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Final

EC290 Study Guide - Final Guide: Open Economy, Aggregate Demand, Interest Rate Parity


Department
Economics
Course Code
EC290
Professor
Edda Claus
Study Guide
Final

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MACROECONOMICS FINAL EXAM
NOTES
Chapter 6 Openness in Goods Markets
Openness
This concept describes that the borders between countries are open instead of closed.
Countries offer transactions in goods and services TRADE.
Transactions occur through financial instruments rather than barter.
Movement of factors of production (LABOUR AND CAPITAL) takes place
internationally and are enormously important to economies.
Canadian imports are items taken into Canada; Exports are items sold and shipped out of
Canada
Most of the last 40 years, Canada ran a trade surplus, where exports of good were larger
than the imports of goods and services.
The size of the trade surplus has varied over time. The surplus was large between 1997-
2007 with a PEAK trade surplus of 5% GDP. In some years in-between there has been
small trade deficits.
Exports in Canada amount to around 40% of GDP, which is one of the largest ratios of
exports to GDP among the rich countries in the world.
Factors that affect the differences between export to GDP ratio between countries are:
Geography, and size. Distance from markets, smaller countries specialize in fewer
products, produce and export them, and rely on imports for the others.
Canada’s biggest trading partner is the UNITED STATES OF AMERICA.
The decline in Canadian trade is considered a policy problem
The large role of the U.S. is considered to be a problem for Canadian trade diplomacy

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Nominal Exchange Rate
Two Definitions of the Nominal Exchange Rate:
1. Direct exchange rate: price of domestic currency in terms of foreign currency.
2. Indirect exchange rate: price of foreign currency in terms of domestic currency.
Canadian dollar and the American dollar could be quoted as either the price of a
Canadian dollar in terms of American dollars (C$1= US$0.9310) or as the price of an
American dollar in terms of Canadian dollars (US$1=C$1.0741).
The most important price in trade within open economies is the exchange rate between
currencies.
Nominal Exchange Rate- the price of foreign currency in terms of domestic currency
denoted by E. Example: E between Canada (domestic) and the US (foreign) is the price
of US$ in terms of C$. E= 1.119 Canadian dollars (domestic) per U.S. dollar (foreign)
Appreciation- of the domestic currency is an increase in the price of the domestic
currency in terms of a foreign currency. Given the definition of exchange rate an
appreciation of the domestic currency corresponds to a decrease in the exchange rate, E.
The domestic currency becomes more valuable and therefore it takes less domestic
currency to buy a unit of foreign currency.
Depreciation – of the domestic currency corresponds to an increase of E. The domestic
currency becomes less valuable and therefore it takes more domestic currency to buy a
unit of foreign currency. Example being that the price of the Canadian dollar in terms of
American dollars goes down, the exchange rate has increased.
E and the value of the currency are negatively related
Real Exchange Rate- the price of foreign goods in terms of domestic goods. The reason
why the nominal exchange rate is so important. It is the most variable component of the
real exchange rate. The real exchange rate is represent by ε epsilon. = EPΕ */ P. The
relative price of foreign goods in terms of domestic goods.
P* is the foreign price level; the number of units of foreign currency to purchase a fixed
bundle of foreign goods. P is the number of units of domestic currency to purchase a
fixed bundle of domestic goods.
Fixed Exchange Rate- a system in which two or more countries maintain an unchanging
exchange rate between their currencies. Decrease in the exchange rate is called
revaluations and increases in the exchange rate are called devaluations.

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Real Exchange Rates Canada + USA
There have been large changes in the Canadian real exchange rates. Changes in the
nominal exchange rate are similar to changes in the real exchange rate.
United States is the dominant Canadian trading partner.
Since the US is so dominant in Canadas trade, we often use the CANADA-US real
exchange rate.
Real Multilateral Exchange Rates (many countries)- weighted average of bilateral real
exchange rates. The weights could be either export shares or import shares (or an average
of these two shares). Canadians. Because the US accounts for 76% of exports and 65% of
imports, rarely bother to calculate a multilateral real exchange rate.
Merchandise Trade- exports and imports of goods; that does not include exports and
imports of services, such as travel services and tourism.
Bilateral Real Exchange Rate- the exchange rate between two countries, implicitly for
Canada, we mean the exchange rate with the United States.
Openness in Financial Markets
Allows financial investors to hold both domestic and foreign assets, to diversify their
portfolios, to speculate on movements in foreign versus domestic interest rates, exchange
rates, and so on.
International financial markets are dominated by trades in assets.
Openness in Financial Markets has an important implication in that it allows the country
to run trade surpluses and trade deficits.
A country running a trade deficit is buying more from the rest of the world than it is
selling to the rest of the world and must borrow the difference. The country borrows by
making it attractive for foreign financial investors to increase their holding of domestic
assets. This lending is key to economic growth.
The Balance of Payments
Balance of Payments- a country’s transactions with the rest of the world is summarized
by a set of accounts called the balance of payments.
Transactions are referred to as either above the line or below the line.
The Current Account- the transactions above the line all record payments to and from
the rest of the world. These are called current account transactions.
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