Textbook Notes (363,006)
Canada (158,140)
Economics (727)
ECON 1BB3 (332)
Chapter 12-15

Economics - Chapter 12-15 Notes.docx

14 Pages
Unlock Document

McMaster University
Bridget O' Shaughnessy

CHAPTER TWELVE – OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS The International Flow of Goods and Capital  Closed economy: does not interact with other economies in the world  Open economy: interacts freely with other economies around the world  Open economy interacts with other economies in two ways: o Buys and sells goods/services in world product markets o Buys and sells stocks/bonds in world financial markets The Flow of Goods: Exports, Imports and Net Exports  Exports: goods/services produced domestically and sold abroad  Imports: goods/services produced abroad and sold domestically  Net exports: value of nation’s exports minus value of its imports (trade balance)  Trade surplus: excess of exports over imports  Trade deficit: excess of exports over imports  Balanced trade: exports equal imports  Factors that might influence country’s exports, imports, net exports: o Tastes of consumers for domestic/foreign goods o Prices of goods at home and abroad o Exchange rates at which people can use domestic currencies to buy foreign currencies o Incomes of consumers at home and abroad o Cost of transporting goods from country to country o Government policies toward international trade The Flow of Financial Resources: Net Capital Outflow  Net capital outflow = (Purchase of foreign assets by domestic residents) – (Purchase of domestic assets by foreign residents)  Foreign direct investment: Canadian owner actively manages investment (ex. Tim Horton’s opens fast-food outlet in Russia)  Foreign portfolio investment: Canadian owner has more passive role (ex. Canadian buy stock in Russian corporation)  Both increase Canadian net capital outflow  Capital inflow: when net capital outflow is negative  Influencers of net capital outflow: o Real interest rates being paid on foreign assets o Real interest rates being paid on domestic assets o Perceived economic and political risks of holding assets abroad o Government policies that affect foreign ownership of domestic assets The Equality of Net Exports and Net Capital Outflow  Net exports measures imbalance between exports and imports  Net capital outflow measures imbalance between amount of foreign assets bought by domestic residents and amount of domestic assets bought by foreigners  Net capital outflow must always equal net exports: NCO = NX  Every international transaction is an exchange o Seller country transfers good/service to buyer country o Buyer country gives up asset to pay for it o Value of asset equals value of good/service sold  NX > 0 means NCO > 0  NX < 0 means NCO < 0 Saving, Investment and Their Relationship to the International Flows  Y = C + I + G + NX  S = Y – C – G  S = I + NX  S = I + NCO  Saving = Domestic investment + Net capital outflow  Closed economy: NCO = 0  Open economy: two uses for saving (domestic investment and NCO)  When S > I then NCO > 0: nation using some of saving to buy assets abroad  When S < I then NCO < 0: foreigners financing some of investment by purchasing domestic assets Summing Up Trade Deficit Balanced Trade Trade Surplus Exports < Imports Exports = Imports Exports > Imports Net exports < 0 Net exports = 0 Net exports > 0 Y < C + I + G Y = C + I + G Y > C + I + G Investment < Saving Saving = Investment Saving > Investment Net capital outflow < 0 Net capital outflow = 0 Net capital outflow > 0 The Prices for International Transactions: Real and Nominal Exchange Rates Nominal Exchange Rates  Nominal exchange rate: rate at which person can trade currency of one country for the currency of another  Appreciation: o Increase in the value of a currency as measured by the amount of foreign currency it can buy o Strengthens dollar o Can buy more foreign currency  Depreciation: o Decrease in value of a currency as measured by amount of foreign currency it can buy o Weakens dollar o Can buy less foreign currency Real Exchange Rates  Real exchange rate: rate at which person can trade goods/services of one country for goods/services of another  Expressed as unit of foreign item per unit of domestic item (ex. half a case of German beer per Canadian beer)  Real exchange rate = (nominal exchange rate x domestic price)/foreign price  Real exchange rate = (e x P)/P* o “e”: exchange rate o P: price of Canadian basket o P*: price of foreign basket  Fall in Canadian RER: o Canadian goods cheaper relative to foreign goods o Consumers buy more Canadian goods o Increase net exports  Rise in Canadian RER: o Canadian goods more expensive relative to foreign goods o Net exports fall A First Theory of Exchange-Rate Determination: Purchasing-Power Parity The Basic Logic of Purchasing-Power Parity  Purchasing-power parity: unit of any given currency should be able to buy same quantity of goods in all countries  Law of one price: good must sell for same price in all locations  Arbitrage: taking advantage of differences in prices in different markets  A unit of all currencies must have the same real value in every country Implications of Purchasing-Power Parity  Nominal exchange rate between currencies of two countries depends of price levels in countries  1 = eP/P* or e = P*/P  Nominal exchange rates change when price levels change  When bank prints a lot of money it loses value in terms of goods/services it can buy and in terms of amount of other currencies it can buy Limitations of Purchasing-Power Parity  Not always completely accurate  Exchange rates do not always move so that dollar has same real value in all countries all the time  Two reasons why: 1. Many goods not easily traded (ex. services) 2. Tradable goods are not always perfect substitutes when produced in different countries  Causes exchange rate to fluctuate over time Interest Rate Determination in a Small Open Economy with Perfect Capital Mobility A Small Open Economy  Small open economy: o Trades goods/services with other economies o Has negligible effect on world prices and interest rates  Changes in Canadian financial markets have negligible effects on world interest rates Perfect Capital Mobility  Perfect capital mobility: full access to world financial markets  Canadians have full access to world financial markets  People in rest of world have full access to Canadian financial markets  Real interest rate in Canada should equal world’s real interest rate  r = r  Interest rate parity: real interest rate on comparable financial assets should be the same in all economies with full access to world financial markets Limitations to Interest Rate Parity  Real interest rate in Canada not always equal to real interest rate in rest of world  Two reasons why: 1. Financial assets carry the possibility of default o Seller ma not repay the buyer o One seller may be more likely to default than another seller of a similar asset o Higher default risk means higher interest rate 2. Financial assets for sale in different countries are not perfect substitutes (ex. different government tax returns) CHAPTER THIRTEEN – A MACROECONOMIC THEORY OF THE OPEN ECONOMY Supply and Demand for Loanable Funds and for Foreign-Currency Exchange  Takes GDP as given  Takes price as given  Takes real interest rate as given (equal to world interest rate because of perfect capital mobility)  Market for loanable funds: coordinates saving, investment, flow of loanable funds abroad (NCO)  Market for foreign-currency exchange: coordinates people who want to exchange domestic currency for currency of other countries The Market for Loanable Funds  S = I + NCO  Saving = Domestic investment + Net capital outflow  Amount a nation saves does not have to equal amount it spends to purchase domestic capital  Demand for loanable funds comes from domestic investment  Supply of loanable funds comes from national saving  If S > I: o Leftover amount can be used to buy assets abroad o NCO is positive  If S < I: o Shortfall can be met by savings of foreigners o NCO is negative  Quantity of loanable funds demanded and supplied depends on real interest rate: o High RER makes people want to save so increases quantity of loanable funds supplied o Also makes borrowing more costly so discourages investment and reduces quantity of loanable funds demanded The Market for Foreign-Currency Exchange  People want to trade goods/services, financial assets with people in other countries  Want to be paid in own currency  Must purchase foreign currency before purchasing foreign good  S – I = NX  Saving – Domestic investment = Net exports  Difference between national saving (S) and domestic investment (I) equals net capital outflow (NCO)  NCO = NX (quantity of dollars supplied in market to buy foreign assets)  RER is price that balances supply and demand in market for foreign-currency exchange  RER appreciates: o Canadian goods become more expensive compared to foreign o Canadian goods less attractive to consumers o Exports from Canada fall o Imports into Canada rise o Net exports fall o Reduces Q of dollars demanded  RER depreciates: Canadian goods become less expensive  Equilibrium in the Open Economy Net Capital Outflow: The Link Between the Two Markets Simultaneous Equilibrium in Two Markets How Policies and Events Affect an Open Economy Increase in World Interest Rates  Small open economy: real interest rate = world interest rate  Events outside Canada that cause world interest to change have effects on Canadian economy  US is largest economy in world  Changes in US interest rate have large impact on world interest rate  Increase in world interest rate: o Market for loanable funds: no curve shifts o Increase causes a slide up the supply and demand curves o Quantity of loanable funds made available by saving rises o Quantity of loanable funds demanded for domestic investment falls o Market for foreign-currency exchange: increase in NCO causes shit to the right o Increase in supply of dollars causes real exchange rate to depreciate o Dollar become less valuable relative to other currencies o Canadian goods are less expensive compared with foreign goods o Exports from Canada rise o Imports into Canada fall o Net exports rise Government Budget Deficits and Surpluses  Government budget deficit in a closed economy: o Reduces supply of loanable funds o Drives up interest rate o Crowds out investment  Budget deficit in an open economy: o Supply curve for loanable funds shifts to the left o Causes net capital outflow (NCO) to fall o Supply of Canadian dollars is reduced o Move supply curve in market for foreign-currency exchange to the left o Dollar becomes more valuable relative to foreign currency o Canadian goods more expensive than foreign goods o Exports fall and imports rise (net exports fall) Trade Policy  Trade policy: government policy that directly influences quantity of goods/services that a country imports/exports  Tariff: tax on goods produced abroad and sold domestically  Import quota: limit on quantity of a good that is produced abroad and sold domestically  Effects of an import quota: o Reduces imports at any given real exchange rate o Net exports rise for any given real exchange rate o Increase in demand for dollars in the market for foreign-currency exchange (D curve shifts to the right) o Real exchange rate appreciates o No change in NCO o No change in net exports o Reduces both imports and exports so net exports are unchanged  Trade policies do not affect the trade balance (do not affect net exports)  Do not alter national saving or domestic investment  NX = NCO = S – I  Real exchange rate adjusts to keep trade balance the same CHAPTER FOURTEEN – AGGREGATE DEMAND AND AGGREGATE SUPPLY Three Key Facts about Economic Fluctuations  Recession: a period of declining real incom
More Less

Related notes for ECON 1BB3

Log In


Don't have an account?

Join OneClass

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

Sign up

Join to view


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.