Exam

1. Exam • MC in-class-Tuesday February 15 • 30 questions, 3.3 marks each • Plus 1 free mark!! • Covers chapters 5-11. • Brief review on Thursday. Principles of Macroeconomics:

2. 12 open econ macro • Define open economy, closed economy, and exports\imports. • Factors that influence open economy transactions. • NX = NCO • Define nominal and real exchange rates. • Calculate real exchange rates. • Examine the theory of purchasing power parity. • Canada is a small, open economy (SOE)with perfect capital mobility. Here financial capital flows-interest rates trigger flows rw

3. Open & Closed Economies • Closed Economy: There are no economic relations with other countries. No exports, no imports, and no capital flows. • Open Economy: An economy that interacts freely with other economies around the world. Goods markets AND financial markets.

4. An Open Economy • An open economy interacts with other countries in two ways: 1. It buys and sells goods and services in world product markets. 2. It buys and sells capital assets in world financial markets. Financial capital. • Canada is a small, open economy with perfect capital mobility.

5. The Flow of Goods • Exports: X Are domestically produced goods that are sold abroad. Exports include foreign spending on goods that are made domestically, shipped to, and sold in a foreign country. Example: Bombardier sells RJs

6. The Flow of Goods • Imports: M Are foreign produced goods and services that are sold to residents of the domestic country. Imports include domestic spending on goods that are made abroad, shipped to, and sold in the domestic economy. Example: Computer monitors made in Korea and wine from France are imported into Canada. CDN Dcm >>>Dkrw to pay>>sell C$--exchange R

7. The Flow of Goods • Net Exports (NX) or Trade Balance: • The value of exports minus the value of imports. • NX =X-M • Trade Deficit: • A situation when net exports (NX) are negative. (i.e. Exports < Imports) • Trade Surplus: • A situation when net exports (NX) are positive. (i.e. Exports > Imports)

8. Trade imbalance • Trade Deficit: X< M NX<0 • Trade Surplus: X>M NX>0 • Trade balance: X=M NX=0 • Only part of story : Value given = value received • Overall accounts must balance -nothing is given away. • If NX<0, we have not paid for all imports so there must be an offsetting financial IOU

9. MORE TRADE: Lower tariffs

10. Factors That Influence a Country’s Exports, Imports, and Net Exports • The tastes of consumers for domestic and foreign goods. Florida OJ and French wine • The prices of goods at home and abroad. • The exchange rates at which people can use domestic currency to buy foreign currencies. • The costs of transporting goods from country to country. • The policies of the government toward international trade. Tariffs, quotas.

11. Net Capital Outflow (NCO) • NCO: difference between foreign assets purchased by residents and domestic assets purchased by foreigners. • Example: Canadian resident buys shares in Telemex-the Mexican phone company. Increases Cdn NCO. Japanese resident buys stock in the Royal Bank. Reduces Canadian NCO.

12. Net Capital Outflow (NCO) • When domestic residents purchase more financial assets in foreign economies than foreigners purchase of domestic assets, there is a net capital outflow from the domestic economy. NCO>0 • If foreigners purchase more Canadian financial assets than Canadian residents spend on foreign financial assets, then there will be a net capital inflow into Canada. NCO<0

13. Financial capital flows : NCO • Two forms of capital flow: • 1. Tim Horton’s opens restaurant in Russia-foreign direct investment. • 2. A Canadian buys shares in a Russian company—foreign portfolio investment. • For both, CDNs buy assets in ROW so both increase Canada’s NCO

14. The Flow of Capital NCO measures the imbalance in a country’s trade in assets: • When NCO > 0, “capital outflow”Domestic purchases of foreign assets exceed foreign purchases of domestic assets. • When NCO < 0, “capital inflow”Foreign purchases of domestic assets exceed domestic purchases of foreign assets.

15. Factors affecting NCO • NCO affected by: • Real interest rates on foreign assets (return) • Real interest rates on domestic assets • Perceived economic and political risks abroad • G policies affecting foreign ownership

16. NCO=NX • An accounting identity: NCO = NX • arises because every transaction that affects NXalso affects NCO by the same amount (and vice versa) • When a foreigner purchases a good from Canada, • Canadian exports and NX increase • the foreigner pays with currency or assets, so the Canadian acquires some foreign assets, causing NCO to rise.

17. The Equality of Net Exports and Net Capital Outflow • For an economy as a whole, NX and NCO balance each other so that: • NX = NCO • An increase in net exports is accompanied by an increase in foreign exchange. • Trade imbalance is exactly offset in the capital account because Value rec’d = Value given.

18. Saving, Investment, and International Flows of Goods & Assets Y= C + I + G + NX accounting identity Y – C – G = I + NX rearranging terms S = I + NX since S = Y – C – G S = I + NCO since NX = NCO • When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow. • When S < I, foreigners are financing some of the country’s investment, and NCO < 0.

19. S, I and NCO • RECAP • Y= C+I+G+NX RE-WRITE • Y-C-G = I+NX • National Saving S= I+NX • Domestic saving= Domestic I + NCO • S = I+ NCO • Because NCO =NX

20. International Flows of Goods & Assets

21. National Saving and Domestic Investment

22. Exam + • MC in-class-Tuesday February 15 • 30 questions, 3.3 marks each • Plus 1 free mark!! • Covers chapters 5-11. • Tutorial group B03—room change- now in ME4332 for the rest of the term.

23. What makes X close to M?? • X : Demand for C$--supply of other currency. • M: Supply of C$-demand for other. • If X>M: DC$>SC$--------X rate goes UP---X goes down and M goes up. • If M>X SC$>DC$---X rate goes DOWN---X goes up and M goes down. • X rate is value of C$ and it adjusts to keep X and M close.

24. Real and Nominal Exchange Rates • International transactions are influenced by international prices. The two most important international prices are: • Nominal Exchange rate • Real Exchange Rate • Exchange rates are prices.

25. The Nominal Exchange Rate • The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. It is expressed in two ways: 1. In units of foreign currency per one Canadian dollar COMMON: 0.80US$=C$1 2. In units of Canadian dollars per one unit of the foreign currency $1US = $1.25 C

26. Example • Bank is not cheating you • Assume 1C$ = US$0.80 • Go to bank –buy US$100 • What should you pay? • 20% difference>> pay $120??

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

28. Exchange rates both ways

29. Nominal Exchange Rate • Example: Assume the exchange rate between the Mexican peso and Canadian dollar is ten to one. One Canadian dollar trades for ten pesos or one peso trades for one tenth of a dollar. • If the exchange rate changes so that a dollar buys more foreign currency, that change is called an appreciation of the dollar. The opposite is called a depreciation of the dollar. • APP: C$ buys more • -DEP: C$ buys less

30. The Real Exchange Rate • The real exchange rate is the ratio at which a person can trade the goods and services of one country for the goods and services of another. Compare the prices of the domestic goods and foreign goods in the domestic economy. • Example: Case of German beer is twice as expensive as Canadian beer. Real exchange rate is 1/2. >> 1G= 2C

31. Calculating the Real Exchange Rate • Real exchange rates are derived from nominal rates. Computing the real exchange rate involves: • REXR=NXR* (Pd/Pf) Nominal Exchange Rate x Domestic Price Real Exchange Rate = Foreign Price

32. The Real Exchange Rate • The real exchange rate is a key determinant of how much a country exports and imports. • When a country’s real exchange rate is low, its goods are cheap relative to foreign goods, so consumers both at home and abroad tend to buy more of that country’s goods and fewer foreign produced goods.

33. Purchasing-Power Parity • The variation of currency exchange rates has different sources. The simplest and most widely accepted theory is called Purchasing-Power Parity Theory. • Purchasing-Power Parity Theory states that “a unit of any given currency should be able to buy the same quantity of goods in all countries.” • Based upon The Law of One Price • Goods means real.

34. The “Law of One Price”“A good must sell for the same price in all locations.” • This law applies in the international market and is a common sense notion. • If the law were not true, unexploited profit opportunities would exist, allowing someone to earn riskless profits by purchasing low in one market and selling high in another. • Example: Buying coffee in Canada or Japan • Internal and external price.

35. Purchasing-Power Parity • A currency must have the same buying power (i.e. parity) in all countries and it is the exchange rate that assures that this purchasing power is approximately equal across countries. • The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries.

36. Limitations of Purchasing-Power Parity • Two things may keep nominal exchange rates from exactly equalizing purchasing power: 1. Many goods are not easily traded or shipped from one country to another. 2. Traded goods are not always perfect substitutes.

37. Quick quiz • You invent a pill allowing students to do all studying in ½ hour • # made-Q ATC-$ • 199 199 • 200 200 • 201 201 • You have made 200 doses • ???╥ of making unit 201 if P=$300

38. Make 1 more for $300 • # made ATC-$ TC • 199 199 39601 • 200 200 40000 • 201 201 40401 • You have made 200 doses • ???╥ of making unit 201 if P=$300 • ╥= -$101 P<MC

39. PPP-Law of 1 price • A good must sell for the same price in all locations. • If the law were not true, unexploited profit opportunities would exist, allowing someone to earn riskless profits by purchasing low in one market and selling high in another. • Called arbitrage. • Some goods are not easily traded or shipped from one country to another. Limits.

40. PPP LIMITATIONS • Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends. • For example, PPP implies: the greater a country’s inflation rate, the faster its currency should depreciate (relative to a low-inflation countries like Canada and the US).

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

42. SOE • By “small” we mean an economy that is a small part of the world economy. By itself it will have only a negligible effect on the prices of goods and services and interest rates in the rest of the world. • Price taker—particularly with interest rates and MKT for loanable funds.

43. Perfect Capital Mobility in a Small Open Economy • By “perfect capital mobility” we mean that Canadians have full access to world financial markets and people in the rest of the world have full access to the Canadian financial market. LF

44. Perfect Capital Mobility in a Small Open Economy • Implication of perfect capital mobility: The real interest rate in Canada should equal the interest rate prevailing in world financial markets. Rc=Rw • Government policy choices can affect the size of risk and therefore Canadian interest rates relative to world interest rates.

45. CHAPTER SUMMARY • Net exports equal exports minus imports. Net capital outflow equals domestic residents’ purchases of foreign assets minus foreigners’ purchases of domestic assets. • Every international transaction involves the exchange of an asset for a good or service, so net exports equal net capital outflow. NX=NCO • Saving can be used to finance domestic investment or to buy assets abroad. Thus, saving equals domestic investment plus net capital outflow. S=I+NCO

46. Summary • The nominal exchange rate is the relative price of the currency of two countries. • The real exchange rate is the relative price of the goods and services of the two countries.

47. Real x rate = e*P/P* • P= domestic price • P*= foreign price • e = nominal x rate • Real=nominal if P=P* • Consider PPP again • Same product—same price everywhere. • e x P = P* • Cdn price*e= foreign price • OR e=P/P*

48. PPP-Big Mac Index

49. PPP—1 good • A Big Mac costs C$3.00 but 250 yen in Japan • PPP implies x rate is P/P* Nominal • 3.00/250= 83 (inverse to get yen rate) • Implied PPP rate is 83 yen per C$ • Actual rate is 84 yen • Big Mac gives good estimate

50. Another example A Ford Escape SUV sells for $24,000 in Canada and 720,000 rubles in Russia. If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)? P* = 720,000 rubles P = $24,000 e = P*/P = 720000/24000 = 30 rubles per dollar