1. Open-Economy Macroeconomics
Basic Concepts

2. Outline: Closed versus open economy
Key macroeconomic variables in an open economy
Understanding and interpretation of data

3. Closed versus open
Closed economy is an economy that does not interact with other economies in the world
Open economy is an economy that interacts freely with other economies in the world

4. International flows of goods
Exports: goods and services that are produced domestically and sold abroad
Imports: goods and services that are produced abroad and sold domestically
Net exports: the value of a nation’s exports minus the value of its imports

5. International flows of goods
Trade balance: also called as net exports
Trade surplus: an excess of exports over imports, i.e. net exports are positive
Trade deficit: an excess of imports over exports, i.e. net exports are negative
Balanced trade: Exports and imports are equal, i.e. net exports are zero

6. Factors affecting international trade in goods and services
Tastes of consumers for domestic and foreign goods
Prices of goods at home and abroad
Exchange rate of domestic currency
Income of consumers at home and abroad
Cost of transportation
Policies of government towards trade

7. Increasing openness of Canadian economy: Reasons
Improvements in transportation
Advances in telecommunications
Technological progress
Free Trade Agreement in 1989
NAFTA in 1993

8. International flow of capital
Net foreign investment: the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners
Foreign Direct Investment (FDI): is investment that gives foreign investor management control of the domestic firm in which the investment is made
Foreign Portfolio Investment: are foreign holdings of government and private sector debt (bonds and shares) and involves no legal control.

9. Variables influencing net foreign investment
Real interest rates paid on foreign assets
Real interest rates paid on domestic assets
Perceived risk of holding assets abroad
Government policies that affect foreign ownership of domestic assets

10. Net Exports (NX)= Net Foreign Investment (NFI)
Exports > Imports
Purchases foreign stock
Canadian resident
+ NFI
Purchases Canadian stock
Foreign resident
- NFI

11. + NX NX=NFI + NFI + NX=+ NFI No change in NX and NFI
Good is exported
+ NX
USA
Canada
NX=NFI
Pays in USD
+ NFI
Invest in US bonds
+ NX=+ NFI
USA
Canada
Imports US goods
No change in NX and NFI

12. Conclusion:
Value of asset= value of goods and services sold
NFI=NX
International flow of goods= international flow of capital

13. Saving, Investment, and international flows
Saving= domestic investment+ net foreign investment
Investment in the Canadian economy
Savings in Canadian economy
Canadian NFI

16. Relation between saving, investment, and NFI: Canada’s experience
Refer transparencies for slides or pp. 382 of the text book.

17. Prices for international transactions: Exchange Rates
Nominal exchange rate: Rate at which a person can trade the currency of one country for the currency of another
Appreciation: An increase in the value of a currency as measured by the amount of foreign currency it can buy
Depreciation: A decrease in the value of a currency as measured by the amount of foreign currency it can buy

18. Real Exchange rate

19. Exchange rate determination: PPP
PPP is a theory of exchange rate whereby a unit of any given currency should be able to buy the same quantity of goods in all countries, i.e., a unit of all currencies must have the same real value in every country.
Implications:
Nominal exchange rate between the currencies of the two countries depends on the price levels in those countries.
Nominal exchange rates change when the price levels change.
Increase in the supply of money lowers value of money and depreciates the nominal exchange rate of the currency as well.

20. PPP Theory: Limitations
Many goods are not easily traded between countries limiting the arbitrage that can be gained from difference in prices.
Tradable goods are not perfect substitutes
Conclusion: Changes in the real exchange rate are often small and temporary. Large changes in nominal exchange rates reflect changes in price levels at home and abroad.

22. Interest rate determination
Assumptions:
Small open economy
Perfect capital mobility
Interest parity is a theory of interest rate determination whereby the real interest rate on comparable financial assets should be the same in all economies with full access to world financial markets.
Limitations:
Possibility of default
Financial assets are imperfect substitutes
Differences in default risk and in tax treatments

23. Consider a small country that exports steel
Consider a small country that exports steel. Suppose that a pro-trade government decides to subsidize steel by paying a certain amount for each ton of steel sold abroad. What are the effects of the export subsidy on :
Domestic price of steel
Quantity of steel produced
Quantity of steel consumed
Quantity of steel exported
Consumer surplus
Producer surplus
Government revenue
Total surplus

24. How would the following transactions affect Canada's imports, exports, net exports, and net foreign investment?
A Canadian spends his summer in Europe
Students in Paris come to watch whales in Victoria, BC
A Canadian cellular phone co establishes an office in the USA
TD mutual fund sells its Volkswagen stock to a French investor
Your uncle buys a new Volvo
A Canadian citizen shops at a store in NY to avoid Canadian sales tax
Harrod’s of London sells stock to the Ontario Teachers’ Pension Plan
Macey’s in NY is selling Roots T-shirts