1. Copyright © 2010 Pearson Education Canada. 6.1 Chapter 6 Openness in Goods and Financial Markets The Short Run Power Point Presentation Brian VanBlarcom Acadia University

2. Copyright © 2010 Pearson Education Canada. 6.2 Openness in Goods and Financial Markets Opening the Economy to International Transactions Three dimensions of openness: 1.Openness in Goods Markets 2.Openness in Financial Markets 3. Openness in Factor Markets

3. Copyright © 2010 Pearson Education Canada. 6.3 Openness in Goods Markets

4. Copyright © 2010 Pearson Education Canada. 6.4 Observations of Canadian Exports and Imports Openness in Goods Markets Exports and imports in Canada were around 15% of GDP in 1960, are around 40% of GDP today. For most of the last 40 years Canada had a trade surplus. The trade surplus was large in 1970 and 1971,1982 to 1985 and very large from 1997 –2007 (with a peak of 5% of GDP).

5. Copyright © 2010 Pearson Education Canada. 6.5 Measuring the Degree of Openness Openness in Goods Markets Export Ratio: Ratio of exports to GDP (Currently for Canada, exports are about 40% of GDP)

6. Copyright © 2010 Pearson Education Canada. 6.6 A Look Around the World Openness in Goods Markets

7. Copyright © 2010 Pearson Education Canada. 6.7 What Do You Think... Can exports exceed GDP? Openness in Goods Markets

8. Copyright © 2010 Pearson Education Canada. 6.8 The Choice Between Domestic and Foreign Goods Nominal Exchange Rates:Price of foreign currency in terms of domestic currency Real Exchange Rates: Price of foreign goods in terms of domestic goods Openness in Goods Markets

9. Copyright © 2010 Pearson Education Canada. 6.9 The Choice Between Domestic and Foreign Goods Nominal Exchange Rates: Two Views 1.The price of domestic currency in terms of foreign currency. 2.The price of foreign currency in terms of domestic currency. For Example: 2007: $1 C = $0.9310 US or $1 US = 1/0.9310 = $1.0741 C Openness in Goods Markets

10. Copyright © 2010 Pearson Education Canada. 6.10 The Choice Between Domestic and Foreign Goods Nominal Exchange Rates--Choosing a Definition: Nominal exchange rates (E): price of foreign currency in terms of domestic currency For Example: E between Canada (domestic) and the US (foreign) is the price of US$ in terms of C$ E = 1.0741 (2007) Openness in Goods Markets

11. Copyright © 2010 Pearson Education Canada. 6.11 The Choice Between Domestic and Foreign Goods Measuring Changes in the Nominal Exchange Rate (E) Appreciation of domestic currency corresponds to a decrease in E Depreciation of domestic currency corresponds to an increase in E Openness in Goods Markets

12. Copyright © 2010 Pearson Education Canada. 6.12 Nominal Exchange Rate, E (Price of US$ in terms of C$) Appreciation of the Canadian dollar Price of C$ in US$ increases Equivalently: Price of US$ in C$ decreases Equivalently: Exchange rate decreases: E Depreciation of the Canadian dollar Price of C$ in US$ decreases Equivalently: Price of US$ in C$ increases Equivalently: Exchange rate increases: E The Nominal Exchange Rate, Appreciation, and Depreciation: The United States and Canada* *From the point of view of Canada Openness in Goods Markets

13. Copyright © 2010 Pearson Education Canada. 6.13 Openness in Goods Markets

14. Copyright © 2010 Pearson Education Canada. 6.14 The Choice Between Domestic and Foreign Goods Observations on E between Canada and the United States: From 1970-1975, 1US$ cost roughly 1C$ For the last 30 years there has been a sustained depreciation of the C$ From 1988 to 1991 the CS appreciated. At end of 1987 US$1 = C$1.31, by Oct 1991, US$1 = C$1.13 A significant appreciation from 2002 (US$1 = C$1.50) to 2007 (C$1.07) Appreciation continued into 2008. Openness in Goods Markets

15. Copyright © 2010 Pearson Education Canada. 6.15 The Choice Between Domestic and Foreign Goods Question: Does a decrease in E of C$s for US$s necessarily mean Canadian citizens can buy more US goods with their dollars? Hint: What is the inflation rate in the United States? Openness in Goods Markets

16. Copyright © 2010 Pearson Education Canada. 6.16 The Choice Between Domestic and Foreign Goods Calculating Real Exchange Rates The price of one U.S. good (SUV) in terms of one Canadian Good (Minivan) 1.Convert the price of the SUV from US$s to C$s P US = 40,000 US$ = 1.5 C$s P C$s = 40,000 x 1.5 = $60,000 2.Compute the ratio of the US$ price of the SUV to the Minivan (Minivan price = $40,000) Real exchange rate between Canada & United States = Openness in Goods Markets

17. Copyright © 2010 Pearson Education Canada. 6.17 The Choice Between Domestic and Foreign Goods Expanding the Real Exchange Rate Calculation to the Entire Economic System If:P = Canadian GDP Deflator P* = U.S. GDP Deflator E = US$- C$ nominal exchange rate Then:Price of US goods in C$s = EP* Real exchange rate ( ) = EP* P NOTE: Real exchange rates ( ) are index numbers and measure only relative change. Openness in Goods Markets

18. Copyright © 2010 Pearson Education Canada. 6.18 The Choice Between Domestic and Foreign Goods Openness in Goods Markets

19. Copyright © 2010 Pearson Education Canada. 6.19 Openness in Goods Markets

20. Copyright © 2010 Pearson Education Canada. 6.20 The Choice Between Domestic and Foreign Goods Openness in Goods Markets

21. Copyright © 2010 Pearson Education Canada. 6.21 The Real and Nominal Exchange Rates Between United States and Canada 1970-2008 Observations: Openness in Goods Markets The real 1970 exchange was roughly the same as in 1984. E and P both rose, so remained unchanged. 1992-2002 the nominal and real exchange rate depreciated. In the 1990s Canada had a lower average inflation rate than the US. The P*/P ratio actually increased. From 1987-1991 the C$ appreciated 15% versus the US$.

22. Copyright © 2010 Pearson Education Canada. 6.22 Openness in Goods Markets

23. Copyright © 2010 Pearson Education Canada. 6.23 The Choice Between Domestic and Foreign Goods Country Composition of Canadian Merchandise Trade, 2007 Observations: United States is the dominant Canadian trading partner. Large trade surplus with U.S in 2007:Exports to U.S. = $356 Billion Imports from = $270 Billion Openness in Goods Markets

24. Copyright © 2010 Pearson Education Canada. 6.24 The Choice Between Domestic and Foreign Goods Real Multilateral Exchange Rates The real exchange rate when considering many countries Calculate by using each countrys share of trade as the weight for that country Openness in Financial Markets

25. Copyright © 2010 Pearson Education Canada. 6.25 Openness in Financial Markets Foreign Exchange: Buying and selling foreign currency 2005 world daily volume of foreign exchange equaled $1.9 trillion. 90% of the value involved US$ dollars on one side of the exchange. Volume of foreign exchange transactions in New York doubled between 2001 and 2005. This increase reflects an increase in financial transactions rather than an increase in trade. Openness in Financial Markets

26. Copyright © 2010 Pearson Education Canada. 6.26 Openness in Financial Markets

27. Copyright © 2010 Pearson Education Canada. 6.27 Openness in Financial Markets The Balance of Payments 2007 The Current Account (Above the Line) All recorded payments to and from the rest of the world 1.Trade in Goods and Services * Exports: Payments from the rest of the world $530.2 Billion * Imports: Payments to the rest of the world $501.5 Billion 2.Investment Income * Canadian residents receive income on their holdings of foreign assets $71.4Billion * Foreign residents receive income on their holdings of Canadian assets $85.6 Billion Openness in Financial Markets

28. Copyright © 2010 Pearson Education Canada. 6.28 Openness in Financial Markets The Balance of Payments 2007 (Continued) The Current Account (Above the Line) All recorded payments to and from the rest of the world 3.Foreign Aid ($1.1) Billion * Net transfers received The difference between foreign aid received and given 4.Current account balance (+,-)= 1+2+3= 13.4 Billion (2007) Openness in Financial Markets

29. Copyright © 2010 Pearson Education Canada. 6.29 Openness in Financial Markets The Balance of Payments 2007 The Capital Account 1.Increase in foreign holdings of Canadian assets $148.1 Billion 2.Increase in Canadian holdings of foreign assets ($170.0) Billion 3.Net capital flows = 2-1 $148.1 Billion - $170.0 Billion = (21.9 Billion) Statistical discrepancy = $8.5b Accounts for differences in data sources. Openness in Financial Markets

30. Copyright © 2010 Pearson Education Canada. 6.30 Openness in Financial Markets The Balance of Payments The Current Account Balance (+,-) = Capital Account Balance (+,-) A Current Account Surplus increases Canadian holdings of foreign assets and vice versa. Openness in Financial Markets

31. Copyright © 2010 Pearson Education Canada. 6.31 Openness in Financial Markets The Choice Between Domestic and Foreign Assets Canadian Bonds i t = Canadian nominal interest rate (1+i t ) = Return next year /C$ purchase of Canadian bonds An Example: Choose between Canadian and U.S. 1 yr. bonds Openness in Financial Markets

32. Copyright © 2010 Pearson Education Canada. 6.32 Openness in Financial Markets The Choice Between Domestic and Foreign Assets (Continued) U.S. Bonds E t = nominal exchange between the C$ and US$ (1/E t ) US = US$/C$ i* t = One year nominal interest rate on U.S. bonds (in US$) (1/E t )(1+i* t ) = Return/US$ invested An Example: Choose between Canadian and U.S. 1 yr. bonds Openness in Financial Markets

33. Copyright © 2010 Pearson Education Canada. 6.33 Openness in Financial Markets The Choice Between Domestic and Foreign Assets (Continued) U.S. Bonds E e t+1 = expected exchange rate next year (1/Et)(1+i* t )E e t+1 = return/US$ invested An Example: Choose between Canadian and U.S. 1 yr. bonds Note:Interest rates and exchange rates influence the choice between domestic and foreign assets. Openness in Financial Markets

34. Copyright © 2010 Pearson Education Canada. 6.34 Openness in Financial Markets

35. Copyright © 2010 Pearson Education Canada. 6.35 Openness in Financial Markets The Choice Between Domestic and Foreign Assets If:Investors will hold only the asset with the highest rate of return. Then:To hold both Canadian and U.S. bonds, they must have the same return. Or: Canadian Bond Return U.S. Bond Return = Openness in Financial Markets

36. Copyright © 2010 Pearson Education Canada. 6.36 Openness in Financial Markets The Choice Between Domestic and Foreign Assets (Continued) Canadian Bond Return US Bond Return = A little reorganizing: The Interest Parity Condition: Openness in Financial Markets

37. Copyright © 2010 Pearson Education Canada. 6.37 Openness in Financial Markets The Choice Between Domestic and Foreign Assets Is the assumption that investors hold only assets with the highest expected return realistic? Some other considerations: -- Transaction Costs -- Exchange Rate Risk Observation: The interest parity condition is a good approximation for developed countries with open, well-organized financial markets. Openness in Financial Markets

38. Copyright © 2010 Pearson Education Canada. 6.38 Openness in Financial Markets The Choice Between Domestic and Foreign Assets Adjusting the interest rate parity condition for changes in the value of the domestic currency The Interest Parity Condition: Or: = Expected rate of depreciation of the domestic currency Openness in Financial Markets

39. Copyright © 2010 Pearson Education Canada. 6.39 Openness in Financial Markets The Choice Between Domestic and Foreign Assets (Continued) An approximation: Openness in Financial Markets

40. Copyright © 2010 Pearson Education Canada. 6.40 Openness in Financial Markets The Choice Between Domestic and Foreign Assets (Continued) OR: Remember! Arbitrage implies: The domestic interest rate must be (approximately) equal to the foreign interest rate plus the expected depreciated rate of the domestic currency. Openness in Financial Markets

41. Copyright © 2010 Pearson Education Canada. 6.41 Openness in Financial Markets The Choice Between Domestic and Foreign Assets (Continued) Its September 1993... Brazilian bonds pay a monthly interest of 36.9% U.S. bonds pay a monthly interest of 0.2% Buy Brazilian? What about currency (Cruziero) depreciation? July 1993: 100,000 Cruzieros = $1.01 August 1993: 100,000 Cruzieros = $0.75 Openness in Financial Markets

42. Copyright © 2010 Pearson Education Canada. 6.42 Openness in Financial Markets The Choice Between Domestic and Foreign Assets (Continued) U.S. vs. Brazil? Do not forget: Risk and Transaction Costs Openness in Financial Markets

43. Copyright © 2010 Pearson Education Canada. 6.43 Openness in Financial Markets

44. Copyright © 2010 Pearson Education Canada. 6.44 Some Conclusions Goods Openness allows choice between domestic goods and foreign goods. Which goods are chosen depends primarily on the real exchange rate. Financial Assets Openness allows choice between domestic and foreign assets. Which assets are chosen depends primarily on: Relative rates of return Expected rate of depreciation of the domestic currency Openness in Financial Markets

45. Copyright © 2010 Pearson Education Canada. 6.45 End of Chapter Openness in Goods and Financial Markets