PowerPoint Presentations for
Principles of Macroeconomics
Sixth Canadian Edition
by Mankiw/Kneebone/McKenzie
Adapted for the
Sixth Canadian Edition by
Marc Prud’homme
University of Ottawa
OPEN-ECONOMY
MACROECONOMICS:
BASIC CONCEPTS
Chapter 12
Copyright © 2014 by Nelson Education Ltd.
12-2
OPEN-ECONOMY MACROECONOMICS:
BASIC CONCEPTS
One of the ten principles of economics
highlighted in Chapter 1 is that trade can
make everyone better off.
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OPEN-ECONOMY MACROECONOMICS:
BASIC CONCEPTS
Closed economy: an economy that does
not interact with other economies in the
world
Open economy: an economy that interacts
freely with other economies around the
world
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THE INTERNATIONAL FLOWS
OF GOODS AND CAPITAL
 Exports: goods and services that are produced
domestically and sold abroad
 Imports: goods and services that are produced
abroad and sold domestically
 Net exports (or trade balance): the value of a
nation’s exports minus the value of its imports
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THE INTERNATIONAL FLOWS
OF GOODS AND CAPITAL
Trade surplus: an excess of exports over
imports
Trade deficit: an excess of imports over
exports
Balanced trade: a situation in which exports
equal imports
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FIGURE 12.1:
The Internationalization of the Canadian Economy
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The Flow of Financial Resources:
Net Capital Outflow
Net capital outflow: the purchase of foreign
assets by domestic residents minus the
purchase of domestic assets by foreigners
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The Flow of Financial Resources:
Net Capital Outflow
 Some of the variables that influence net capital
outflow (NCO):
 Real interest rates being paid on foreign assets
 Real interest rates being paid on domestic assets
 Perceived economic and political risks of holding
assets abroad
 Government policies that affect foreign ownership of
domestic assets
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The Equality of Net Exports
and Net Capital Outflow
 Net exports measure an imbalance between a
country’s exports and its imports.
 Net capital outflow measures an imbalance
between the amount of foreign assets bought by
domestic residents and the amount of domestic
assets bought by foreigners.
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The Equality of Net Exports
and Net Capital Outflow
 That is, net capital outflow (NCO) always equals
net exports (NX):
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The Equality of Net Exports
and Net Capital Outflow
 When NX > 0, the country is selling more goods and
services to foreigners than it is buying from them.
 What is it doing with the foreign currency it receives from
the net sale of goods and services abroad?
 It must be using it to buy foreign assets.
 Capital is flowing out of the country (i.e., NCO > 0).
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The Equality of Net Exports
and Net Capital Outflow
 When NX < 0, the country is buying more goods and
services from foreigners than it is selling to them.
 How is it financing the net purchase of these goods and
services in world markets?
 It must be selling assets abroad.
 Capital is flowing into the country (i.e., NCO < 0).
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Saving, Investment, and
Their Relationship to the International Flows
 Saving, investment, and international capital flows are
inextricably linked.
Closed
Economy
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TABLE 12.1:
International Flows of Goods and Capital: Summary
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QuickQuiz
Define net exports and net capital
outflow.
Explain how they are related.
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THE PRICES FOR INTERNATIONAL TRANSACTIONS:
REAL AND NOMINAL EXCHANGE RATES
Two important international prices are
discussed here:
1. The nominal x-rate
2. The real x-rates
Orion-v / Shutterstock
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Nominal Exchange Rates
 Nominal exchange rate: the 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
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Real Exchange Rates
 Real exchange rate: The rate at which a person
can trade the goods and services of one country
for the goods and services of another
 Why does the real exchange rate matter?
 It is a key determinant of how much a country exports
and imports.
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Real Exchange Rates
 From the example …
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FIGURE 12.3:
The Value of the Canadian Dollar
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Real Exchange Rates
 When studying an economy as a whole,
macroeconomists focus on overall prices rather
than the prices of individual items.
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FIGURE 12.4:
Real and Nominal Exchange Rates
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Active Learning
Compute the Real Exchange Rate
e = 10 pesos per $
price of tall Starbucks latte
P = $3 in CDA, P* = 24 pesos in Mexico
A. What is the price of a Canadian latte measured
in pesos?
B. Calculate the real exchange rate,
measured as Mexican lattes per Canadian
latte.
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Active Learning
Answers
e = 10 pesos per $
price of a tall Starbucks Latte
P = $3 in CDA, P* = 24 pesos in Mexico
A. What is the price of a Canadian latte in
pesos?
B. Calculate the real exchange rate.
exP
30 pesos per CDA latte
=
P*
24 pesos per Mexican latte
= 1.25 Mexican lattes per CDA latte
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QuickQuiz
Define nominal exchange rate and real exchange
rate, and explain how they are related.
If the nominal exchange rate goes from 100 to 120
yen per dollar, has the dollar appreciated or
depreciated?
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A FIRST THEORY OF EXCHANGE-RATE
DETERMINATION: PURCHASING POWER PARITY
 Purchasing-power parity (PPP): a theory of
exchange rates whereby a unit of any given
currency should be able to buy the same
quantity of goods in all countries
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The Basic Logic of Purchasing-Power Parity
 The theory of purchasing-power parity is based
on a principle called the law of one price (LOP).
 A good must sell for the same price in all
locations.
 According to the PPP theory, a currency must
have the same purchasing power in all countries.
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Implications of Purchasing-Power Parity
 It tells us that the nominal exchange rate between the
currencies of two countries depends on the price levels
in those countries.
 If a dollar buys the same quantity of goods in Canada
(where prices are measured in dollars) as in Japan
(where prices are measured in yen), then the number of
yen per dollar must reflect the prices of goods in
Canada and Japan.
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Implications of Purchasing-Power Parity
 For the purchasing power of a dollar to be the same in
the two countries, it must be that:
 Then
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Implications of Purchasing-Power Parity
 Rearranging
 According to the theory of purchasing-power parity, the
nominal exchange rate between the currencies of two
countries must reflect the different price levels in those
countries.
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Limitations of Purchasing-Power Parity
 PPP provides a simple model of how exchange rates are
determined.
 Exchange rates do not, however, always move to
ensure that a dollar has the same real value in all
countries all the time.
 Many goods are not easily traded.
 Tradable goods are not always perfect substitutes.
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Case Study:
PRILL/ Shutterstock
The Hamburger Standard
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QuickQuiz
Over the past 20 years, Spain has had high
inflation and Japan has had low inflation.
What do you think has happened to the
number of Spanish pesetas a person can buy
with a Japanese yen?
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INTEREST RATE DETERMINATION IN A SMALL OPEN
ECONOMY WITH PERFECT CAPITAL MOBILITY
 Why do interest rates in Canada and the United
States tend to move up and down together?
 The model most economists prefer to use to
explain this phenomenon is one that describes
Canada as a small open economy (SOE) with
perfect capital mobility.
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A Small Open Economy
 Small open economy: an economy that trades
goods and services with other economies and,
by itself, has a negligible effect on world prices
and interest rates
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Perfect Capital Mobility
 Perfect capital mobility: full access to world financial
markets
 The implication of perfect capital mobility for a small
open economy like Canada’s is that the real interest
rate in Canada should equal the real interest rate
prevailing in world financial markets.
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Perfect Capital Mobility
 Interest rate parity: 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.
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Limitations to Interest Rate Parity
 The real interest rate in Canada is not always
equal to the real interest rate in the rest of the
world.
 Financial assets carry with them the possibility of
default.
 Financial assets offered for sale in different
countries are not necessarily perfect substitutes for
one another.
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Classroom Activity
International Beer Consumption
“I went to the bar the other night with two friends. We each
ordered a beer: a Corona, a Beck’s, and a Budweiser. The
bartender brought us our drinks. Then he said, ‘That’ll be 100
pesos, 3 marks, and 2 U.S. dollars.’ Luckily, we had it.
“What could we have done if we didn’t have those
currencies?”
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THE END
Chapter 12
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