassets
by domestic residents by foreigners
2. The flow of capital abroad takes two forms.
a. Foreign direct investment occurs when a capital investment is owned
and operated by a foreign entity.
b. Foreign portfolio investment involves an investment that is financed with
foreign money but operated by domestic residents.
3. Factors that Influence a Country’s Net Capital Outflow
a. The real interest rates being paid on foreign assets.
b. The real interest rates being paid on domestic assets.
c. The perceived economic and political risks of holding assets abroad.
d. The government policies that affect foreign ownership of domestic
C. The Equality of Net Exports and Net Capital Outflow
1. Net exports and net capital outflow each measure a type of imbalance in a world
a. Net exports measures the imbalance between a country’s exports and
imports in world markets for goods and services.
b. Net capital outflow measures the imbalance between the amount of
foreign assets bought by domestic residents and the amount of domestic
assets bought by foreigners in world financial markets.
2. For an economy, net exports must be equal to net capital outflow. 4 ☞ Chapter 13/Open-Economy Macroeconomics: Basic Concepts
3. Example: Bombardier sells some airplanes to a Japanese airline.
a. Bombardier gives planes to the Japanese firm, and the Japanese firm
gives yen to Bombardier. Exports have increased (which raises net
exports) and Canada has acquired some foreign assets in terms of yen
(which raises net capital outflow).
b. Or Bombardier may exchange its yen for dollars with another entity that
wants yen. Suppose a Canadian mutual fund wants to buy some stock
in a Japanese company. In this case, Bombardier’s net export of planes
equals the mutual fund’s net capital outflow in stock.
c. Or Bombardier may exchange its yen with a Canadian firm that wants to
buy some good or service from a Japanese company. In this case, the
imports will exactly offset the exports, so net exports is unchanged.
Note that net capital outflow remains the same as well.
4. Every international transaction involves exchange. When a seller country
transfers a good or service to a buyer country, the buyer country gives up some
asset to pay for the good or service.
5. Thus, the net value of the goods and services sold by a country (net exports)
must equal the net value of the assets acquired (net capital outflow).
D. Saving, Investment, and Their Relationship to the International Flows
1. Recall that GDP (Y) is the sum of four components: consumption (C), investment
(I), government purchases (G) and net exports (NX).
Y = C + I + G + NX
2. Recall that national saving is equal to the income of the nation after paying for
current consumption and government purchases.
S = Y - C - G Chapter 13/Open-Economy Macroeconomics: Basic Concepts ☞ 5
3. We can rearrange the equation for GDP to get:
Y - C - G = I + NX
Substituting for the left-hand side, we get:
S = I + NX
4. Because net exports and net capital outflow are equal, we can rewrite this as:
S = I + NCO
5. This implies that saving is equal to the sum of domestic investment ( I) and net
capital outflow (NCO).
6. When a Canadian citizen saves $1 of his income, that dollar can be used to
finance accumulation of domestic capital or it can be used to finance the
purchase of capital abroad.
7. Note that, in a closed economy such as the one we assumed earlier (Chapter 8),
net capital outflow would equal zero and saving would simply be equal to
8. Table 13.1 describes three possible outcomes for an open economy: a country
with a trade deficit, a country with balanced trade, and a country with a trade
9. Case Study: Saving, Investment and Net Capital Outflow of Canada
a. Panel (a) of Figure 13.2 shows national saving and domestic investment
for as a percentage of GDP since 1961.
b. Panel (b) of Figure 13.2 shows net capital outflow for Canada as a
percentage of GDP for the 1961 to 1998 time period.
c. Between 1961 and 1998, Canada typically experienced negative net
capital outflow as foreigners purchased more Canadian assets than
Canadians purchased foreign assets causing domestic investment in
Canada to excel Canada’s national saving.
d. When national savings fall, other domestic investment will have to fall or
the trade deficit gets larger.
e. Since 1999, Canada’s net capital outflow turned positive as national
saving increased from 14 percent of GDP in 1993 to 22 percent in 2002.
f. This was due, in large part, to the federal government and most
provincial governments eliminating their deficits.
g. The positive net capital outflow since 1999 has been the result of an
increase in national saving which reflects the fact that Canadians are
putting away more of their incomes for the future. 6 ☞ Chapter 13/Open-Economy Macroeconomics: Basic Concepts
III. The Prices for International Transactions: Real and Nominal Exchange Rates
A. Nominal Exchange Rates
1. Definition of nominal exchange rate: the rate at which a person can