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ECN 204 (348)
Lecture

Chapter 12 Open Economy

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Department
Economics
Course
ECN 204
Professor
Paul Missios
Semester
Winter

Description
Chapter 12: Open Economy Macro-Economic Basic Concepts Closed Economy: an economy that does not interact with other economies in the world Open Economy: an economy that interacts freely with other economies around the world. The International Flow of Goods and Capital Economy interacts with others in two ways: Buys/Sells Goods and Services and Buys/Sells Capital Assets such as stocks and bonds The Flow of Goods: Exports, Imports, and Net Exports Exports: goods and services that are produced domestically and sold abroad Imports: goods and services that are produced abroad and sold domestically Net Exports/Trade Balance: the value of a nation’s exports minus the value of its imports. If net exports are positive, exports are greater than imports indicating that the country sells more goods abroad than it buys from other countries Trade Surplus: an excess of exports over imports Trade Deficit: an excess of imports over exports Balanced Trade: a situation in which exports equal imports Example: What do you think would happen to Canadian net exports if: A: The US experiences a recession (falling incomes, rising unemployment) Answer: Canadian net exports would fall due to a fall in American consumer’s purchase of Canadian exports B. Canadian consumers decide to be patriotic and buy more products made in Canada Answer: Canadian exports would rise due to a fall in imports C. Prices of goods produced in Mexico rise faster than prices of goods produced in Canada Answer: This makes Canadian goods more attractive relative to Mexico’s good. Exports to Mexico increase, imports from Mexico decrease, so Canadian net exports increase The Flow of Financial Resources: Net Capital Outflow Net Capital Outflow (Net Foreign Investment): the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Example, when Canadian resident buys stocks in Mexican company, the purchase raises Canadian net capital flow. When Japanese resident buys a bond issued by Canadian government, the purchase reduces Canadian net capital flow. Flow of Capital Abroad takes Two Forms: 1) Foreign Direct Investment: domestic residents actively manage the foreign investment. Example, Tim Horton opens a fast food outlet in Russia 2) Foreign Portfolio Investment: domestic resident purchase foreign stocks or bonds, supplying “loanable funds: to a foreign firm. Example, Canadians buy stocks in Russia corporation -In both cases, Canadian residents are buying assets located in another country, so both purchases increase Canadian net capital outflow Net Capital Outflow measures the imbalance in a country’s trade in assets: Capital Outflow= positive, domestic residents are buying more foreign assets than foreign are buying domestic assets. Capital is said to be flowing out of the countryTrade Deficit Balanced Trade Trade Surplus Exports Imports Exports Imports Exports mports Net exports 0 Net exports 0 Net exports 0 Y C+ I G Saving nvestment Saving nvestment Saving Investment Net capital outflow 0 Net capital outflow 0 Net capital outflow 0 Trade Deficit Balanced Trade Trade Surplus Exports Imports Exports Imports Exports mports Net exports 0 Net exports 0 Net exports 0 Y C+ I G Saving nvestment Saving nvestment Saving Investment Net capital outflow 0 Net capital outflow 0 Net capital outflow 0Capital Inflow= negative, domestic residents are buying less foreign assets than foreigners are buying domestic assets. Capital is flowing into the country Variables that Influence NCO: real interest rates paid on foreign assets, domestic assets, perceived risks of holding foreign assets, government policies affecting foreign ownership of domestic assets The Equality of Net Exports and Net Capital Outflow Accounting Identity= Net Capital Outflow (NCO) = Net Exports (NX) -arises because every transaction that affects NX also affects NCO by the same amount and vice versa -When a seller country transfers a good or service to a buyer country, the buyer country gives up some assert to pay for this. The value of the asset equals the value of the good and service sold. When we add everything up, the net value of goods/service sold by a country (NX) must equal the net value of asset acquired (NCO). Example: When a foreigner purchase goods from Canada. Canadian exports and NX increase, the foreigner pays with currency or assets, so the Canadian acquire some foreign assets, causing NCO to rise. When a Canadian citizen buys foreign goods, Canadian import rises, NX falls, the Canadian buyer pays with Canadian dollars or assets, so the country acquires Canadian assets, causing Canadian NCO to fall Saving, Investment, and International Flows of Goods and Assets GDP (Y)= Consumption (C) + Investment (I) + Government Purchase (G) + Net Exports (NX) Savings: national saving is the income of the nation that is left after paying for current consumption and government purchases. National Saving (S)= Y- C – G Rearranged Equation: Y – C – G = I + NX Rearranged Equation: S = I + NX Because net exports (NX) also equals net capital outflow (NCO): S = I + NCO = Savings = Domestic Investment + Net Capital Outflow -When Savings exceed Domestic Investment, its net capital outflow is positive, indicating that the nation is using some of its savings to buy assets abroad -When Domestic Investment exceeds Savings, its net capital outflow is negative, indicating that foreigners are financing some of this investment by purchasing domestic assets Therefore, a nations saving must equal its domestic investment plus its net capital outflow. Three Possible Outcomes for an Open Economy:Trade Deficit: the value of export is less than value of imports. Because net exports are exports minus imports, net exports (NX) are negative. Thus Income (Y= C + I + G + NX) must be less than domestic spending (C + I + G). But if Y is less than C + I + G, then Y – C – G must be less than I. That is, saving must be less than investment = net capital outflow must be negative. Trade Surplus: value of exports exceeds the value of imports. Because net exports are exports minus imports, net exports (NX) are greater than zero. As a result, income (Y= C + I+G+NX) must be greater than domestic spending (C + I + G). But if Y is more than C + I + G, then Y – C – G must be more than I. That is, saving (S= Y – C – G) must exceed investment. Because the country is saving more than its investing, it must be sending some of its saving abroad = net capital outflow must be greater than 0 The Prices for International Transactions: Real and Nominal E
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