3-4 pages economic essay with graph

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Chapter12.pdf

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CHP 12: OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS Context

Chapter 12 is the first chapter in a two-chapter sequence dealing with open-economy macroeconomics. The purpose of the sequence is to show how government policies and international events impact productivity and living standards in a small, open economy. The chapters are a more realistic extension of the closed-economy analysis developed in Chapter 8. Chapter 12 develops the basic concepts and vocabulary associated with macroeconomics in an international setting: trade flows, capital flows, real and nominal exchange rates, purchasing-power parity, and real interest rate parity. It a a a a a a , why the nominal exchange rate adjusts to price level differences between countries [purchasing power parity], and why real interest rates are expected [after accounting for differential risk and tax treatment ] to be equal across countries. These concepts and relationships are put to work in Chapter 13, which builds an open-economy macroeconomic model capable of predicting the productivity effects of various government policies and international events.

Main Messages

Net exports are the value of domestic goods and services sold abroad minus the value of foreign goods and services sold domestically. Net capital outflow is the acquisition of foreign-held assets by domestic residents minus the acquisition of domestic-held assets by foreigners. Because every international transaction involves an exchange of an a a , a a a a a a . A a a a a a a a . T , a a a a domestic investment plus net capital outflow. The nominal exchange rate is the relative price of the currency of two countries, and the real exchange rate is the relative price of the goods and services of two countries. When the nominal exchange rate changes so that each dollar buys more foreign currency, the dollar is said to appreciate or strengthen. When the nominal exchange rate changes so that each dollar buys less foreign currency, the dollar is said to depreciate or weaken. According to the theory of purchasing-power parity [PPP], a dollar (or a unit of any other currency) should be able to buy the same quantity of goods in all countries. This is equivalent to saying that the real exchange rate between two countries should equal 1. PPP also implies that the nominal exchange rate between the currencies of two countries should reflect the price levels in those two countries. As a result, countries with relatively high inflation should have depreciating currencies, and countries with relatively low inflation should have appreciating currencies. Most economists prefer to use a model that describes Canada as a small open economy with perfect capital mobility. In such economies, real interest rate parity is expected to hold. Real interest rate parity is a theory that predicts real interest rates in Canada will equal those in the rest of the world. The theory does not always hold true - differences in tax rates and concerns about default risk mean that real interest rates in Canada can differ from those in the rest of the world. However, we expect Canadian real interest rates to move in step with world real interest rates.

Learning Objectives

After studying this chapter and the supplementary notes, you should be able to: 1. Define the key concepts. 2. Explain why net exports must always equal net capital outflows. 3. Explain how national saving, domestic investment and net capital outflows are related. 4. Explain the relationship between the nominal exchange rate, price levels, and the real exchange rate; that is,

explain why economists a a . 5. Explain how long-run real interest rates are determined in a small, open economy with perfect capital mobility;

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Key Concepts

Closed economy: an economy that does not trade goods, services, or financial assets [i.e. stocks, bonds, and currency] with other economies in the world. Open economy: an economy that trades goods, services and financial assets with other economies around the world. Globalization: increased openness between countries facilitated by improvements in transportation, communication, and the development of government trade agreements. Net exports (NX) or trade balance : a a a a . 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. Assets: in a , a , , a . Capital flow: the movement of assets from one country to another. Capital inflow: when foreigners purchase domestic-owned assets funds flow into the domestic economy in pursuit of domestic-owned assets. Domestic-owned assets can be such things as stocks, bonds, land/company title, or currency. Capital outflow: when domestic citizens purchase foreign-owned assets funds flow out of the domestic economy in pursuit of foreign-owned assets. Foreign-owned assets can be such things as stocks, bonds, land/company title, or currency. Net capital outflow (NCO): the difference between capital outflows and capital inflows in a given period; NCO is positive if capital outflows exceed inflows, and negative if inflows exceed outflows. Net export - net capital outflow identity: NX NCO Open economy saving - investment identity: S I + NCO Nominal exchange rate: the 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. Real exchange rate: the relative price of goods between countries, measured in a common currency unit. Real exchange rate formula: Real exchange rate = (e x P)/P*, where:

e = the nominal exchange rate P = the domestic price index for a basket of goods and services P* = the foreign price index for a comparable basket of goods and services

Purchasing power parity [PPP]: a long-run theory asserting that nominal exchange rates adjust to price level differences so that a currency can buy the same quantity of goods in all countries. PPP implies the real exchange rate between countries should equal 1.

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Small open economy: an economy that trades goods, services and assets with other economies and that, by itself, has a negligible effect on world prices and interest rates. Perfect capital mobility: full access to world financial markets [i.e. no restrictions on the flow of assets into or out of a country]. Risk premium: a positive or negative differential between domestic and world interest rates that compensates lenders for risk [i.e. the possibility of either loan default or exchange rate appreciation or depreciation] and differences in tax treatment on assets.

Rules of Thumb A a a a a tal outflows; NX NCO. Nominal exchange rates adjust to price level differences between countries so that the real exchange rate approaches a value equal to 1; R = (e x P)/P* = 1. After accounting for risk and tax treatment factors, the real interest rate in a small, open economy equals the world real interest rate; rdomestic = rworld + + , a a a a a a a , a a a rest rate premium demanded by lenders who face an additional tax burden when lending to domestic borrowers. Web Link

Data on Canadian exports and imports are available from the Statistics Canada website at http://www.statcan.gc.ca. F a a , Ca a a S a , , T E , I a a T a . T a a a a

country with which Canada is trading.

Supplementary Notes The Nece i f Balanced In e na i nal E change The text book contains several illustrations showing the necessary equality of net exports and net capital outflows see the discussion on pp. 262-263. A key idea to be grasped in this presentation is that every trade transaction must involve balanced exchange. To understand the meaning of balanced exchange, consider the following 3 cases: Case 1: Americans purchase $100 [US] worth stocks held by Canadians In this case, Americans acquire financial assets [i.e. $100 [US] worth of stocks] from Canadians. F Ca a a perspective, the loss of these stocks is classified as a capital inflow [CI] [i.e. foreigners have acquired domestic-owned assets]. H , a a Ca a a receipt of $100 [US] in payment for these stocks the $100 [US] receipt is classified as a capital outflow [i.e. domestic citizens have acquired foreign owned assets [US currency]. Thus, Canada experiences no change in net capital outflows [i.e. in NCO, which equals CO CI, is unaltered]; Case 1 involves balanced international exchange. Note that, since no trade in goods and services occurs in this example, net exports [NX] equal 0. Since NCO also equals 0 in this example, the NX = NCO identity is maintained. Case 2: Americans purchase $100 [US] worth of stock held by Canadians; Canadians use the US dollar payment to purchase $100 [US] worth of American goods.

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In this case, Americans again ac $100 [US] Ca a a . F Ca a a , CI again increases by $100 [US]. However, unlike in Case 1, Canadians do not retain the $100 [US] received in payment for the stocks they use it is to acquire $100 [US] worth of American goods. As such, there is no counter-balancing increase in CO Canada experiences negative NCO equal to $100 [US]. However, balanced international exchange is achieved through Canadian receipt of $100 [US] worth of goods from Americans; in effect, Canada has traded $100 [US] worth of stock to gain $100 [US] worth of goods. Receipt of American goods counts as Canadian imports [M]. Since no Canadian exports [X] occur in this example, Canadian net exports [i.e. NX, which equals X M] equal negative $100 [US]. As such, the balance between NCO [in this case, negative $100 [US]] and NX [in this case, negative $100 [US]] is maintained. Case 3: Americans purchase $100 [US] worth of stock held by Canadians; Canadians use the US dollar payment to purchase $100 [US] worth of American stock. I a , A a a $100 [US] Ca a a . F Ca a a , CI once again increases by $100 [US]. Like in Case 2, Canadians do not retain the $100 [US]; unlike in Case 2, they use it to acquire $100 [US] worth of American stocks [not goods]. Because Canada acquires $100 [US] in stocks, it experiences a CO equal to $100 [US]. Since CO matches CI, Canada experiences no change in NCO - Case 3 once again involves balanced international exchange. Note that, since no trade in goods and services occurs in this example, NX equals 0. Since NCO also equals 0, the NX = NCO identity is maintained. The Real Exchange Rate The real exchange rate can be viewed as the relative price of goods between countries, measured in a common currency unit. The formula is: Real exchange rate = Nominal exchange rate x Domestic price Foreign price Working with the example in the text [pp.279-280], if a tonne of Canadian wheat costs 200 dollars, a tonne of equivalent Russian wheat costs 1600 rubles, and the nominal exchange rate is 4 rubles to $1, the real exchange rate is: Real exchange rate = [4 rubles/$1] x $200 = 800 rubles = 0.5 1600 rubles 1600 rubles This means that, when measured in terms of rubles, one tonne of Canadian wheat is half as expensive as one tonne of Russian wheat. Thus, wheat is relatively cheaper when purchased from Canada. Note that if the real exchange rate had exceeded one, Canadian wheat would have been more expensive than Russian wheat. Neither country would have a price advantage if the real exchange rate equaled one. The more general formula for the real exchange rate is: Real exchange rate = (e x P)/P*, where:

e = the nominal exchange rate P = the domestic price index for a basket of goods and services P* = the foreign price index for a comparable basket of goods and services.

Purchasing Power Parity Why do nominal exchange rates change over time? A basic explanation is found in the theory of purchasing power parity. This theory asserts that, in the long run, nominal exchange rates adjust so that a dollar of domestic currency buys the same amount of goods at home as it would abroad. In other words, adjustments occur so that there is parity in a a a .

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The theory can be understood by focusing on the real exchange rate. Recall that the real exchange rate determines the relative price of goods between countries. If the real rate does not equal one, one country has a trade advantage over the other, and trade flows will occur to exploit the advantage. In the example above concerning Canadian and Russian wheat, the real exchange rate was 0.5, meaning Canadian wheat was half as expensive as Russian wheat. In this circumstance, we expect that exports of Canadian wheat will increase, while exports of Russian wheat will decline. The resulting trade flows can be expected to bring about an adjustment in the real exchange rate. To see why an adjustment must occur, assume to start that the nominal exchange rate is fixed at 4 rubles for 1 dollar. With Canadian wheat costing 800 rubles per tonne [$200 x 4 rubles per dollar] compared to the Russian price of 1600 rubles per tonne, Canadian wheat is a bargain. The resulting increased demand for Canadian wheat will drive the domestic price of wheat in Canada up, while less demand for Russian wheat will push the domestic wheat price in Russia down. Referring to the real exchange rate formula, these adjustments in prices will cause the real exchange rate to rise. Canadian wheat prices will continue to rise and Russian wheat prices will continue to fall until Canada no longer has a trade advantage. This occurs when wheat prices settle at levels that imply a real exchange rate equal to one. Referring to the formula, if the price of Canadian wheat rises to $300, the price of Russian wheat must fall to 1200 rubles: [4 rubles/$1] x $300 = 1200 rubles = 1

1200 rubles 1200 rubles When the real exchange rate equals one, purchasing power parity is achieved: a dollar of domestic currency buys the same amount of goods at home as it would abroad. In our example, note that with a fixed nominal exchange rate of 4 rubles for 1 dollar, $300 Canadian buys one tonne of wheat in either Canada or Russia. The adjustment process discussed above follows from the law of one price: trade flows eventually force a good to sell for the same price in all locations. Purchasing power parity and the law of one price can also be achieved through adjustment in the nominal exchange rate. Assume that domestic wheat prices in both Canada and Russia are fixed, but that the nominal exchange rate is free to adjust. With Canadian wheat initially a bargain relative to Russian wheat, demand for Canadian dollars [necessary to purchase Canadian wheat] will increase, while the demand for Russian rubles [necessary to purchase Russian wheat] will decline. These pressures will cause the dollar to appreciate against the ruble, driving the nominal exchange rate up. Referring again to the real exchange rate formula, note that thi a ( . . a ) also cause the real exchange rate to rise. Nominal exchange rate adjustment will stop when Canada no longer has a trade advantage; that is, when the real exchange rate again equals one. For example, with the price of Canadian wheat fixed at $200 and the price of Russian wheat fixed at 1600 rubles, the exchange rate would have to rise to the point where 8 rubles trade for one dollar. Consider now how the theory of purchasing power parity helps predict long run movements in nominal exchange rates. R a a , a a . I a partners pursue monetary policies that result in differing inflation rates, [ . . P n the real exchange rate formula] will vary between the countries, pressuring the real exchange rate to move away from a value equal to one. As this occurs, trade flows will emerge to take advantage of the relatively cheaper goods in the country with lower inflation [i.e. the country with superior monetary policy]. Because we know that these trade flows will eventually force the real exchange rate back to a value of one, we predict that the nominal exchange rate will adjust to counter-balance inflation rate differences. In particular, lower inflation rate currencies will appreciate against the higher inflation rate currencies so as to maintain purchasing power parity.

TYU Questions

1. Complete Problems and Applications 1 on p.282 of the textbook. 2. Complete Questions for Review 1 on p.282. 3. Complete Questions for Review 2 on p.282.

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4. Complete Questions for Review 3 on p.282. 5. Complete Problems and Applications 8 on p283. 6. Complete Questions for Review 4 on p.282. 7. Complete Problems and Applications 9 on p.283. 8. Complete Problems and Applications 10 on p.283 9. Complete Problems and Applications 11 on p.283. 10. Complete Questions for Review 5 on p.282. 11. Complete Questions for Review 6 on p.282.

Quick Check Multiple Choice

Try the Quick Check Multiple Choice questions 1 6 on p.282 of the course textbook. TYU Answers

1. [a] When a Canadian art professor spends the summer touring museums in Europe, he spends money buying foreign goods and services, so Canadian exports are unchanged, imports increase, and net exports decrease. [b] When students in Paris flock to see the latest Diana Krall concert, foreigners are buying a Canadian good, so Canadian exports rise, imports are unchanged, and net exports increase. [c] When your uncle buys a new Volvo, a Canadian is buying a foreign good, so Canadian exports are unchanged, imports rise, and net exports decline. [d] When the student bookstore at Oxford University sells a pair of Bauer hockey skates, foreigners are buying Canadian goods, so Canadian exports increase, imports are unchanged, and net exports increase. [e] When a Canadian shops in northern Vermont to avoid Canadian sales taxes, a Canadian is buying foreign goods, so Canadian imports increase, exports are unchanged, and net exports decrease. 2. The net exports of a country are the value of its exports minus the value of its imports. Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Net exports are equal to net capital outflow by an accounting identity, since exports from one country to another are matched by payments of some asset from the second country to the first.

3. Saving equals domestic investment plus net capital outflow, since any dollar saved can be used to finance accumulation of domestic capital or it can be used to finance the purchase of capital abroad.

4. If a dollar can buy 100 yen, the nominal exchange rate is 100 yen per dollar. The real exchange rate equals the nominal exchange rate times the domestic price divided by the foreign price, which equals 100 yen per dollar times $10,000 per Canadian car divided by 500,000 yen per Japanese car, which equals 2 Japanese cars per Canadian car.

5. All the parts of this question can be answered by keeping in mind the definition of the real exchange rate. The real exchange rate equals the nominal exchange rate times the domestic price level divided by the foreign price level. [a] I Ca a a a a a a , ise faster in Canada than abroad, the real exchange rate rises. [b] I Ca a a a a a a , a a a a Ca a a, the real exchange rate declines. [c] I Ca a a a a a , a ces are unchanged in Canada and abroad, the real exchange rate declines. [d] I Ca a a a a a , a a a a a Ca a a, real exchange rate declines.

6. The economic logic behind the theory of purchasing-power parity is that a good must sell for the same price in all locations. Otherwise, people would profit by engaging in arbitrage. Therefore, a dollar of domestic currency should acquire the same amount of goods at home as it can in a foreign country, once the dollar is exchanged for foreign currency at the prevailing nominal exchange rate.

7. Three goods for which the law of one price is likely to hold are farm goods like wheat, which are nearly identical no matter where they are produced, technological goods like computer software, which have low shipping costs because they are light, and clothing, which also has low shipping costs. Three goods for which the law of one price is not likely to hold are real estate, because you can't move land or buildings from one country to another;

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goods that are mainly consumed in one country and so are not traded, like frog legs in France; and services like haircuts, which cannot be arbitraged even if the price is very different in different countries.

8. If purchasing-power parity holds, then 12 pesos per pop divided by $0.75 per pop equals the exchange rate of 16 pesos per dollar. If prices in Mexico doubled, the exchange rate will double to 32 pesos per dollar.

9. a. To make a profit, you would want to buy wheat where it is cheap and sell it where it is expensive. Since Canadian wheat costs 100 dollars per tonne, and the exchange rate is 4 rubles per dollar, Canadian wheat costs

100 × 4 equals 400 rubles per tonne. So, Canadian wheat at 400 rubles per tonne is cheaper than Russian wheat at 1600 rubles per tonne. So you could take 400 rubles, exchange them for 100 dollars, buy a tonne of

Canadian wheat, and then sell it for 1600 rubles, making a profit of 1200 rubles. As people did this, the demand for Canadian wheat would rise, increasing the price in Canada, and the supply of Russian wheat would rise, reducing the price in Russia. The process would continue until the prices in the two countries were the same.

b. If wheat were the only commodity in the world, the real exchange rate between Canada and Russia would start out too low, and then rise as people bought wheat in Canada and sold it in Russia, until the real exchange rate became one in long-run equilibrium.

10. If the Bank of Canada started printing large quantities of Canadian dollars, Canadian price level would increase, and a dollar would buy fewer Japanese yen.

11. Interest rate parity, a theory which suggests that the real interest rate in Canada should adjust to equal the real interest rate in the rest of the world, is based on the same concept as the law of one price and purchasing-power parity. People take advantage of the differences in real interest rates until the differentials disappear.

Quick Check Multiple Choice Answers

1. [a] 2. [a] 3. [d] 4. [a] 5. [b] 6. [d]

Assigned Problems 1. Explain why, in each of the following cases, the identity NX = NCO a a Ca a a

Hints: See pp.262-263 of the textbook. Also see the Key Concepts in the Chapter 12 Student Package, and the S a N T N Ba a I a a E a [ . 3-4].

[a] Managers of the BC Public Service Pension Fund use $20 million in Canadian dollars to purchase new shares issued by a California electric company. The California electric company uses the proceeds to buy hydro- power equipment produced in Quebec. [b] HO Sports, a US company, buys $3 million [US] worth of water ski rope produced by Canadian manufacturer. The Canadian manufacturer accepts payment in US dollars, and deposits the amount in a Canadian bank.

2. How would the following transactions affect Ca a a [ ] a a (CO) a [ ] a a (CI) [ . . a , a , a a ]? W a Ca a a [ ] net capital outflow (NCO)

[i.e. increase, decrease, or remain unchanged]? Hints: See pp. 261-262 in Chapter 12 of the course text. See also the Key Concepts in the Chapter 12 Student Pa a , a S a N T N Ba a I a a E a [ . 3-4]. Something to think about for this question: Be careful to remember that NX = NCO. With this in mind, if a

transaction does not involve NX, what must be the ultimate impact of the transaction on NCO? Why? It may be helpful to refer back to your thinking in Question 1.

[a] A Czech Republic cellular phone company purchases shares of a cellular company in Canada.

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[i] [ii] [iii] [b] German pension fund managers purchase government bonds from the Canadian federal government. The federal government uses Euros received from the Germans to purchase software products produced in Italy. [i] [ii] [iii] [c] Managers of the B.C. Municipal Workers Pension Plan sell Russian oil company shares [previously owned by the Plan] to the Alberta Teachers Pension Plan. [i] [ii] [iii]

3. The United States recently experienced trade deficits with China. What would be true of capital flows between the

two countries [i.e. would US net capital outflows [NCO] vis-à-vis China be positive, negative, or zero]? Hints: See the macroeconomic identities and discussion on pp. 262-263 in Chapter 12 of the course text. See also TYU Question 3 in the Chapter 12 Student Package.

4. A can of pop costs $1.00 in Canada and 12.5 pesos in Mexico. Hints: See pp.270-273 in Chapter 12 of the course text. See also the Supplementary Notes, pp. 3-4, in the Chapter 12 Student Package. See also TYU Questions 5, 7, 8, and 9 in the Chapter 12 Student Package. [a] What would the peso-dollar exchange rate [i.e. e1 in the equation R = [e1 x PD]/PF] be if purchasing power parity holds? [b] If a monetary expansion by the Mexican government caused all prices in Mexico to double, so that the price of pop rose to 25 pesos, what would be the new peso-dollar exchange rate? [c] Would you expect the law of one price to apply to taxi rides in different countries? Explain. 5. Canadian nominal interest rates have not historically been equal to US nominal interest rates. How is this possible, given the theory of interest rate parity? Hint: See pp. 278-280 in Chapter 12 of the course text.