Open Economy Macroeconomics: Key Concepts

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Questions and Answers

What does Purchasing Power Parity (PPP) indicate about exchange rates?

  • Exchange rates should adjust based on capital flows.
  • Nominal exchange rates should not differ across countries. (correct)
  • It disregards the differences in cost of living between countries.
  • Exchange rates should reflect inflation differentials. (correct)

What correction must occur when a country experiences high inflation according to the theory of PPP?

  • Stabilization of trade balances
  • Appreciation of the currency
  • Depreciation of the currency (correct)
  • Increase in foreign capital inflows

How is it estimated that $1 CN compares to $1.00 US in terms of purchasing power?

  • $1 CN exceeds $1.00 US by 10%.
  • $1 CN has no equivalent US value.
  • $1 CN is valued at approximately $0.80 US. (correct)
  • They are equal in value.

Which of the following statements is true regarding nominal and real exchange rates?

<p>Nominal rates consider current price levels. (B)</p> Signup and view all the answers

What does the Big Mac index serve as an indicator of?

<p>Purchasing Power Parity. (A)</p> Signup and view all the answers

In the context of exchange rate parity, what was the last time nominal exchange rates reached perfect equality?

<p>2007 (C)</p> Signup and view all the answers

What is a likely effect of an undervalued currency?

<p>Boost to domestic products' competitiveness. (C)</p> Signup and view all the answers

What does interest rate parity relate to in international finance?

<p>The equivalence of interest rates for identical risks in different currencies. (D)</p> Signup and view all the answers

Which condition must be satisfied for nominal exchange rates to reflect real exchange rates?

<p>Price levels must be similar. (B)</p> Signup and view all the answers

According to the theory of PPP, what should happen to the nominal exchange rate if one country experiences very high inflation compared to another?

<p>It should depreciate. (C)</p> Signup and view all the answers

What was the main reason for Canada running a trade deficit from 1961 to 1998?

<p>Higher domestic investment than national saving (C)</p> Signup and view all the answers

What economic situation occurred in Canada between 1998 and 2008 regarding trade balance?

<p>Trade surplus with increased national saving (B)</p> Signup and view all the answers

In the context of exchange rates, what does depreciation imply for domestic consumers?

<p>Costlier imports and cheaper exports (C)</p> Signup and view all the answers

What is the effect of an appreciation of the domestic currency on imports?

<p>Imports become less expensive (A)</p> Signup and view all the answers

Which of the following factors primarily drives the demand for the Canadian dollar in the foreign exchange market?

<p>Demand for Canadian-made goods and services (C)</p> Signup and view all the answers

How does an increase in interest rates in Canada likely affect the NCO?

<p>It decreases NCO as investors prefer to invest domestically (C)</p> Signup and view all the answers

If Canada is experiencing a trade surplus, what can be concluded about the relation between X and Im?

<p>X &gt; Im (A)</p> Signup and view all the answers

What is indicated by a nominal exchange rate of $1 CN = $0.71 US?

<p>The US dollar is stronger than the Canadian dollar (C)</p> Signup and view all the answers

Which scenario accurately describes the conditions of national savings during the trade deficit period in Canada?

<p>National saving was low (A)</p> Signup and view all the answers

What happens to the trade balance (NX) when imports become more expensive due to depreciation?

<p>NX increases (B)</p> Signup and view all the answers

What factors are included in the calculation of real exchange rates?

<p>Foreign price level (A), Nominal exchange rates (C), Domestic price level (D)</p> Signup and view all the answers

What does the real exchange rate determine in an economy?

<p>The trade balance (B)</p> Signup and view all the answers

Which statement best describes the relationship between real exchange rates and nominal exchange rates?

<p>Real exchange rates adjust for domestic and foreign inflation. (D)</p> Signup and view all the answers

How can inflation impacts in Canada and the USA affect perceived savings when shopping in the USA?

<p>Inflation in either country can erode the advantage of exchange rates over time. (A)</p> Signup and view all the answers

What is one primary reason for the discrepancy observed between real and nominal exchange rates?

<p>Adjustments for inflation rates over the observed period. (B)</p> Signup and view all the answers

Flashcards

Real Exchange Rate (RER)

The rate at which you can buy foreign goods using Canadian dollars. It's different from nominal exchange rate because it considers price levels in both countries.

Nominal Exchange Rate (NXR)

The rate at which one currency can be exchanged for another. It doesn't account for inflation/price differences.

RER calculation

Real exchange rate equals the nominal exchange rate times the ratio of domestic price level to foreign price level, RER = Nominal XR * (Domestic Price Level/Foreign Price Level).

RER vs. Nominal XR

Real exchange rates account for price differences between countries, while nominal exchange rates do not account for price differences.

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Discrepancy between RER and NXR

A change in nominal exchange rate doesn't always show a corresponding change in purchasing power. Inflation in either country can erode the apparent advantage.

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Purchasing Power Parity (PPP)

The idea that the exchange rate between two currencies should reflect the relative prices of goods and services in those countries.

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Purchasing Power Parity (PPP) is NOT currently holding true

The current exchange rate does not reflect relative prices of goods and services across all countries.

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Undervalued Currency

A currency whose exchange rate is lower than what is predicted by PPP.

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Inflation and Currency Depreciation

High inflation in a country often leads to a weakening of its currency.

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Big Mac Index

A popular way to illustrate purchasing power parity, comparing the price of a Big Mac across countries.

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Interest Rate Parity

The idea that interest rate differences between countries should be reflected in exchange rate differences.

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Law of One Price

The concept that identical goods should cost the same in different places (after accounting for exchange rates).

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Small, Open Economy

An economy that is a small part of the global economy and is heavily affected by international trade.

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Net Capital Outflow (NCO)

The difference between a nation's total investments abroad and foreign investments in the nation.

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Trade Deficit

When a country imports more goods and services than it exports, leading to a negative net export (NX).

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Trade Surplus

When a country exports more goods and services than it imports, leading to a positive net export (NX).

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Impact of NCO on Domestic Investment

A positive NCO means a nation is investing more abroad than foreign investments at home, leading to lower domestic investment. A negative NCO indicates the opposite, with higher domestic investment.

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Nominal Exchange Rate

The rate at which one currency can be directly exchanged for another.

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Appreciation

When a currency becomes more valuable relative to another currency.

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Depreciation

When a currency becomes less valuable relative to another currency.

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Impact of Depreciation on Exports and Imports

Depreciation makes imports more expensive and exports cheaper for foreign buyers, ultimately influencing the net export (NX).

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Impact of Appreciation on Exports and Imports

Appreciation makes imports cheaper and exports more expensive for foreign buyers, affecting the net export (NX).

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Key Drivers of Canadian Dollar Demand

Demand for Canadian goods and services, relative interest rates compared to other countries, and perceived investment risk in Canada are major factors influencing the demand for the Canadian dollar.

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Study Notes

Open Economy Macroeconomics: Basic Concepts

  • Most economists strongly believe international trade is beneficial.
  • The principle of comparative advantage is a key element.
  • The Canadian economy is highly open, encompassing both money markets and goods and services.
  • A closed economy is often referred to as "autarky".

Trade Flows and GDP

  • Trade flows have significantly increased as a percentage of GDP over the past four decades.
  • This increase is largely due to the implementation of the FTA, NAFTA, and USMCA.
  • Technological advancements in transportation and telecommunications play a role.
  • Trade flows peaked around 2000.

Canadian Economy's Dependence on the US

  • Canada relies heavily on the USA as a trading partner.
  • About 85% of Canadian exports go to the US.
  • The 2008-2009 recession in the US impacted Canada significantly.

Internationalization of the Canadian Economy (Figure 12.1)

  • The graph shows Canada's growing trade dependence on the US.
  • In 2020, imports from the US and exports to the US made up approximately 50% of the GDP.
  • Historical data demonstrates increases and dips in both imports from and exports to the US.

International Flows of Goods and Capital

  • Exchange of goods and capital are closely linked.
  • Net exports (NX) = trade balance, which can be a surplus, deficit, or balanced.
  • Trade in financial capital (financial assets) is also substantial.
  • Foreign direct investment (FDI) and foreign portfolio investments are key indicators.

Critical Accounting Identity

  • Net capital outflow (NCO) equals net exports (NX).
  • This is an important identity in international economics.
  • National savings equals domestic investment and NCO.
  • The excess or shortage of savings is affected by NX.

Macroeconomic History of Canada

  • Between 1961-1998, Canada had a trade deficit (NX<0).
  • Canada's total domestic investment exceeded national savings.
  • This was fueled by inflows of financial capital from other countries.
  • Between 1998 and 2008, Canada had a trade surplus (NX>0).
  • Total domestic investment was lower than national savings.
  • There was outflow of financial capital to other countries.

Exchange Rates

  • Exchange rates are the prices for international trade in goods and services.
  • Nominal exchange rates indicate actual transactions.
  • Factors influencing exchange rates include interest rates, inflation, and perceived risk in Canada's investment environment.

Real Exchange Rates

  • Real exchange rates affect purchasing power across countries.
  • Real exchange rates reflect a country's relative price levels.
  • The comparison of real and nominal exchange rates reveals important information about the economy's performance.

Purchasing Power Parity (PPP)

  • Nominal exchange rates should reflect the purchasing power parity.
  • Real exchange rates show the differences in purchasing power.
  • The example of the Big Mac Index illustrates how PPP deviations occur.

Interest Rate Parity

  • Interest rates in Canada should equal world interest rates in a small open economy.
  • Factors such as inflation and government policies can affect interest rates.
  • Perfect capital mobility allows financial assets to move across borders freely.

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