Principles of Macroeconomics:

ExamExam MC in-class-Tuesday February 15MC in-class-Tuesday February 15 30 questions, 3.3 marks each30 questions, 3.3 marks each Plus 1 free mark!!Plus 1 free mark!! Covers chapters 5-11.Covers chapters 5-11. Brief review on Thursday.Brief review on Thursday.

12 open econ macro12 open econ macro

Define open economy, closed economy, and exports\Define open economy, closed economy, and exports\imports.imports.

Factors that influence open economy transactions.Factors that influence open economy transactions. NX = NCONX = NCO Define nominal and real exchange rates.Define nominal and real exchange rates. Calculate real exchange rates.Calculate real exchange rates. Examine the theory of purchasing power parity. Examine the theory of purchasing power parity. Canada is a small, open economy (SOE)with perfect Canada is a small, open economy (SOE)with perfect

capital mobility. Here financial capital flows-interest rates capital mobility. Here financial capital flows-interest rates trigger flows trigger flows rrww

Open & Closed EconomiesOpen & Closed Economies

Closed EconomyClosed Economy: :

There are no economic relations with other There are no economic relations with other countries. No exports, no imports, and no countries. No exports, no imports, and no capital flows.capital flows.

Open EconomyOpen Economy: :

An economy that interacts freely with other An economy that interacts freely with other economies around the world. Goods economies around the world. Goods markets AND financial markets.markets AND financial markets.

An Open EconomyAn Open Economy

An open economy interacts with other An open economy interacts with other countries in two ways:countries in two ways:1. It buys and sells goods and services in world 1. It buys and sells goods and services in world

product markets.product markets.

2. It buys and sells capital assets in world financial 2. It buys and sells capital assets in world financial markets. Financial capital.markets. Financial capital.

Canada is a small, open economy with perfect Canada is a small, open economy with perfect capital mobility. capital mobility.

The Flow of GoodsThe Flow of Goods

ExportsExports: X: XAre domestically produced goods that are sold Are domestically produced goods that are sold

abroad. Exports include foreign spending on abroad. Exports include foreign spending on goods that are made domestically, shipped to, goods that are made domestically, shipped to, and sold in a foreign country.and sold in a foreign country.

Example: Bombardier sells RJsExample: Bombardier sells RJs

The Flow of GoodsThe Flow of Goods

ImportsImports: M: MAre foreign produced goods and services that are Are foreign produced goods and services that are

sold to residents of the domestic country. sold to residents of the domestic country. Imports include domestic spending on goods Imports include domestic spending on goods that are made abroad, shipped to, and sold in that are made abroad, shipped to, and sold in the domestic economy. the domestic economy.

Example: Computer monitors made in Korea and Example: Computer monitors made in Korea and wine from France are imported into Canada.wine from France are imported into Canada.

CDN Dcm >>>Dkrw to pay>>sell C$--exchange RCDN Dcm >>>Dkrw to pay>>sell C$--exchange R

The Flow of GoodsThe Flow of Goods

Net Exports (NX) or Trade Balance:Net Exports (NX) or Trade Balance:– The value of exports minus the value of imports.The value of exports minus the value of imports.– NX =X-M NX =X-M

Trade DeficitTrade Deficit::– A situation when net exports (NX) are A situation when net exports (NX) are negativenegative. .

(i.e. Exports < Imports)(i.e. Exports < Imports)

Trade SurplusTrade Surplus::– A situation when net exports (NX) are A situation when net exports (NX) are positivepositive. .

(i.e. Exports > Imports)(i.e. Exports > Imports)

Trade imbalanceTrade imbalance

Trade DeficitTrade Deficit: X< M NX<0: X< M NX<0 Trade SurplusTrade Surplus: X>M NX>0: X>M NX>0 Trade balance: X=M NX=0Trade balance: X=M NX=0 Only part of story : Value given = value receivedOnly part of story : Value given = value received

Overall accounts must balance -nothing is Overall accounts must balance -nothing is given away.given away.

If NX<0, we have not paid for all imports so If NX<0, we have not paid for all imports so there must be an offsetting financial IOUthere must be an offsetting financial IOU

MORE TRADE: Lower tariffsMORE TRADE: Lower tariffs

Factors That Influence a Country’s Factors That Influence a Country’s Exports, Imports, and Net ExportsExports, Imports, and Net Exports

The tastes of consumers for domestic and foreign The tastes of consumers for domestic and foreign goods. Florida OJ and French winegoods. Florida OJ and French wine

The prices of goods at home and abroad.The prices of goods at home and abroad.The exchange rates at which people can use The exchange rates at which people can use

domestic currency to buy foreign currencies.domestic currency to buy foreign currencies.The costs of transporting goods from country to The costs of transporting goods from country to

country.country.The policies of the government toward The policies of the government toward

international trade. Tariffs, quotas.international trade. Tariffs, quotas.

Net Capital Outflow (NCO)Net Capital Outflow (NCO)

NCONCO: difference between foreign assets : difference between foreign assets purchased by residents and domestic purchased by residents and domestic assets purchased by foreigners. assets purchased by foreigners. – Example: Canadian resident buys shares in Example: Canadian resident buys shares in

Telemex-the Mexican phone company. Telemex-the Mexican phone company. Increases Cdn NCO. Japanese resident buys Increases Cdn NCO. Japanese resident buys stock in the Royal Bank. Reduces Canadian stock in the Royal Bank. Reduces Canadian NCO.NCO.

Net Capital Outflow (NCO)Net Capital Outflow (NCO)

When domestic residents purchase more financial When domestic residents purchase more financial assets in foreign economies than foreigners assets in foreign economies than foreigners purchase of domestic assets, there is a net capital purchase of domestic assets, there is a net capital outflowoutflow from the domestic economy. NCO>0 from the domestic economy. NCO>0

If foreigners purchase more Canadian financial If foreigners purchase more Canadian financial assets than Canadian residents spend on foreign assets than Canadian residents spend on foreign financial assets, then there will be a net capital financial assets, then there will be a net capital inflowinflow into Canada. NCO<0 into Canada. NCO<0

Financial capital flows : NCOFinancial capital flows : NCO

Two forms of capital flow:Two forms of capital flow: 1. Tim Horton’s opens restaurant in Russia-1. Tim Horton’s opens restaurant in Russia-

foreign direct investment.foreign direct investment. 2. A Canadian buys shares in a Russian 2. A Canadian buys shares in a Russian

company—foreign portfolio investment.company—foreign portfolio investment. For both, CDNs buy assets in ROW so both For both, CDNs buy assets in ROW so both

increase Canada’s NCOincrease Canada’s NCO

The Flow of CapitalThe Flow of Capital

NCONCO measures the imbalance in a country’s trade in measures the imbalance in a country’s trade in assets:assets:

– When When NCONCO > 0, “capital outflow” > 0, “capital outflow”Domestic purchases of foreign assets exceed Domestic purchases of foreign assets exceed foreign purchases of domestic assets.foreign purchases of domestic assets.

– When When NCONCO < 0, “capital inflow” < 0, “capital inflow”Foreign purchases of domestic assets exceed Foreign purchases of domestic assets exceed domestic purchases of foreign assets. domestic purchases of foreign assets.

Factors affecting NCOFactors affecting NCO

NCO affected by:NCO affected by: Real interest rates on foreign assets (return)Real interest rates on foreign assets (return) Real interest rates on domestic assetsReal interest rates on domestic assets Perceived economic and political risks Perceived economic and political risks

abroadabroad G policies affecting foreign ownershipG policies affecting foreign ownership

NCO=NXNCO=NX

An accounting identity: An accounting identity: NCONCO = = NXNX – arises because every transaction that affects arises because every transaction that affects NXNX also also

affects affects NCONCO by the same amount by the same amount (and vice versa)(and vice versa)

When a foreigner purchases a good When a foreigner purchases a good from Canada, from Canada,

– Canadian exports and Canadian exports and NXNX increase increase

– the foreigner pays with currency or assets, the foreigner pays with currency or assets, so the Canadian acquires some foreign assets, so the Canadian acquires some foreign assets, causing causing NCONCO to rise. to rise.

The Equality of Net Exports and The Equality of Net Exports and Net Capital OutflowNet Capital Outflow

For an economy as a whole, NX and NCO For an economy as a whole, NX and NCO balance each other so that:balance each other so that:

NX = NCONX = NCO An increase in net exports is accompanied by An increase in net exports is accompanied by

an increase in foreign exchange.an increase in foreign exchange. Trade imbalance is exactly offset in the capital Trade imbalance is exactly offset in the capital

account because Value rec’d = Value given.account because Value rec’d = Value given.

Saving, Investment, and International Flows Saving, Investment, and International Flows of Goods & Assetsof Goods & Assets

Y= Y= CC + + II + + GG + + NXNX accounting identityaccounting identity

YY – – CC – – GG = = II + + NXNX rearranging termsrearranging terms

SS = = II + + NXNX since since SS = = YY – – CC – – GG

SS = = II + + NCONCO since since NXNX = = NCONCO

When When SS > > II, the excess loanable funds flow , the excess loanable funds flow abroad in the form of positive net capital outflow. abroad in the form of positive net capital outflow.

When When SS < < II, foreigners are financing some of the , foreigners are financing some of the country’s investment, and country’s investment, and NCONCO < 0. < 0.

S, I and NCOS, I and NCO

RECAPRECAP Y= C+I+G+NX RE-WRITEY= C+I+G+NX RE-WRITE Y-C-G = I+NXY-C-G = I+NX National Saving S= I+NXNational Saving S= I+NX Domestic saving= Domestic I + NCODomestic saving= Domestic I + NCO S = I+ NCOS = I+ NCO Because NCO =NXBecause NCO =NX

International Flows of Goods & International Flows of Goods & AssetsAssets

National Saving and Domestic Investment

Exam +Exam +

MC in-class-Tuesday February 15MC in-class-Tuesday February 15 30 questions, 3.3 marks each30 questions, 3.3 marks each Plus 1 free mark!!Plus 1 free mark!! Covers chapters 5-11.Covers chapters 5-11. Tutorial group B03—room change- now Tutorial group B03—room change- now

in ME4332 for the rest of the term.in ME4332 for the rest of the term.

What makes X close to M??What makes X close to M??

X : Demand for C$--supply of other currency.X : Demand for C$--supply of other currency. M: Supply of C$-demand for other.M: Supply of C$-demand for other. If X>M: DC$>SC$--------X rate goes UP---X If X>M: DC$>SC$--------X rate goes UP---X

goes down and M goes up. goes down and M goes up. If M>X SC$>DC$---X rate goes DOWN---X If M>X SC$>DC$---X rate goes DOWN---X

goes up and M goes down.goes up and M goes down. X rate is value of C$ and it adjusts to keep X X rate is value of C$ and it adjusts to keep X

and M close.and M close.

Real and Nominal Exchange Real and Nominal Exchange RatesRates

International transactions are influenced by International transactions are influenced by international prices. The two most important international prices. The two most important international prices are:international prices are:– Nominal Exchange rateNominal Exchange rate– Real Exchange RateReal Exchange Rate

– Exchange rates are prices.Exchange rates are prices.

The Nominal Exchange RateThe Nominal Exchange Rate

The The nominal exchange rate nominal exchange rate is the rate at is the rate at which a person can trade the currency of which a person can trade the currency of one country for the currency of another. It is one country for the currency of another. It is expressed in two ways:expressed in two ways:1. In units of foreign currency per one Canadian 1. In units of foreign currency per one Canadian

dollar COMMON: 0.80US$=C$1dollar COMMON: 0.80US$=C$1

2. In units of Canadian dollars per one unit of the 2. In units of Canadian dollars per one unit of the foreign currency $1US = $1.25 Cforeign currency $1US = $1.25 C

ExampleExample

Bank is not cheating youBank is not cheating you Assume 1C$ = US$0.80 Assume 1C$ = US$0.80 Go to bank –buy US$100Go to bank –buy US$100 What should you pay?What should you pay?

20% difference>> pay $120??20% difference>> pay $120??

US/CUS/C

If US$0.80 = C$1If US$0.80 = C$1 >> US$0.80/0.80 =C$1/.80>> US$0.80/0.80 =C$1/.80 US$1 = C$1.25US$1 = C$1.25 C$120 buys 120*.80 =$96C$120 buys 120*.80 =$96 US$100 costs 100/.80= C$125US$100 costs 100/.80= C$125

Exchange rates both waysExchange rates both ways

Nominal Exchange RateNominal Exchange Rate– Example: Assume the exchange rate between the Example: Assume the exchange rate between the

Mexican peso and Canadian dollar is ten to one. Mexican peso and Canadian dollar is ten to one. One Canadian dollar trades for ten pesos or one One Canadian dollar trades for ten pesos or one peso trades for one tenth of a dollar. peso trades for one tenth of a dollar.

– If the exchange rate changes so that a dollar buys If the exchange rate changes so that a dollar buys more foreign currency, that change is called an more foreign currency, that change is called an appreciationappreciation of the dollar. The opposite is called a of the dollar. The opposite is called a depreciationdepreciation of the dollar. of the dollar.

– APP: C$ buys moreAPP: C$ buys more– -DEP: C$ buys less-DEP: C$ buys less

The Real Exchange RateThe Real Exchange Rate The The real exchange rate real exchange rate is the ratio at which a is the ratio at which a

person can trade the goods and services of person can trade the goods and services of one country for the goods and services of one country for the goods and services of another. Compare the prices of the domestic another. Compare the prices of the domestic goods and foreign goods in the domestic goods and foreign goods in the domestic economy.economy.

Example: Case of German beer is twice as Example: Case of German beer is twice as expensive as Canadian beer. Real exchange expensive as Canadian beer. Real exchange rate is 1/2. >> 1G= 2Crate is 1/2. >> 1G= 2C

Calculating the Real Exchange Calculating the Real Exchange RateRate

Real exchange rates are derived from Real exchange rates are derived from nominal rates. Computing the real nominal rates. Computing the real exchange rate involves:exchange rate involves:

REXR=NXR* (Pd/Pf)REXR=NXR* (Pd/Pf)

RealExchange

Rate=

Nominal Exchange Ratex Domestic Price

Foreign Price

The Real Exchange RateThe Real Exchange Rate

The real exchange rate is a key determinant The real exchange rate is a key determinant of how much a country exports and imports.of how much a country exports and imports.

When a country’s real exchange rate is low, When a country’s real exchange rate is low, its goods are cheap relative to foreign its goods are cheap relative to foreign goods, so consumers both at home and goods, so consumers both at home and abroad tend to buy more of that country’s abroad tend to buy more of that country’s goods and fewer foreign produced goods.goods and fewer foreign produced goods.

Purchasing-Power ParityPurchasing-Power Parity The variation of currency exchange rates has The variation of currency exchange rates has

different sources. The simplest and most different sources. The simplest and most widely accepted theory is called widely accepted theory is called Purchasing-Purchasing-Power Parity Theory.Power Parity Theory.– Purchasing-Power Parity Theory Purchasing-Power Parity Theory states that “a unit states that “a unit

of any given currency should be able to buy the of any given currency should be able to buy the same quantity of same quantity of goodsgoods in all countries.” in all countries.” Based upon The Law of One PriceBased upon The Law of One Price GoodsGoods means real. means real.

The “Law of One Price”The “Law of One Price”“A good must sell for the same price in all “A good must sell for the same price in all

locations.”locations.”

This law applies in the international market This law applies in the international market and is a common sense notion.and is a common sense notion.– If the law were not true, unexploited profit If the law were not true, unexploited profit

opportunities would exist, allowing someone to opportunities would exist, allowing someone to earn riskless profits by purchasing low in one earn riskless profits by purchasing low in one market and selling high in another. market and selling high in another.

– Example: Buying coffee in Canada or JapanExample: Buying coffee in Canada or Japan– Internal and external price.Internal and external price.

Purchasing-Power ParityPurchasing-Power Parity

A currency must have the same buying power A currency must have the same buying power (i.e. parity) in all countries and it is the (i.e. parity) in all countries and it is the exchange rate that assures that this purchasing exchange rate that assures that this purchasing power is approximately equal across countries.power is approximately equal across countries.

The nominal exchange rate between the The nominal exchange rate between the currencies of two countries must reflect the currencies of two countries must reflect the different price levels in those countries.different price levels in those countries.

Limitations of Purchasing-Power ParityLimitations of Purchasing-Power Parity

Two things may keep nominal exchange Two things may keep nominal exchange rates from exactly equalizing purchasing rates from exactly equalizing purchasing power:power:

1. Many goods are not easily traded or 1. Many goods are not easily traded or shipped from one country to another.shipped from one country to another.

2. Traded goods are not always perfect 2. Traded goods are not always perfect substitutes.substitutes.

Quick quizQuick quiz

You invent a pill allowing students to do all You invent a pill allowing students to do all studying in ½ hourstudying in ½ hour

# made-Q# made-QATC-$ATC-$ 199199 199199 200200 200200 201201 201201 You have made 200 dosesYou have made 200 doses ??????╥╥ of making unit 201 if P=$300 of making unit 201 if P=$300

Make 1 more for $300Make 1 more for $300

# made# made ATC-$ATC-$ TCTC 199199 199199 3960139601 200200 200200 4000040000 201201 201201 4040140401 You have made 200 dosesYou have made 200 doses ??????╥╥ of making unit 201 if P=$300 of making unit 201 if P=$300

╥╥= = -$101 P<MC-$101 P<MC

PPP-Law of 1 pricePPP-Law of 1 price

A good must sell for the same price in all A good must sell for the same price in all locations.locations.

If the law were not true, unexploited profit If the law were not true, unexploited profit opportunities would exist, allowing someone to opportunities would exist, allowing someone to earn riskless profits by purchasing low in one earn riskless profits by purchasing low in one market and selling high in another. market and selling high in another.

Called arbitrage.Called arbitrage. Some goods are not easily traded or shipped Some goods are not easily traded or shipped

from one country to another. Limits.from one country to another. Limits.

PPP LIMITATIONSPPP LIMITATIONS

Nonetheless, PPP works well in many Nonetheless, PPP works well in many cases, especially as an explanation of long-cases, especially as an explanation of long-run trends.run trends.

For example, PPP implies: For example, PPP implies: the greater a country’s inflation rate, the greater a country’s inflation rate, the faster its currency should depreciate the faster its currency should depreciate (relative to a low-inflation countries like (relative to a low-inflation countries like Canada and the US).Canada and the US).

PPP examplePPP example

Assume C$1=US$1 =1 bushel of wheatAssume C$1=US$1 =1 bushel of wheat This is PPP: equal real value of moneyThis is PPP: equal real value of money Assume PdotC= 10% US=0Assume PdotC= 10% US=0 Therefore Pcw=$1.10Therefore Pcw=$1.10 >>C$1 Buys 0.9 bushel US$1 buys 1 bu.>>C$1 Buys 0.9 bushel US$1 buys 1 bu. C$ must fall to restore equalityC$ must fall to restore equality 1C$ = US$0.90 =9/10 bushel 1C$ = US$0.90 =9/10 bushel

SOESOE

By By “small”“small” we mean an economy that is a we mean an economy that is a small part of the world economy. By itself it small part of the world economy. By itself it will have only a negligible effect on the will have only a negligible effect on the prices of goods and services and interest prices of goods and services and interest rates in the rest of the world.rates in the rest of the world.

Price taker—particularly with interest rates Price taker—particularly with interest rates and MKT for loanable funds.and MKT for loanable funds.

Perfect Capital Mobility in a Small Perfect Capital Mobility in a Small Open EconomyOpen Economy

By By “perfect capital mobility”“perfect capital mobility” we mean that we mean that Canadians have full access to world Canadians have full access to world financial markets and people in the rest of financial markets and people in the rest of the world have full access to the Canadian the world have full access to the Canadian financial market. LFfinancial market. LF

Perfect Capital Mobility in a Small Perfect Capital Mobility in a Small Open EconomyOpen Economy

Implication of perfect capital mobility:Implication of perfect capital mobility:

The real interest rate in Canada should The real interest rate in Canada should equal the interest rate prevailing in world equal the interest rate prevailing in world financial marketsfinancial markets. Rc=Rw. Rc=Rw

Government policy choices can affect the Government policy choices can affect the size of risk and therefore Canadian interest size of risk and therefore Canadian interest rates relative to world interest rates. rates relative to world interest rates.

CHAPTER SUMMARYCHAPTER SUMMARY

Net exports equal exports minus imports. Net exports equal exports minus imports. Net capital outflow equals domestic residents’ Net capital outflow equals domestic residents’ purchases of foreign assets minus foreigners’ purchases of foreign assets minus foreigners’ purchases of domestic assets. purchases of domestic assets.

Every international transaction involves the Every international transaction involves the exchange of an asset for a good or service, exchange of an asset for a good or service, so net exports equal net capital outflow. NX=NCOso net exports equal net capital outflow. NX=NCO

Saving can be used to finance domestic Saving can be used to finance domestic investment or to buy assets abroad. Thus, saving investment or to buy assets abroad. Thus, saving equals domestic investment plus net capital equals domestic investment plus net capital outflow. S=I+NCOoutflow. S=I+NCO

SummarySummary

The nominal exchange rate is the relative The nominal exchange rate is the relative price of the price of the currencycurrency of two countries. of two countries.

The real exchange rate is the relative price The real exchange rate is the relative price of the of the goods and servicesgoods and services of the two of the two countries. countries.

Real x rate = e*P/P*Real x rate = e*P/P*

P= domestic priceP= domestic price P*= foreign priceP*= foreign price e = nominal x ratee = nominal x rate Real=nominal if P=P*Real=nominal if P=P* Consider PPP againConsider PPP again Same product—same price everywhere.Same product—same price everywhere. ee x x PP = = P*P* Cdn price*e= foreign priceCdn price*e= foreign price OR e=P/P*OR e=P/P*

PPP-Big Mac IndexPPP-Big Mac Index

PPP—1 goodPPP—1 good

A Big Mac costs C$3.00 but 250 yen in JapanA Big Mac costs C$3.00 but 250 yen in Japan PPP implies x rate is P/P* NominalPPP implies x rate is P/P* Nominal 3.00/250= 83 (inverse to get yen rate)3.00/250= 83 (inverse to get yen rate) Implied PPP rate is 83 yen per C$Implied PPP rate is 83 yen per C$ Actual rate is 84 yenActual rate is 84 yen Big Mac gives good estimateBig Mac gives good estimate

Another exampleAnother example

A Ford Escape SUV sells for $24,000 in Canada and A Ford Escape SUV sells for $24,000 in Canada and 720,000 rubles in Russia. 720,000 rubles in Russia.

If purchasing-power parity holds, what is the If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)?nominal exchange rate (rubles per dollar)?

P*P* = 720,000 rubles = 720,000 rubles

PP = $24,000 = $24,000

ee = = P*P*//PP = 720000/24000 = = 720000/24000 = 30 rubles per dollar30 rubles per dollar