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Principles of Macroeconomics ECON 202

COQUITLAM COLLEGE

Kojo Laryea

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

Chapter 12

Objectives

▪ Learn how net exports measure the international flow of goods and services

▪ Learn how net capital outflow measures the international flow of capital

▪ Consider why net exports must always equal net capital outflow

▪ See how saving, domestic investment, and net foreign investment are related

▪ Learn the meaning of the nominal exchange rate and the real exchange rate

▪ Examine purchasing power parity as a theory of how exchange rates are determined

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

▪ So far our development of macroeconomics has

largely ignored the economy’s interaction with other

economies around the world.

▪One of the ten principles of economics highlighted in

Chapter 1 is that trade can make everyone better off.

▪When macroeconomists study an open economy, they

encounter a whole set of new issues.

▪Closed economy: An economy that does not

interact with other economies in the world.

▪Open economy: An economy that interacts

freely with other economies around the world.

OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

▪An open economy interacts with other economies in two ways:

▪ It buys and sells goods and services in world product/ commodity markets.

▪ It buys and sells capital assets such as stocks and bonds in world financial markets.

▪ These two activities are discussed here as well as the close relationship between them.

THE FLOW OF GOODS: EXPORTS, IMPORTS, AND NET EXPORTS

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

▪ Exports: Goods and services that are produced domestically and sold abroad. ▪ When Bombardier, the Canadian aircraft manufacturer, builds a plane and

sells to Air France, the sale is an export to Canada

▪ Imports: Goods and services that are produced abroad and sold domestically. ▪ When Volvo, the Swedish car manufacturer, makes a car and sells it to a

Canadian resident, the sale is an import to Canada

▪ Net exports (or trade balance): The value of a nation’s exports minus the value of its imports.

THE FLOW OF GOODS: EXPORTS, IMPORTS,

AND NET EXPORTS (CONTINUED)

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

Net Export= Value of Country’s Exports- Value of Country’s Import

▪ Bombardier sale raises Canada’s exports

▪ Volvo sale reduces Canada’s net exports

THE FLOW OF GOODS: EXPORTS, IMPORTS,

AND NET EXPORTS (CONTINUED)

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

▪ Trade balance: The value of a nation’s exports minus the value of its imports; also called 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.

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

THE FLOW OF GOODS: EXPORTS, IMPORTS,

AND NET EXPORTS (CONTINUED)

FIGURE 12.1 The Internationalization of the Canadian Economy

▪Net capital outflow: The purchase of foreign assets by

domestic residents minus the purchase of domestic

assets by foreigners.

Net capital outflow= Purchase of foreign assets by domestic

residents- Purchase of domestic assets by foreigner

THE FLOW OF FINANCIAL RESOURCES:

NET CAPITAL OUTFLOW (CONTINUED)

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

▪When a Canadian buys stocks in Telmex, the Mexican

phone company, the purchase raises Canadian net

capital outflow

▪When Japanese resident buys a bond issued by the

Canadian government, the purchase reduces

Canadian net capital outflow

THE FLOW OF FINANCIAL RESOURCES:

NET CAPITAL OUTFLOW (CONTINUED)

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

▪ Note that the flow of capital abroad takes two forms

▪ If Tim Hortons opens a fast-food outlet in Russia, that is an example of foreign direct investment

▪ Alternatively, if a Canadian buys stock in a Russian corporation, that is an example of foreign portfolio investment

▪ In the first case, the Canadian owner is actively managing the investment, whereas in the second case 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 capital outflow

THE FLOW OF FINANCIAL RESOURCES:

NET CAPITAL OUTFLOW (CONTINUED)

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

▪Net capital outflow can be either positive or negative

▪When it is positive, domestic residents are buying more foreign assets than foreigners are buying domestic assets. Capital is said to be flowing out of the country

▪When the net capital outflow is negative, domestic residents are buying less foreign assets than foreigner are buying domestic assets. Capital is said to be flowing into the country

THE FLOW OF FINANCIAL RESOURCES:

NET CAPITAL OUTFLOW (CONTINUED)

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

▪ Some of the variables that influence net capital outflow

(NCO):

▪ Real interest rates being paid on foreign assets

▪ Real interest rates being paid on domestic assets

▪ Perceived economic and political risks of holding

assets abroad

▪Government policies that affect foreign ownership of

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

THE FLOW OF FINANCIAL RESOURCES:

NET CAPITAL OUTFLOW (CONTINUED)

▪Net exports measure an imbalance between a

country’s exports and its imports.

▪Net capital outflow measures an imbalance between

the amount of foreign assets bought by domestic

residents and the amount of domestic assets bought by

foreigners.

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

THE FLOW OF FINANCIAL RESOURCES:

NET CAPITAL OUTFLOW (CONTINUED)

▪ That is, net capital outflow (NCO) always equals net

exports (NX):

▪ This equation holds because every transaction that

affects one side of this equation must also affect the

other side by exactly the same amount

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

THE FLOW OF FINANCIAL RESOURCES:

NET CAPITAL OUTFLOW (CONTINUED)

▪When NX > 0, the country is selling more goods and

services to foreigners than it is buying from them.

▪What is it doing with the foreign currency it receives from

the net sale of goods and services abroad?

▪ It must be using it to buy foreign assets.

▪Capital is flowing out of the country (i.e., NCO > 0).

THE EQUALITY OF NET EXPORTS AND NET CAPITAL OUTFLOW

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

▪When NX < 0, the country is buying more goods and

services from foreigners than it is selling to them.

▪How is it financing the net purchase of these goods and

services in world markets?

▪ It must be selling assets abroad.

▪Capital is flowing into the country (i.e., NCO < 0).

THE EQUALITY OF NET EXPORTS AND

NET CAPITAL OUTFLOW (CONTINUED)

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

Closed Economy

▪ Saving, investment, and international capital flows are

inextricably linked.

12-20

SAVING, INVESTMENT, AND THEIR RELATIONSHIP TO THE INTERNATIONAL FLOWS

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

SAVING, INVESTMENT, AND THEIR RELATIONSHIP TO THE

INTERNATIONAL FLOWS (CONTINUED)

THE INTERNATIONAL FLOWS OF GOODS AND CAPITAL

▪ Because net exports (NX) also equal NCO, we can write

this equation as:

TABLE 12.1 International Flows of Goods and Capital: Summary

QuickQuiz

✓ Define net exports and net capital outflow.

✓ Explain how they are related.

Quick

Quiz

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES

▪ Two important international prices are discussed here:

1. The nominal x-rate

2. The real x-rate

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12-24

▪ Nominal exchange rate: The rate at which a person can

trade the currency of one country for the currency of

another.

▪ For example, if you go to the bank, you might see a posted exchange rate

of 80 yen per dollar. If you give the bank one Canadian dollar, it will give

you 80 Japanese yen

▪ 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.

NOMINAL EXCHANGE RATES

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES

▪ For example, when the exchange rates rises from 80 to 90 yen per

dollar, the dollar is said to appreciate

▪ At the same time, because a Japanese yen now buys less of a

Canadian dollar, the yen is said to depreciate

▪ When the exchange rate fall from 80 to 70 yen per dollar, the

dollar is said to depreciate, and the yen is said to appreciate

NOMINAL EXCHANGE RATES

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES

▪ Real exchange rate: The rate at which a person can

trade the goods and services of one country for the

goods and services of another.

▪Why does the real exchange rate matter?

▪ It is a key determinant of how much a country exports

and imports.

REAL EXCHANGE RATES

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES

▪ For example, suppose you go to shopping and find that

a case of German beer is twice as expensive as a case

of Canadian beer.

▪We should say that the real exchange rate is half of a

case of German beer per case of Canadian beer

▪Notice that, like the nominal exchange rate, we express

the real exchange as unit of the foreign item per unit of

domestic item

REAL EXCHANGE RATES

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES

▪ Real and nominal exchange rates are closely related

▪ To see how, consider an example. Suppose that a bushel of

Canadian wheat sells for $200, and a bushel Russian wheat sells

for 1600 rubles.

▪ What is the real exchange rate between Canadian and Russian

wheat

▪ To answer this, we must first use the nominal exchange rate to

convert prices into a common currency

▪ If the nominal exchange rate is 4 rubles per dollar, then a price for

Canadian wheat of $200 is equivalent to 800 rubles per bushel 12-29

REAL EXCHANGE RATES

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES

REAL EXCHANGE RATES (CONTINUED)

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES

▪Why does the real exchange rate matter?

▪ The real exchange rate is a key determinant of how

much a country exports and imports.

REAL EXCHANGE RATES (CONTINUED)

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES

FIGURE 12.3 The Value of the Canadian Dollar

FIGURE 12.3 The Value of the Canadian Dollar (Continued)

▪When studying an economy as a whole,

macroeconomists focus on overall prices rather than

the prices of individual items.

REAL EXCHANGE RATES (CONTINUED)

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES

FIGURE 12.4 Real and Nominal Exchange Rates

e = 10 pesos per $

price of tall Starbucks latte P = $3 in CDA, P* = 24 pesos in Mexico

A. What is the price of a Canadian latte measured in pesos?

B. Calculate the real exchange rate, measured as Mexican lattes per Canadian latte.

12-36

Active Learning Compute the Real Exchange Rate

e = 10 pesos per $

price of a tall Starbucks Latte

P = $3 in CDA, P* = 24 pesos in Mexico

A. What is the price of a Canadian latte in

pesos?

B. Calculate the real exchange rate.

30 pesos per CDA latte =

e x P

P* 24 pesos per Mexican latte

= 1.25 Mexican lattes per CDA latte

12-37

Active Learning Answers

QuickQuiz

✓ Define nominal exchange rate and real exchange rate, and explain how they are related.

✓ If the nominal exchange rate goes from 100 to 120 yen per dollar, has the dollar appreciated or depreciated?

Quick

Quiz

A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING POWER PARITY

▪ Purchasing-power parity (PPP): A theory of exchange

rates whereby a unit of any given currency should be

able to buy the same quantity of goods in all countries.

▪ The theory of purchasing-power parity is based on a principle

called the law of one price (LOP).

▪ The law asserts that a good must sell for the same price in all

locations. Otherwise, opportunity for profit would be left unexploited

▪ For example, suppose that coffee beans sold for less in Vancouver

than in Halifax. A person could buy coffee in Vancouver and sell in

Halifax

▪ The process of taking advantage of differences in prices in different

markets is called arbitrage

▪ According to the PPP theory, a currency must have the same

purchasing power in all countries. 12-40

THE BASIC LOGIC OF PURCHASING-POWER PARITY

A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING POWER PARITY

▪ It tells us that the nominal exchange rate between the

currencies of two countries depends on the price levels

in those countries.

▪ 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

IMPLICATIONS OF PURCHASING-POWER PARITY

A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING POWER PARITY

▪ For example, if a kilo of coffee costs 500 yen in Japan

and $5 in Canada, then the nominal exchange rate

must be 100 yen per dollar (500yen/$5=100 yen per

dollar)

▪Otherwise purchasing power of the dollar would not be

the same in the two countries

IMPLICATIONS OF PURCHASING-POWER PARITY

A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING POWER PARITY

▪ For the purchasing power of a dollar to be the same in

the two countries, it must be that:

▪ Then

IMPLICATIONS OF PURCHASING-POWER

PARITY (CONTINUED)

A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING POWER PARITY

▪ Rearranging

▪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 those

countries.

IMPLICATIONS OF PURCHASING-POWER

PARITY (CONTINUED)

A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING POWER PARITY

▪ PPP provides a simple model of how exchange rates are

determined.

▪ Exchange rates do not, however, always move to

ensure that a dollar has the same real value in all

countries all the time.

▪Many goods are not easily traded.

▪ Tradable goods are not always perfect substitutes.

LIMITATIONS OF PURCHASING-POWER PARITY

A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING POWER PARITY

The Hamburger Standard

case

study

THE END

Chapter 12