Eco1102S_3 PDF - Open Economy Macroeconomics

Chapter 12 Open economy macroeconomics: Basic Concepts 1 Basic Tenet Most economists believe strongly that international trade is economically beneficial for both participants – Basic principle of the theory of comparativ...

Chapter 12 Open economy macroeconomics: Basic Concepts 1 Basic Tenet Most economists believe strongly that international trade is economically beneficial for both participants – Basic principle of the theory of comparative advantage – A minority beg to differ The Canadian economy is one of the most open in the world, which goes for both money markets and G & S markets – There is an important interface between those two markets – A closed economy is called ‘autarky’ 2 Next figure shows that trade flows have increased drastically as a percentage of GDP over the past 40 years – especially since the implementation of the FTA NAFTA, and now USMCA – Innovations in transportation and telecommunications are also a factor – Down from a peak reached around the year 2000 * Université d’Ottawa / University of Ottawa 3  Also shows our critical dependence on the USA as a trading partner – On the order of 85 % of our exports go there – We contracted the great recession of 2008- 2009 from the USA – Graph ends at around 2021 * Université d’Ottawa / University of Ottawa 4 Figure 12.1 Internationalization of the Canadian economy 7-5 5 Most recent trade report – Report for September 2024 – https://www150.statcan.gc.ca/n1/daily- quotidien/241105/dq241105a- eng.htm?lnk=dai-quo&indid=3612- 2&indgeo=0 * Université d’Ottawa / University of Ottawa 6  International Flows of Goods and Capital They are closely linked to each other Definitions for trade in G & S are easy – Imports and exports – Net exports (NX) = trade balance – Trade surplus, trade deficit, and balanced trade 7 In addition to trade in G & S, there is ENORMOUS trade in assets and financial capital that is far greater in magnitude – FDI = foreign direct investment Canadian enterprises have operations in foreign countries – Foreign portfolio investments Canadians acquire financial instruments issued in foreign countries 8 Net capital outflow (NCO) = capital outflow – capital inflow = purchase of foreign assets by domestic residents (the counterpart to imports of G & S) minus the purchase of domestic assets by foreigners (the counterpart to exports of G & S) * Université d’Ottawa / University of Ottawa 9  – When it is positive, financial capital is flowing OUT We are buying up their securities more than they are buying ours. We get more securities, but make liquid payments flowing OUT of Canada for them – When it is negative, financial capital is flowing IN They are buying up our securities more than we are buying theirs They get more securities, but we receive liquid payments flowing IN to Canada for them 10 Critical accounting identity How do we stand vis à vis the rest of the world? NCO = NX by necessity, by identity – Due to fact that every international transaction is an exchange – In words, the net value of G & S sold by a country (NX) = net value of financial assets acquired – This is NOT an equilibrium condition, but rather an identity 11 – Since Canada sometimes has NX > 0, NCO > 0 (capital is flowing out) We are buying up foreign securities and sending out liquid assets in return, as we have to dispose of the proceeds of our trade surplus somehow – Since the USA always has NX < 0, NCO < 0 (capital is flowing in) They are selling their securities and receiving liquid assets in return, which in turn finances their trade deficit 12  Now integrate this foreign sector to the rest of the economy Recall the national accounting identity: Y = C + I + G + NX – + Y – C – G = I + NX Recall the identity for savings: S = Y – C – G – Called national savings – It includes both public and private savings Thus S = I + NX = I + NCO – In words, total saving equals domestic investment spending and net capital outflow, so national savings can be allocated to either domestic investment or buying/selling capital with foreign partners * Université d’Ottawa / University of Ottawa 13 National S = private S + public S * Université d’Ottawa / University of Ottawa 14 Main point is that there is another outlet for national savings If NX > 0, then S > I, and thus these excess savings have to go outside of the Canadian macroeconomy If NX < 0, S < I, and thus the shortage of savings has to come from outside of the Canadian macroeconomy * Université d’Ottawa / University of Ottawa 15  Figure 12.2 National S, Domestic I, and NCO * Université d’Ottawa / Copyright University© 2020 byof Ottawa Nelson Education Ltd. 7-16 16 * Université d’Ottawa / University of Ottawa 17 A little macroeconomic history From 1961-1998, Canada ran a trade deficit (NX < 0), and thus NCO was also negative. Total domestic investment was higher than total national saving due to inflow of financial capital from other countries. – We were borrowing big time from foreigners or selling them our assets – Our own, domestic national savings were low, so we were sucking in financial capital, which created long-term liabilities 18  Between 1998 and 2008, Canada ran a trade surplus (NX > 0), and thus NCO is positive. Total domestic investment is lower than total national saving due to outflow of financial capital to other countries. – National saving is much higher – The difference between the 2 periods lies in the end of federal government deficits, which put an end to the sale of bonds to foreigners in order to finance these deficits * Université d’Ottawa / University of Ottawa 19 Exchange rates These are essentially the prices for international trades of G & S and assets Nominal exchange rate is the actual transactions rate – $ 1 CN = $ 0.71 US Was $ 0.75 US when I taught this course three years ago, and so it has depreciated Was $ 0.74 US 9 months ago – $ 1 CN = about 0.67 euros Has been pretty stable in recent years 1 euro = $ 1.48 CN (reciprocal of 0.67) 20 Appreciation means more of the foreign currency per loonie, or fewer loonies per unit of the foreign currency Depreciation means less of the foreign currency per loonie, or more loonies per unit of the foreign currency * Université d’Ottawa / University of Ottawa 21  All other factors held constant, a depreciation makes: – our imports more expensive, so Im – Our exports less expensive for our trading partners to obtain, so X – And thus NX = X – Im * Université d’Ottawa / University of Ottawa 22 All other factors held constant, an appreciation makes: – our imports less expensive, so Im – Our exports more expensive for our trading partners to obtain, so X – And thus NX = X – Im * Université d’Ottawa / University of Ottawa 23 Foreign Exchange Market Supply and demand framework In the case of the Canadian $, it is mostly demand driven Demand shifters – Demand for Canadian-made goods and services – interest rates in Canada relative to rest of the World – Perceived riskiness of investment in Canada 24  FIGURE 12.3 ‐ The Value of the Canadian Dollar in this century Note how volatile it can be (# of units per Canadian $) Copyright © 2020 by Nelson Education Ltd. 25 Real exchange rates Real exchange rates are the rates for which you can buy foreign goods for Canadian $ (as opposed to obtaining foreign currencies for Canadian $) It is the real XR that determines where the purchases will be made, and what exports and imports will be. Real XR = nominal XR * domestic price level / foreign price level – This is an identity 26 Real XR includes: – Nominal XR – Overall foreign P – Overall domestic P The units on the right side ($ US / $ C) * ($ C / $ US) should cancel out, leaving a unitless real XR – It should be just a scalar * Université d’Ottawa / University of Ottawa 27  Why the discrepancy between real and nominal XR? Consider the following illustration – Against the US $, between 2002 and 2008, the loonie had appreciated in nominal terms by about 60 % As shown in Figure 12-3 – Does that mean that the price differential between Canada and the USA shifted so that we could have saved 60 % by shopping in the USA compared to what we would have paid 6 years earlier? 28 –NO – we have to consider what had happened to inflation in the USA over that period. What if prices have risen a lot there? Then the advantage is eroded –NO – we also have to consider what had happened to inflation in Canada over that period. What if prices had fallen here? Then the advantage is eroded * Université d’Ottawa / University of Ottawa 29 Figure 12.4 – real versus nominal XR Copyright © 2020 by Nelson Education Ltd. 7-30 30  Exchange rate parity With parity for real XR, $ 1.00 CN in the USA buys exactly what $ 1.00 CN buys in Canada after having exchanged it for US currency – Called “Purchasing Power Parity” With parity for nominal XR, $ 1.00 US = $ 1.00 CN when exchanging foreign currency wherever you are – Last attained in 2007 31 It is estimated that $ 1 CN will buy approximately what $ 0.80 US will buy in the USA averaged out over all goods and services Since the current nominal XR is about $ 0.71 US per $ CN, the loonie is undervalued by about 11 % – So NO purchasing power parity overall (including all goods and services) * Université d’Ottawa / University of Ottawa 32 Illustrations of PPP Textbook mentions ‘the Big Mac’ index – Illustrated on page 267 My illustration: recent gasoline prices – In France, 1 liter costs 1.89 euros, and one euro exchanges for $ 1.47 CN – In the UK, 1 liter costs 1.53 pounds, and one pound exchanges for $ 1.67 CN – Recent gasoline price in Canada: $ 1.47 CN per* liter Université d’Ottawa / University of Ottawa 33  Doing the conversion for France: (1.88 euros / liter) * ($ 1.47 CN / euro) = $ 2.77 CN per liter – So 88 % more expensive Doing the conversion for UK: (1.53 pounds / liter) * ($ 1.67 CN / pound) = $ 2.55 CN per liter – So 74 % more expensive * Université d’Ottawa / University of Ottawa 34 The Theory of Purchasing-Power Parity Nominal XR, which are determined by supply and demand forces in FOREX markets, are set such that a unit of any given currency should be able to buy the same quantity of goods in all countries – It is also called “the law of one price” * Université d’Ottawa / University of Ottawa 35 If it did apply now, the nominal XR would be about $ 0.80 US = $ 1.00 CN – That is only an estimate Therefore, it does not apply right now BUT Figure 12.4 shows that the real XR and the nominal XR are strongly positively correlated over time * Université d’Ottawa / University of Ottawa 36  Major Implications of PPP theory The nominal XR between the currencies in two countries must reflect the price levels (in local currencies) in those countries Any country that experiences really high inflation will also experience a huge depreciation in their currency * Université d’Ottawa / University of Ottawa 37 Interest rate parity Consider the following two conditions – Canada is a small, open economy Although we are a rich country, financially speaking we are a small player. We cannot influence world prices or interest rates. – Perfect capital mobility Financial assets can be bought and sold across international borders without any major obstacles, taxes, or subsidies. 38 These conditions imply that interest in Canada = the rate of interest in world capital markets – r = rW where both are real interest rates Will not hold exactly, BUT we do expect Canadian interest rates to rise and fall with increases and decreases in world interest rates * Université d’Ottawa / University of Ottawa 39