1 Chapter 17 Open-economy Macroeconomics: Basic Concepts The International Flows of Goods and Capital The Prices for International Transactions: Real and Nominal Exchange Rates Interest Rate Determination in a Small Open Economy with Perfect Capital Mobility

2 Closed Economy: There are no economic relations with other countries. No exports, no imports, and no capital flows. Open Economy: An economy that interacts freely with other economies around the world. The International Flows of Goods and Capital An open economy interacts with other countries in two ways:  It buys and sells goods and services in world product markets.  It buys and sells capital assets in world financial markets. Canada is a small, open economy with perfect capital mobility.

3 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 Ex: Bombardier, the Canadian aircraft manufacturer, builds a plane and sells it to New Zealand Airline, the sale is an export for Canada and an import for New Zealand. Net Exports (NX): the value of a nation’s exports minus the value of its imports, also called the trade balance. Ex: the Bombardier sale raises Canada’s net exports; however, decreases New Zealand’s net exports. 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

4 Factors That Influence a Country’s Exports, Imports, and Net Exports  The tastes of consumers for domestic and foreign goods.  The prices of goods at home and abroad.  The exchange rates at which people can use domestic currency to buy foreign currencies.  The costs of transporting goods from country to country.  The policies of the government toward international trade. The increasing openness of the Canadian Economy See Figure In the 1960s, exports of goods and services averaged less than 20% of GDP. Today they are more than twice that level and still rising. Imports of goods and services have risen by a similar amount.

5 The Flow of Capital: Net Foreign Investment (NFI) Net foreign investment: the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Example: Canadian resident buys a car from Toyota. Mexican citizen buys stock in the Royal Bank. When domestic residents purchase more financial assets in foreign economies than foreigners purchase of domestic assets, there is a net capital outflow from the domestic economy. If foreigners purchase more Canadian financial assets than Canadian residents spend on foreign financial assets, then there will be a net capital inflow into Canada. Foreign investment takes two forms: foreign direct investment and foreign portfolio investment.

6 foreign direct investment Example: Tim Hortons opens up a fast food outlet in Russia. The Canadian owner is actively managing the investment. foreign portfolio investment Example: A Canadian buys stock in a Russian Corporation. The Canadian owner has a more passive role. In both cases, Canadian residents are buying assets located in another country, so both purchases increase Canadian net foreign investment. The Equality of Net Exports and Net Foreign Investment For an economy as a whole, NX and NFI balance each other so that: NX = NFI An increase in exports is accompanied by an increase in foreign exchange.

7 Y = C + I + G + NX where Y is GDP, C is consumption, I is investment, G is government purchases and NX is net exports. National Saving (S) = Y-C-G And Y-C-G = I + NX; so S = I + NX Because NX = NFI, we can write this equation as S = I + NFI Saving = Domestic Investment + Net Foreign investment In a closed economy, NFI=0, so Saving equals Investment. Saving, Investment and net foreign investment of Canada See Figure In all but three years from 1961 to 1999, net foreign investment has been negative. This indicates that foreigners typically purchase more Canadian assets than Canadians purchase foreign assets.

8 The Prices for International Transactions: Real and Nominal Exchange Rates International transactions are influenced by international prices. The two most important international prices are: – Nominal Exchange rate – Real Exchange Rate The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. It is expressed in two ways: 1. In units of foreign currency per one Canadian dollar 2. In units of Canadian dollars per one unit of the foreign currency Example: Assume the exchange rate between the Mexican peso and Canadian dollar is ten to one. One Canadian dollar trades for ten pesos or one peso trades for one tenth of a dollar.

9 – If the exchange rate changes so that a dollar buys more foreign currency, that change is called an appreciation of the dollar. The opposite is called a depreciation of the dollar. The real exchange rate is the ratio at which a person can trade the goods and services of one country for the goods and services of another. Compare the prices of the domestic goods and foreign goods in the domestic economy. The real exchange rate is a key determinant of how much a country exports and imports. We can summarize this calculation for the real exchange rate with the following formula: Real Exchange rate = [Nominal Exchange Rate* Domestic price] / foreign price

10 When a country’s real exchange rate is low, its goods are cheap relative to foreign goods, so consumers both at home and abroad tend to buy more of that country’s goods and fewer foreign produced goods. Example: A tonne of Canadian wheat sells for $200 Canadian dollars and a tonne of French wheat sells for 1600 Francs. Assume nominal exchange rate is 4 francs per Canadian dollar. Then Real Exchange rate = [Nominal Exchange Rate* Domestic price] / foreign price = [4 francs per dollar * 200 per tonne of Canadian wheat]/ 1600 francs per tonne of French wheat =1/2 tonne of French wheat per tonne of Canadian wheat. Thus, the real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in the local currencies.

11 When studying an economy as a whole, macroeconomists focus on overall prices rather than the prices of individual items. That is, to measure the real exchange rate, they use price indexes, such as consumer price index, which measure the price of a basket of goods and services. Suppose that P is the price of a basket of goods in Canada ( measured in dollars), P* is the price of a basket of goods in Japan (measured in yen), and e is the nominal exchange rate ( the number of yen a Canadian dollar can buy). We can compute the overall real exchange rate between Canada and other countries as follows: Real exchange rate = (e x P)/ P* See Figure 17-3 the value of Canadian dollar

12 A First Theory of Exchange-Rate Determination: Purchasing-Power Parity The variation of currency exchange rates has different sources. The simplest and most widely accepted theory is called Purchasing-Power Parity Theory. Parity means equality,and purchasing power refers to the value of money. Purchasing-Power Parity Theory states that “a unit of any given currency should be able to buy the same quantity of goods in all countries.” –Based upon The Law of One Price: “A good must sell for the same price in all locations.” Otherwise, opportunities for profit would be left unexploited. –Example: Buying coffee in Vancouver for, say, $4 a pound and then sell it in Victoria for $5 a pound, making a profit of $1 per pound from the difference in price.

13 –The process of taking advantage of differences in prices in different markets is called arbitrage. –This process would increase the demand for coffee in Vancouver and increase the supply for coffee in Victoria. So, the price in Vancouver would rise and the price in Victoria would decrease. This process would continue until, eventually, the price were the same in the two markets. This law applies in the international market. – If the law were not true, unexploited profit opportunities would exist, allowing someone to earn riskless profits by purchasing low in one market and selling high in another. – Example: Buying coffee in Canada or Japan – The process of price adjustment is the same as our previous example.

14 – In the end, the law of one price tells us that a dollar must buy the same amount of coffee in all countries. Implication of Purchasing-power parity What does the theory of purchasing-power parity say about exchange rates? It tells us that the nominal exchange rate between the currencies of two countries depends on the price level in those countries. e = P*/P If a dollar buys the same quantity of goods in Canada ( where prices are measured in dollars) as in Japan ( where prices are measured in yen), then the number of yen per dollar must reflect the prices of goods in Canada and Japan. Example: If a pound of coffee costs 500 yen in Japan and $5 in Canada, then the nominal exchange rate must be 100 yen per dollar. Otherwise, the purchasing power of the dollar would not be the same in the two countries.

15 Suppose that P is the price of a basket of goods in Canada ( measured in dollars), P* is the price of a basket of goods in Japan (measured in yen), and e is the nominal exchange rate ( the number of yen a Canadian dollar can buy). Now consider the quantity of goods a dollar can buy at home and abroad. –At home, the price level is P,so the purchasing power of $1 at home is 1/P –At abroad, a Canadian dollar can be exchanged into e units of foreign currency, which in turn have purchasing power e/P* –For the purchasing power of a dollar to be the same in two countries, it must be the case that 1/P = e/P* –With arrangement, this equation becomes 1=ep/P* –The left hand side is a constant, 1, and the right-hand side is the real exchange rate. ( see slide 11)

16 Thus, if the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate, the relative price of domestic and foreign goods, cannot change. Rearrange the equation, we can get e = P*/P. That is, the nominal exchange rate equals the ratio of the foreign price level to the domestic price level. According to the theory of purchasing-power parity, the nominal exchange rate between the currencies of two countries must reflect the different price levels in these countries. A key implication of this theory is that nominal exchange rates change when price levels change. As we saw in Chapter 16, the price level in any country adjusts to bring the quantity of money supplied and the quantity of money demanded into balance.

17 Because the nominal exchange rate depends on the price levels, it also depends on the money supply and money demand in each country. Therefore, when the central bank prints large quantities of money, the money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy. See Figure Consider the German hyperinflation of the early 1920s. Notice that these series move closely together. When the supply of money starts growing quickly, the price level also takes off, and the German mark depreciates. When the money supply stabilizes, so does the price level and the exchange rate.

18 Limitations of Purchasing-Power Parity Two things may keep nominal exchange rates from exactly equalizing purchasing power: 1. Many goods are not easily traded or shipped from one country to another. 2. Traded goods are not always perfect substitutes.

19 Interest Rate Determination in a Small Open Economy with Perfect Capital Mobility Small open economy: an economy that trades goods and services with other economies and by itself, has a negligible effect on world prices and interest rates Perfect Capital Mobility: full access to world financial markets. Implication of perfect capital mobility: The real interest rate in Canada, r, should equal the interest rate prevailing in world financial markets, r w. The theory that the real interest rate in Canada should equal that in the rest of world is known as interest rate parity. Limitations to interest rate parity: The real interest rate in Canada is not always equal to the real interest rate in the rest of world, for two key reasons.

20 First, financial assets carry with them the possibility of default. That is, while the seller of a financial asset promises to repay the buyer as some future date, the possibility always exists that the seller may not do so. In this case, buyers of financial assets are therefore said to incur a default risk. The higher the default risk, the higher the interest rate asset buyers demand from asset sellers. Second, financial assets offered for sale in different countries are not necessarily perfect substitutes for one another. For example, while similar assets in tow countries may pay the same rate of pre-tax return, different tax regimes in these two countries may result in different after- tax returns.