Open Economy Concepts and Capital Flows

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Questions and Answers

What distinguishes an open economy from a closed economy?

An open economy interacts with other economies around the world, while a closed economy does not.

Define net exports and explain its relationship with trade balance.

Net exports are the value of a nation's exports minus its imports; it is also known as the trade balance.

What is net capital outflow (NCO), and how is it related to net foreign investment (NFI)?

Net capital outflow (NCO) is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners, and it is also referred to as net foreign investment (NFI).

Describe the two forms that flow of capital abroad can take.

<p>The two forms are foreign direct investment, where a foreign owner actively manages the asset, and foreign portfolio investment, where ownership is more passive.</p> Signup and view all the answers

What happens when Alberta exports oil to the US in terms of net exports and net capital outflow?

<p>When Alberta exports oil to the US, it increases net exports, which correspondingly raises net capital outflow as Alberta receives US dollars.</p> Signup and view all the answers

What is a trade surplus and how does it differ from balanced trade?

<p>A trade surplus occurs when net exports are positive, meaning exports exceed imports, while balanced trade occurs when exports equal imports.</p> Signup and view all the answers

How can Canadians engage with foreign economies through financial markets?

<p>Canadians can buy shares in foreign companies and acquire various foreign assets such as government and corporate debt.</p> Signup and view all the answers

Explain the term 'trade deficit' and its economic implications.

<p>A trade deficit occurs when net exports are negative, indicating that a country imports more than it exports.</p> Signup and view all the answers

How is national saving calculated in an open economy?

<p>National saving is calculated as S = Y - C - G, where Y is national income, C is consumption, and G is government spending.</p> Signup and view all the answers

What does S = I + NCO signify in the context of national saving?

<p>It signifies that national saving is equal to domestic investment plus net capital outflow.</p> Signup and view all the answers

Define nominal exchange rate in your own words.

<p>Nominal exchange rate is the rate at which one currency can be exchanged for another, such as British pounds per Canadian dollar.</p> Signup and view all the answers

What is the formula for calculating the real exchange rate?

<p>The real exchange rate is calculated as nominal exchange rate multiplied by the domestic price divided by the foreign price.</p> Signup and view all the answers

In the context of PPP, what does the law of one price imply?

<p>The law of one price implies that identical goods should sell for the same price in different countries when expressed in a common currency.</p> Signup and view all the answers

What conditions could cause the nominal exchange rate to adjust in the presence of arbitrage?

<p>Nominal exchange rate adjustments could occur through changes in prices or fluctuations in the exchange rate itself.</p> Signup and view all the answers

List one reason why purchasing power parity (PPP) might not hold in real life.

<p>One reason PPP might not hold is that not all goods are easily traded, such as services like haircuts.</p> Signup and view all the answers

Explain perfect capital mobility.

<p>Perfect capital mobility is the condition where economies can fully access world financial markets and vice versa.</p> Signup and view all the answers

What is interest rate parity, and why is it important?

<p>Interest rate parity is the theory that real interest rates on comparable assets should be the same across economies with full market access, ensuring fair investment conditions.</p> Signup and view all the answers

What effect would a higher world interest rate (rw) have on Canadian savings?

<p>If rw &gt; r, Canadians would be more inclined to save by purchasing foreign assets rather than domestic ones.</p> Signup and view all the answers

Why might some financial assets require a higher interest rate?

<p>Some financial assets may be riskier due to potential defaults, requiring a higher interest rate to compensate for this risk.</p> Signup and view all the answers

What does a lower real exchange rate indicate about a country's goods?

<p>A lower real exchange rate indicates that a country's goods are cheaper relative to foreign goods.</p> Signup and view all the answers

What is the significance of net capital outflow (NCO) in savings?

<p>Net capital outflow (NCO) reflects the amount of money leaving the country for foreign investments and affects the overall level of domestic investment.</p> Signup and view all the answers

How can government policies impact interest rates and capital flows?

<p>Government policies, such as taxes and regulations, can influence the net returns on investments, affecting interest rates and capital flows.</p> Signup and view all the answers

Flashcards

Open economy

An economy that trades goods, services, and assets with other countries.

Closed economy

An economy that is completely isolated from the global economy.

Exports

Goods and services produced domestically and sold to other countries.

Imports

Goods and services produced in other countries and purchased domestically.

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Net exports

The difference between the value of a country's exports and its imports.

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Trade surplus

A situation where a country's exports exceed its imports.

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Trade deficit

A situation where a country's imports exceed its exports.

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Net capital outflow (NCO)

The purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.

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Nominal Exchange Rate

The nominal exchange rate is a measure of one currency's value in relation to another currency. It tells you how much of one currency you need to buy a specific amount of another currency. For example, if the nominal exchange rate is 1.20 USD/CAD, you need 1.20 USD to purchase 1 CAD.

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Currency Appreciation

A currency appreciation means its value is increasing against another currency, meaning you can buy more of that other currency with the appreciating currency. Think of it like a stronger currency.

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Currency Depreciation

The opposite of currency appreciation, depreciation means the value of a currency is decreasing against another currency. It will take more of that currency to buy an equivalent amount of the other currency.

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Real Exchange Rate

The real exchange rate measures the rate at which you can exchange goods and services from one country for goods and services from another, considering price levels in both countries.

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Law of One Price

The law of one price states that a good traded in different countries should have the same price, adjusted for exchange rates. This assumes that there are no barriers to trade and goods are perfect substitutes.

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Purchasing Power Parity (PPP)

Purchasing power parity (PPP) is a theory of exchange rates that assumes a unit of currency should buy the same quantity of goods in all countries. It aims to capture the idea that exchange rates should adjust to reflect differences in price levels between countries.

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Arbitrage

Arbitrage occurs when someone takes advantage of price differences in different markets to make a profit. For example, buying coffee in the US at a lower price than in Canada and selling it in Canada for a higher price.

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Effect of Price Differences on Trade

When goods are cheaper in one country, importers from other countries tend to buy these products at a lower price and import them to sell in their own countries. This can lead to increased demand and higher prices in the source country and conversely, lower prices in the importing countries. This is a driving force towards purchasing power parity.

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Small Open Economy

A small open economy is an economy that trades goods and services with other economies but has very little influence on world prices and interest rates.

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Perfect Capital Mobility

Perfect capital mobility occurs when there are no restrictions on individuals and businesses moving capital across borders. It implies that interest rates in the domestic and global markets should align.

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Interest Rate Parity

Interest rate parity suggests that, with perfect capital mobility, the real interest rate for comparable assets across different developed nations should be equal. This is because investors will seek out the highest return possible, driving interest rates towards convergence.

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Risk in Interest Rate Parity

Riskier financial assets may offer a higher interest rate to compensate investors for taking on the risk of potential losses. This divergence in interest rates is not an arbitrage opportunity because the higher return is a price for the risk.

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Tax in Interest Rate Parity

Tax differences across countries can influence the attractiveness of investments in different locations. Investors are more interested in after-tax returns, so pre-tax interest rates need not be equal in a world with varying tax policies.

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Study Notes

Open Economy Concepts

  • Open Economy: An economy that interacts with other economies globally, allowing for trade in goods and services and financial assets.
  • Closed Economy: An economy that does not interact with other economies.
  • Exports: Domestically produced goods and services sold abroad.
  • Imports: Foreign-produced goods and services sold domestically.
  • Net Exports (Trade Balance): Value of exports minus imports; can be positive (surplus) or negative (deficit).
  • Balanced Trade: Exports equal imports.

Capital Flows and Net Capital Outflow

  • Net Capital Outflow (NCO): Purchases of foreign assets by domestic residents less purchases of domestic assets by foreigners (also called Net Foreign Investment).
  • Foreign Direct Investment: Foreign ownership with active management of the asset.
  • Foreign Portfolio Investment: Foreign ownership with a more passive role.
  • Relationship between Net Exports and NCO: Net exports (NX) always equal net capital outflow (NCO), meaning NX = NCO. This arises from the exchange occurring in every transaction. For example, selling oil (exports) generates foreign currency, which is an acquisition of a foreign asset.

National Accounting in an Open Economy

  • National Saving (S): Portion of national income remaining after consumption and government spending.
  • National Income Identity: Y = C + I + G + NX, where Y is national income, C is consumption, I is investment, G is government spending, and NX is net exports.
  • Saving-Investment Relationship: S = I + NX, implying national saving can finance domestic investment or investment abroad.

Exchange Rates

  • Nominal Exchange Rate: Rate at which one currency can be exchanged for another.
    • Appreciation: Increase in currency value, measured by the amount of foreign currency it can buy.
    • Depreciation: Decrease in currency value.
  • Real Exchange Rate: Rate at which goods and services of one country can be exchanged for goods and services of another. RealExchangeRate = (Nominal Exchange Rate × Domestic Price) / Foreign Price.
  • Example Calculation: A real exchange rate calculation can determine how many units of foreign beer can be bought with one unit of domestic beer.
  • Calculating Real Exchange Rate: Computation involves a basket of goods and prices in each country. The formula (real exchange rate) = (e × P) / P*, where e is the nominal exchange rate, P is the domestic price, and P* is the foreign price, establishes the relationship.

Purchasing Power Parity (PPP)

  • Purchasing Power Parity (PPP): A theory where a unit of currency should buy the same quantity of goods in all countries
  • Law of One Price: Underlying principle that goods should sell for the same price everywhere, theoretically enabling arbitrage when prices differ.
  • Factors Affecting PPP: Real exchange rate is affected by the relative prices of goods in different countries.
  • Reasons PPP Doesn't Always Hold: Non-traded goods, imperfect substitutes for traded goods, and government policies.

Small Open Economy and Perfect Capital Mobility

  • Small Open Economy: An economy whose actions have negligible impact on global prices and interest rates.
  • Perfect Capital Mobility: Implies equal real interest rates in the domestic economy and the world.

Interest Rate Parity

  • Interest Rate Parity: Theory stating that real interest rates on comparable assets should be the same in all economies with full access to world financial markets. Different interest rates for similar assets could lead to arbitrage opportunities, requiring rates to converge.
  • Factors Impacting Interest Rate Parity: Differences in risk levels and tax treatment of returns can affect the observed interest rates.

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