Open-Economy

Macroeconomics
Basic Concepts
Outline:
 Closed versus open economy
 Key macroeconomic variables in an
open economy
 Understanding and interpretation of
data
Closed versus open
 Closed economy is an economy that
does not interact with other
economies in the world

 Open economy is an economy that

interacts freely with other economies
in the world
International flows of goods
 Exports: goods and services that are
produced domestically and sold
abroad
 Imports: goods and services that are
produced abroad and sold
domestically
 Net exports: the value of a nation’s
exports minus the value of its
imports
International flows of goods
 Trade balance: also called as net
exports
 Trade surplus: an excess of exports
over imports, i.e. net exports are
positive
 Trade deficit: an excess of imports over
exports, i.e. net exports are negative
 Balanced trade: Exports and imports
are equal, i.e. net exports are zero
Factors affecting international
trade in goods and services
 Tastes of consumers for domestic
and foreign goods
 Prices of goods at home and abroad
 Exchange rate of domestic currency
 Income of consumers at home and
abroad
 Cost of transportation
 Policies of government towards trade
Increasing openness of Canadian
economy: Reasons
 Improvements in transportation
 Advances in telecommunications
 Technological progress
 Free Trade Agreement in 1989
 NAFTA in 1993
International flow of capital
 Net foreign investment: the purchase of
foreign assets by domestic residents minus
the purchase of domestic assets by foreigners
 Foreign Direct Investment (FDI): is
investment that gives foreign investor
management control of the domestic firm in
which the investment is made
 Foreign Portfolio Investment: are foreign
holdings of government and private sector
debt (bonds and shares) and involves no legal
control.
Variables influencing net foreign
investment
 Real interest rates paid on foreign
assets
 Real interest rates paid on domestic
assets
 Perceived risk of holding assets
abroad
 Government policies that affect
foreign ownership of domestic assets
Net Exports (NX)= Net Foreign
Investment (NFI)
 Exports > Imports + NX

Purchases
foreign stock
Canadian
resident + NFI
Purchases
Canadian
stock
Foreign - NFI
resident
 Good is
exported

USA + NX
Canada

NX=NFI
Pays in USD

Invest in US + NFI
bonds
+ NX=+ NFI
USA
Canada
Imports US goods
No change in NX
and NFI
 Conclusion:

 Value of asset= value of goods and

services sold
 NFI=NX
 International flow of goods=
international flow of capital
 Saving, Investment, and
international flows
Saving= domestic investment+ net
foreign investment
Investment in
the
Canadian
Savings in Canadian economy
economy

Canadian
NFI
Relation between saving, investment,
and NFI: Canada’s experience

• Refer transparencies for slides or pp. 382

of the text book.
Prices for international
transactions: Exchange Rates
 Nominal exchange rate: 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
 Exchange rate determination: PPP

 PPP is a theory of exchange rate whereby a unit

of any given currency should be able to buy the
same quantity of goods in all countries, i.e., a unit
of all currencies must have the same real value in
every country.
 Implications:
 Nominal exchange rate between the currencies of the two
countries depends on the price levels in those countries.
 Nominal exchange rates change when the price levels change.
 Increase in the supply of money lowers value of money and
depreciates the nominal exchange rate of the currency as well.
 PPP Theory: Limitations
 Many goods are not easily traded between
countries limiting the arbitrage that can be
gained from difference in prices.
 Tradable goods are not perfect substitutes

 Conclusion: Changes in the real exchange

rate are often small and temporary. Large
changes in nominal exchange rates reflect
changes in price levels at home and abroad.
 Interest rate determination
 Assumptions:
 Small open economy
 Perfect capital mobility
 Interest parity is 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:
 Possibility of default
 Financial assets are imperfect substitutes
 Differences in default risk and in tax treatments
Consider a small country that exports steel.
Suppose that a pro-trade government decides to
subsidize steel by paying a certain amount for each
ton of steel sold abroad. What are the effects of the
export subsidy on :
• Domestic price of steel
• Quantity of steel produced
• Quantity of steel consumed
• Quantity of steel exported
• Consumer surplus
• Producer surplus
• Government revenue
• Total surplus
How would the following transactions affect
Canada's imports, exports, net exports, and net
foreign investment?
• A Canadian spends his summer in Europe
• Students in Paris come to watch whales in Victoria, BC
• A Canadian cellular phone co establishes an office in the
USA
• TD mutual fund sells its Volkswagen stock to a French
investor
• Your uncle buys a new Volvo
• A Canadian citizen shops at a store in NY to avoid
Canadian sales tax
• Harrod’s of London sells stock to the Ontario Teachers’
Pension Plan
• Macey’s in NY is selling Roots T-shirts