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
Canadian
resident
Foreign
resident
+ NX
Purchases
foreign stock
+ NFI
Purchases
Canadian
stock
- NFI
Good is
exported
Canada
+ NX
USA
NX=NFI
Pays in USD
Invest in US
bonds
Canada
USA
Imports US goods
+ NFI
+ NX=+ NFI
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
Savings in Canadian economy
Investment in
the
Canadian
economy
Canadian
NFI
Year Q1
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
19
77
19
75
19
73
19
71
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
Exports, Imports
Exports and Imports: Canada
600000
500000
Exports
400000
Imports
300000
200000
100000
0
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