Chapter 12- introduction to open-economy macroeconomics.

So far our development of macroeconomics has largely ignored the economy’s

interaction with other economies around the world. To keep their analysis simple,
macroeconomists often assume a
Closed economy-an economy that does not interact with other economies.
Yet some new macroeconomic issues arise in an
Open economy -an economy that interacts freely with other economies around the world.
Interacts with other economies in two ways: It buys and sells goods and services in world
product markets, and it buys and sells capital assets such as stocks and bonds in world
financial markets

The Flow of Goods: Exports, Imports, and Net Exports

Exports are domestically produced goods and services that are sold abroad.
Imports are foreign-produced goods and services that are sold domestically.

Net exports of any country are the value of its exports minus the value of its imports.
Trade balance the value of a nations 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

6 Factors that might influence a country’s exports, imports, and net exports.
 Tastes of consumers for domestic and foreign goods
 Prices of goods at home and abroad
 Exchange rates at which people can use domestic currency to buy foreign
currencies
 Incomes of consumers at home and abroad
 Cost of transporting goods from country to country
 Policies of the government toward international trade

As these variables change over time, so does the amount of international trade.

The Flow of Financial Resources: Net Capital Outflow

Net capital outflow the purchase of foreign assets by domestic residents minus the
purchase of domestic assets by foreigners (It is sometimes called net foreign investment.)
Ex. Canadian resident buys stock in Telmex, the Mexican phone company (Increase)
Ex. Japanese resident buys a bond issued by the Canadian government (Decrease)

Variables that influence net capital outflow:

 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

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  Government policies that affect foreign ownership of domestic assets

Canadian investors deciding whether to buy Mexican government bonds or Canadian

government bonds.
 The higher the bond’s real interest rate, the more attractive it is.
 Canadian investors must also take into account the risk that one of these
governments might default on its debt
 Restrictions that the Mexican government has imposed, or might impose in the
future, on foreign investors in Mexico.

Open economy interacts with the rest of the world in two ways in world markets for
goods and services and in world financial markets. Net exports and net capital outflow
each measure a type of imbalance in these markets. 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. An important but subtle fact of
accounting states that, for an economy as a whole, these two imbalances must offset each
other.
NCO = NX
Every transaction that affects one side of this equation must also affect the other side by
exactly the same amount. This equation is an identity -an equation that must hold because
of the way the variables in the equation are defined and measured.
To see why this accounting identity is true, consider an example. Suppose that
Bombardier, the Canadian aircraft maker, sells some planes to a Japanese airline.
In this sale, a Canadian company gives planes to a Japanese company, and a
Japanese company gives yen to a Canadian company. Notice that two things have
occurred simultaneously. Canada has sold to a foreigner some of its output (the planes),
and this sale increase Canadian net exports. In addition, Canada has acquired some
foreign assets (the yen), and this acquisition increases Canada’s net capital outflow.
Vice Versa. When a seller country transfers a good or service to a buyer country, the
buyer country gives up some asset to pay for this good or service. The value of that asset
equals the value of the good or service sold. The international flow of goods and services
and the international flow of capital are two sides of the same coin.

Where do we account for the future flow of financial capital that will result from the
payment of dividends? Similarly, while the initial purchase and sale of bonds are
measured in NCO, where do we account for the net flow of interest payments that will
eventually result?
Current account balance = Net exports + Net inflow of dividends and interest payments

Saving, Investment, and Their Relationship to the International Flows

Y = C + I + G + NX

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 National Saving S=Y- C - G

Y- C - G = I + NX, so National Saving also equals S = I + NX

Net exports (NX) also equal net capital outflow (NCO), so we can write

Remember: S=I (closed economy)

S = I + NCO (open economy)

By contrast, an open economy has two uses for it’s saving: domestic investment and net
capital outflow. Canadian citizens save a dollar of their income for the future, that dollar
can be used to finance accumulation of domestic capital or it can be used to finance the
purchase of capital abroad. As before, we can view the financial system as standing
between the two sides of this identity.
For example, suppose the Smith family decides to save some of its income for retirement.
This decision contributes to national saving, the left-hand side of our equation. If the
Smiths deposit their saving in a mutual fund, the mutual fund may use some of the deposit
to buy stock issued by Stelco, which uses the proceeds to build a new steel plant in
Ontario. In addition, the mutual fund may use some of the Smiths’ deposit to buy stock
issued by Toyota, which uses the proceeds to build a steel plant in Osaka. These
transactions show up on the right- hand side of the equation. From the standpoint of
Canadian accounting, the Stelco expenditure on a new steel plant is domestic investment,
and the purchase of Toyota stock by a Canadian resident is net capital outflow. Thus, all
saving in the Canadian economy shows up as investment in the Canadian economy or as
Canadian net capital outflow. When a nation’s saving exceeds its domestic investment,
its net capital outflow is positive; indicating that the nation is using some of it’s saving to
buy assets abroad. When a nation’s domestic investment exceeds it’s saving, its net
capital outflow is negative, indicating that foreigners are financing some of this
investment by purchasing domestic assets.

Canada is a net debtor in world financial markets. This means that foreigners own more
Canadian assets than Canadians own foreign assets.

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND

NOMINAL EXCHANGE RATES

Just as the price in any market serves the important role of coordinating buyers and
sellers in that market, international prices help coordinate the decisions of consumers and
producers as they interact in world markets. Here we discuss the two most important
international prices- the nominal and real exchange rates.

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 Nominal Exchange Rates

The nominal exchange rate is the rate at which a person can trade the currency of one
country for the currency of another. Throughout this book, we always express the
nominal exchange rate as units of foreign currency per Canadian dollar, such as 80 yen
per dollar.

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

80 to 90 yen per dollar, the dollar is said to appreciate for Canada. For the Japanese yen
depreciates. Vice versa.

At times you may have heard the media report that the dollar is either strong or weak.
These descriptions usually refer to recent changes in the nominal exchange rate. When a
currency appreciates, it is said to strengthen because it can then buy more foreign
currency. Similarly, when a currency depreciates, it is said to weaken.
For any country, there are many nominal exchange rates. The Canadian dollar can be
used to buy Japanese yen, British pounds, Mexican pesos, U.S. dollars, and so on. Just as
the consumer price index turns the many prices in the economy into a single measure of
the price level, an exchange rate index turns these many exchange rates into a single
measure of the international value of the currency.

Real Exchange Rates

Real exchange rate is the rate at which a person can trade the goods and services of one
country for the goods and services of another.
For example, suppose you go shopping and find that a case of German cheese is twice as
expensive as a case of Canadian cheese. We would then say that the real exchange rate is
half of a case of German cheese per case of Canadian cheese.

Nominal Exchange rate= . (P*) Foreign Price .

(P) Canadian Price

Real exchange rate = Nominal exchange rate × Domestic price

Foreign price

Why does the real exchange rate matter? As you might guess, the real exchange rate is a
key determinant of how much a country exports and imports. (ex. Going on vacation and
comparing hotel costs between different countries is basing your decision on real
exchange rate.)

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 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 the consumer price index, which measure the price of a basket of
goods and services. By using a price index for a Canadian basket (P), a price index for a
foreign basket (P*), and the nominal exchange rate between the Canadian dollar and
foreign currencies (e), we can compute the overall real exchange rate between Canada
and other countries
Real exchange rate = e x P
P*
A depreciation (fall) in Canada’s real exchange rate means that Canadian goods have
become cheaper relative to foreign goods. This change encourages consumers both at
home and abroad to buy more Canadian goods and fewer goods from other countries. As
a result, Canada’s exports rise and Canada’s imports fall, and both of these changes raise
Canada’s net exports. Conversely, an appreciation (rise) in Canada’s real exchange rate
means that Canadian goods have become more expensive compared to foreign goods, so
Canada’s net exports fall.

A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING-

POWER PARITY

Over this period the value of the dollar fell compared with the mark and rose compared
with the lira. What explains these large and opposite changes?

Economists have developed many models to explain how exchange rates are determined,
each emphasizing just some of the many forces at work. Here we develop the simplest
theory of exchange rates
Purchasing-power parity 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. (Units of all
currencies must have the same real value in all countries)
Many economists believe that purchasing-power parity describes the forces that
determine exchange rates in the long run. We now consider the logic on which this long-
run theory of exchange rates is based, as well as the theory’s implications and limitations.

The Basic Logic of Purchasing-Power Parity

The theory of purchasing-power parity is based on a principle called the law of one
price. This law asserts that a good must sell for the same price in all locations.
Otherwise, opportunities 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 for, say, $4 a kilo and then sell it in Halifax for $5 per kilo, making a profit of
$1 per kilo from the difference in price. The process of taking advantage of differences in
prices in different markets is called arbitrage. As people took advantage of this arbitrage
opportunity, they would increase the demand for coffee in Vancouver and increase the
supply in Halifax. The price of coffee would rise in Vancouver (in response to greater
demand) and fall in Halifax (in response to greater supply). This process would continue
until, eventually, the prices were the same in the two markets.

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 Implications 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
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 Canada and Japan. 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 (500 yen/$5 = 100 yen per dollar). Otherwise, the purchasing
power of the dollar would not be the same in the two countries. A key implication of this
theory is that nominal exchange rates change when price levels change.

The price level in any country adjusts to bring the quantity of money supplied and the
quantity of money demanded into balance. Because the nominal exchange rate depends
on the price levels, it also depends on the money supply and money demand in each
country. When a central bank in any country increases the money supply and causes the
price level to rise, it also causes that country’s currency to depreciate relative to other
currencies in the world. In other words, when the central bank prints large quantities of
money, that 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. We can now answer the question that
began this section: Why did the Canadian dollar lose value compared to the German
mark and gain value compared to the Italian lira? The answer is that Germany pursued
a less inflationary monetary policy than Canada, and Italy pursued a more inflationary
monetary policy. From 1970 to 1998, inflation in Canada was 5.4 percent per year. By
contrast, inflation was 3.5 percent in Germany, and 9.6 percent in Italy. As Canadian
prices rose relative to German prices, the value of the dollar fell relative to the mark.
Similarly, as Canadian prices fell relative to Italian prices, the value of the dollar rose
relative to the lira.

Common currency two or more countries share a single monetary policy and that the
inflation rates in the two countries will be closely linked. But the historical lessons of the
lira and the mark will apply to the euro as well. Whether the Canadian dollar buys more
or fewer euros 20 years from now than it does today depends on whether the European
Central Bank produces more or less inflation in Europe than the Bank of Canada does in
Canada.

Purchasing-power parity provides a simple model of how exchange rates are determined.
For understanding many economic phenomena, the theory works well. It can also explain
the major changes in exchange rates that occur during hyperinflations.

Limitations of Purchasing-Power Parity

Yet the theory of purchasing-power parity is not completely accurate. That is, exchange
rates do not always move to ensure that a dollar has the same real value in all countries
all the time. There are two reasons why the theory of purchasing-power parity does not
always hold in practice:

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  Some goods are not tradable. Yet such arbitrage would probably be too limited to
eliminate (since it’s a service) the differences in prices. Thus, the deviation from
purchasing-power parity might persist, and a dollar (or euro) would continue to
buy less of a haircut in Paris than in Montreal.
 Even tradable goods are not always perfect substitutes when they are produced in
different countries. For example, some consumers prefer German cars, and others
prefer Canadian cars. Moreover, consumer tastes can change over time. If German
beer suddenly becomes more popular, the increase in demand will drive up the
price of German cars compared to Canadian cars. But despite this difference in
prices in the two markets, there might be no opportunity for profitable arbitrage
because consumers do not view the two cars as equivalent.

For these reasons, real exchange rates fluctuate over time. Nonetheless, the theory of
purchasing-power parity does provide a useful first step in understanding exchange rates.
The basic logic is persuasive: As the real exchange rate drifts from the level predicted by
purchasing-power parity, people have greater incentive to move goods across national
borders. Even if the forces of purchasing-power parity do not completely fix the real
exchange rate, they provide a reason to expect that changes in the real exchange rate are
most often small or temporary. As a result, large and persistent movements in nominal
exchange rates typically reflect changes in price levels at home and abroad.

INTEREST RATE DETERMINATION IN A SMALL OPEN ECONOMY WITH

PERFECT CAPITAL MOBILITY

When they want to predict whether Canadian interest rates will rise or fall, Canadian
economists tend to pay a lot of attention to anticipated changes in U.S. interest rates.
They do so because interest rates in Canada tend to increase when interest rates in the
United States increase and fall when interest rates in the United States fall. Why do
interest rates in Canada and the United States tend to move up and down together? Recall
our earlier discussion of the market for loanable funds, which we used to explain the
determination of the real interest rate. That discussion assumed a closed economy.
Canada is an open economy in which trade with other countries makes up a very large
part of GDP.

A Small Open Economy

The model most economists prefer to use is one that describes Canada as a small open
economy with perfect capital mobility. By “small” we mean an economy that is a small
part of the world economy.
An increase in demand for computer chips by Canadians is unlikely to have an effect on
the world price for computer chips. Canada’s share of the total world demand for
computer chips is too small for such a change to have anything but a negligible effect on
the world price. An increase in the supply of Canadian bonds has a negligible effect on
the total world supply of bonds. Changes in Canadian financial markets therefore have
negligible effects on world interest rates.

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 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

Perfect capital mobility we mean that Canadians have full access to world financial
markets and that people in the rest of the world have full access to the Canadian financial
market.

The implication of perfect capital mobility for a small open economy like Canada’s is
that the real interest rate in Canada should equal the real interest rate prevailing in world
financial markets.
R(world) = R

Why should this be so? Some examples will illustrate. If rw = 8 %and r = 5%, this
situation cannot persist. The reason is simple: With full access to world financial markets,
Canadian savers would prefer to buy foreign assets that pay an interest rate of 8 % than
Canadian assets that pay an interest rate of just 5%. We would expect to see savers sell
their Canadian assets and buy foreign assets instead. As long as the Canadian and the
foreign assets are close substitutes, the difference in interest rates provides an arbitrage
opportunity for either borrowers or savers. The logic by which the real interest rates in
Canada should adjust to equal the real interest rate in the rest of the world should remind
you of our discussion of the law of one price and purchasing-power parity. This is
because the concepts are closely related.
Interest rate parity- 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 to Interest Rate Parity

The real interest rate in Canada is not always equal to the real interest rate in the rest of
the world, for two key reasons:
 Financial assets carry with them the possibility of default (Default risk)
 Financial assets offered for sale in different countries are not necessarily perfect
substitutes for one another (ex. Tax treatment)

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