Class Notes (837,435)
Canada (510,273)
Economics (1,296)
ECN 204 (348)
Lecture

Chapter 13 Theory of an Open Economy

9 Pages
118 Views
Unlock Document

Department
Economics
Course
ECN 204
Professor
Paul Missios
Semester
Winter

Description
Chapter 13: A Macroeconomic Theory of the Open Economy -Canadas net capital outflow has been negative for the past 40 years, over that period foreigners have purchases more Canadian assets than Canadians purchased foreign assets as a result many firms located in Canada are owned by foreigners = prompted government legislation limiting foreign -In 1999, Canadas NCO turned positive and remained so till 2008, Canadians were buying more foreign assets than foreigners were buying Canadian assets = Canadians savings are going abroad The Market for Loanable Funds Market for Loanable Funds: coordinates the economys saving, investment, and the flow of loanable funds abroad called Net Capital Outflow Identity: Saving (S) = Domestic Investment (I) + Net Capital Outflow (NCO) Positive NCO: the amount of national saving EXCEEDS the amount needed to finance the purchase of domestic capital; the amount left over can finance purchase of asset abroad. If S > I Negative NCO: the amount of national saving is INSUFFICIENT to finance the purchase of domestic capital; the shortfall can be met by the savings of foreigners. If S < I Supply of loanable funds = Savings. A dollar of saving can be used to finance the purchase of domestic capital and the purchase of foreign assets Demand for loanable funds = I + NCO Demand for loanable funds comes from domestic investment (I) -The quantity of loanable funds supplied and the quantity of loanable funds demanded DEPEND on the real interest rate. Higher interest rate encourages people to save = raise quantity of loanable funds made available by national saving, makes borrowing to finance capital more costly thus discourages investment and reduces the quantity of loanable funds demanded Net Capital Outflow: is determined by the difference between the supply of loanable funds due to national saving (S) and the demand for loanable funds (I) at the world interest rate. Net Exports: are determined by the difference between the supply of loanable funds due to national saving (S) and the demand for loanable funds (I) at the world interest rate. NCO=NX How NCO Depends on the Real Interest Rate GRAPH: The real interest rate, r, is the real return on domestic assets. A fall in r makes domestic assets less attractive to foreign assets. Canadians purchase more foreign assets and purchase fewer domestic assets = NCO rises -The supply and demand for loanable funds depend on the real interest rate. A higher real interest rate encourages people to save and raise the quantity of loanable funds supplied. The interest rate adjusts to bring the supply and demand for loanable funds into balance. At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment. -S depends positively on the real interest rate, r and I depends negatively on r Exercise 1 Question: Suppose the government runs a budget deficit (previously, the budget was balanced). Use the appropriate diagrams to determine the effect on the real interest rate and net capital outflow. Answer: A budget deficit reduces savings and the supply of loanable funds, causing r to rise. The higher r makes US bonds more attractive relative to foreign bonds, which reduce NCO. The LF market determines r (in left graph), then this value of r determines NCO (in right graph) -In a small open economy with perfect capital mobility like Canada, the domestic interest rate will equal the world interest rate. As a result, the quantity of loanable funds made available by the savings of Canadians does not have to equal the quantity of loanable funds demanded for domestic investments. The difference between these two amounts is net capital outflow (NCO). Positive NCO Negative NCOThe Market for Foreign-Currency Exchange Market of Foreign-Currency Exchange: coordinates people who want to exchange the domestic currency for the currency of other country. -The market for foreign currency exchanges exists because people want to trade with people in other countries, but they want to be paid in their own currency. -The two sides of the foreign currency exchange market are represented by Net Exports and Net Capital Outflow. NCO represents the imbalance between the purchases and sales of capital assets; NX represents the imbalance between exports and imports of goods and services. Identity: NCO = NX NX= demand for dollars, Foreigners need dollars to buy Canadian net exports NCO = supply of dollars, Canadian residents sell dollars to obtain foreign currency they need to buy foreign assets Identity: S = I + NCO and NX = S I NX= S I: states that the imbalance between the domestic supply of loanable funds that is due for national saving (S) and the demand for loanable funds for domestic investment (I) must equal the imbalance between exports and imports (NX). -The difference between national saving and domestic investment represents NCO/NX which represents the quantity of dollars supplied in the market for foreign currency exchange for the purpose of buying foreign assets. -The real exchange rate balances the supply and demand in the market for foreign currency exchange. -E is the real value of a dollar in the market for foreign currency exchange. The Canadian real exchange rate (E) measures the quantity of foreign goods and services that trade for one unit of Canadian g&s -When Canadas real exchange rate appreciates, Canadian goods become more expensive relative to foreign goods making the Canadian goods
More Less

Related notes for ECN 204

Log In


OR

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


OR

By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.


Submit