Transcript real exchange rate

Exam
 MC in-class-Tuesday February 15
 30 questions, 3.3 marks each
 Plus 1 free mark!!
 Covers chapters 5-11.
 Brief review on Thursday.
Principles of Macroeconomics:
12 open econ macro
 Define open economy, closed economy, and
exports\imports.
 Factors that influence open economy transactions.
 NX = NCO
 Define nominal and real exchange rates.
 Calculate real exchange rates.
 Examine the theory of purchasing power parity.
 Canada is a small, open economy (SOE)with
perfect capital mobility. Here financial capital
flows-interest rates trigger flows rw
Open & Closed Economies
 Closed Economy:
There are no economic relations with other
countries. No exports, no imports, and no
capital flows.
 Open Economy:
An economy that interacts freely with other
economies around the world. Goods
markets AND financial markets.
An Open Economy
 An open economy interacts with other
countries in two ways:
1. It buys and sells goods and services in world
product markets.
2. It buys and sells capital assets in world financial
markets. Financial capital.
 Canada is a small, open economy with perfect
capital mobility.
The Flow of Goods
 Exports: X
Are domestically produced goods that are sold
abroad. Exports include foreign spending on
goods that are made domestically, shipped to,
and sold in a foreign country.
Example: Bombardier sells RJs
The Flow of Goods
 Imports: M
Are foreign produced goods and services that are
sold to residents of the domestic country.
Imports include domestic spending on goods
that are made abroad, shipped to, and sold in
the domestic economy.
Example: Computer monitors made in Korea and
wine from France are imported into Canada.
CDN Dcm >>>Dkrw to pay>>sell C$--exchange R
The Flow of Goods
 Net Exports (NX) or Trade Balance:
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The value of exports minus the value of imports.
NX =X-M
 Trade Deficit:
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A situation when net exports (NX) are negative.
(i.e. Exports < Imports)
 Trade Surplus:
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A situation when net exports (NX) are positive.
(i.e. Exports > Imports)
Trade imbalance
 Trade Deficit: X< M
 Trade Surplus: X>M
 Trade balance: X=M
NX<0
NX>0
NX=0
 Only part of story : Value given = value received
 Overall accounts must balance -nothing is
given away.
 If NX<0, we have not paid for all imports so
there must be an offsetting financial IOU
MORE TRADE: Lower tariffs
Factors That Influence a Country’s
Exports, Imports, and Net Exports
The tastes of consumers for domestic and foreign
goods. Florida OJ and French wine
The prices of goods at home and abroad.
The exchange rates at which people can use
domestic currency to buy foreign currencies.
The costs of transporting goods from country to
country.
The policies of the government toward
international trade. Tariffs, quotas.
Net Capital Outflow (NCO)
 NCO: difference between foreign assets
purchased by residents and domestic assets
purchased by foreigners.
–
Example: Canadian resident buys shares in
Telemex-the Mexican phone company.
Increases Cdn NCO. Japanese resident buys
stock in the Royal Bank. Reduces Canadian
NCO.
Net Capital Outflow (NCO)
 When domestic residents purchase more financial
assets in foreign economies than foreigners
purchase of domestic assets, there is a net capital
outflow from the domestic economy. NCO>0
 If foreigners purchase more Canadian financial
assets than Canadian residents spend on foreign
financial assets, then there will be a net capital
inflow into Canada. NCO<0
Financial capital flows : NCO
 Two forms of capital flow:
 1. Tim Horton’s opens restaurant in Russiaforeign direct investment.
 2. A Canadian buys shares in a Russian
company—foreign portfolio investment.
 For both, CDNs buy assets in ROW so both
increase Canada’s NCO
The Flow of Capital
NCO measures the imbalance in a country’s trade in
assets:
– When NCO > 0, “capital outflow”
Domestic purchases of foreign assets exceed
foreign purchases of domestic assets.
– When NCO < 0, “capital inflow”
Foreign purchases of domestic assets exceed
domestic purchases of foreign assets.
Factors affecting NCO
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NCO affected by:
Real interest rates on foreign assets (return)
Real interest rates on domestic assets
Perceived economic and political risks
abroad
 G policies affecting foreign ownership
NCO=NX
 An accounting identity: NCO = NX
– arises because every transaction that affects
NX also affects NCO by the same amount
(and vice versa)
 When a foreigner purchases a good
from Canada,
– Canadian exports and NX increase
– the foreigner pays with currency or assets,
so the Canadian acquires some foreign assets,
causing NCO to rise.
The Equality of Net Exports and
Net Capital Outflow
 For an economy as a whole, NX and NCO
balance each other so that:
 NX = NCO
 An increase in net exports is accompanied by
an increase in foreign exchange.
 Trade imbalance is exactly offset in the capital
account because Value rec’d = Value given.
Saving, Investment, and International Flows of
Goods & Assets
Y= C + I + G + NX
accounting identity
Y – C – G = I + NX
rearranging terms
S = I + NX since S = Y – C – G
S = I + NCO
since NX = NCO
 When S > I, the excess loanable funds flow
abroad in the form of positive net capital outflow.
 When S < I, foreigners are financing some of the
country’s investment, and NCO < 0.
S, I and NCO
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RECAP
Y= C+I+G+NX RE-WRITE
Y-C-G = I+NX
National Saving S= I+NX
Domestic saving= Domestic I + NCO
S = I+ NCO
Because NCO =NX
International Flows of Goods &
Assets
National Saving and Domestic
Investment
Exam +
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MC in-class-Tuesday February 15
30 questions, 3.3 marks each
Plus 1 free mark!!
Covers chapters 5-11.
Tutorial group B03—room change- now
in ME4332 for the rest of the term.
What makes X close to M??
 X : Demand for C$--supply of other
currency.
 M: Supply of C$-demand for other.
 If X>M: DC$>SC$--------X rate goes UP---X
goes down and M goes up.
 If M>X SC$>DC$---X rate goes DOWN---X
goes up and M goes down.
 X rate is value of C$ and it adjusts to keep X
and M close.
Real and Nominal Exchange
Rates
 International transactions are influenced by
international prices. The two most important
international prices are:
– Nominal Exchange rate
– Real Exchange Rate
–
Exchange rates are prices.
The Nominal Exchange Rate
 The nominal exchange rate is the rate at
which a person can trade the currency of
one country for the currency of another. It is
expressed in two ways:
1. In units of foreign currency per one Canadian
dollar COMMON: 0.80US$=C$1
2. In units of Canadian dollars per one unit of the
foreign currency $1US = $1.25 C
Example
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Bank is not cheating you
Assume 1C$ = US$0.80
Go to bank –buy US$100
What should you pay?
 20% difference>> pay $120??
US/C
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If US$0.80 = C$1
>> US$0.80/0.80 =C$1/.80
US$1 = C$1.25
C$120 buys 120*.80 =$96
US$100 costs 100/.80= C$125
Exchange rates both ways
Nominal Exchange Rate
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Example: Assume the exchange rate between the
Mexican peso and Canadian dollar is ten to one.
One Canadian dollar trades for ten pesos or one
peso trades for one tenth of a dollar.
If the exchange rate changes so that a dollar buys
more foreign currency, that change is called an
appreciation of the dollar. The opposite is called a
depreciation of the dollar.
APP: C$ buys more
-DEP: C$ buys less
The Real Exchange Rate
 The real exchange rate is the ratio at which a
person can trade the goods and services of
one country for the goods and services of
another. Compare the prices of the domestic
goods and foreign goods in the domestic
economy.
 Example: Case of German beer is twice as
expensive as Canadian beer. Real exchange
rate is 1/2.
>> 1G= 2C
Calculating the Real Exchange
Rate
 Real exchange rates are derived from
nominal rates. Computing the real
exchange rate involves:
Nominal Exchange Rate
Real
x Domestic Price
Exchange =
Foreign Price
Rate
 REXR=NXR* (Pd/Pf)
The Real Exchange Rate
 The real exchange rate is a key determinant
of how much a country exports and imports.
 When a country’s real exchange rate is low,
its goods are cheap relative to foreign
goods, so consumers both at home and
abroad tend to buy more of that country’s
goods and fewer foreign produced goods.
Purchasing-Power Parity
 The variation of currency exchange rates has
different sources. The simplest and most
widely accepted theory is called PurchasingPower Parity Theory.
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Purchasing-Power Parity Theory states that “a unit
of any given currency should be able to buy the
same quantity of goods in all countries.”
 Based upon The Law of One Price
 Goods means real.
The “Law of One Price”
“A good must sell for the same price in all
locations.”
 This law applies in the international market
and is a common sense notion.
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If the law were not true, unexploited profit
opportunities would exist, allowing someone to
earn riskless profits by purchasing low in one
market and selling high in another.
Example: Buying coffee in Canada or Japan
Internal and external price.
Purchasing-Power Parity
 A currency must have the same buying power
(i.e. parity) in all countries and it is the
exchange rate that assures that this purchasing
power is approximately equal across countries.
 The nominal exchange rate between the
currencies of two countries must reflect the
different price levels in those countries.
Limitations of Purchasing-Power Parity
 Two things may keep nominal exchange
rates from exactly equalizing purchasing
power:
1. Many goods are not easily traded or
shipped from one country to another.
2. Traded goods are not always perfect
substitutes.
Quick quiz
 You invent a pill allowing students to do all
studying in ½ hour
 # made-Q ATC-$
 199
199
 200
200
 201
201
 You have made 200 doses
 ???╥ of making unit 201 if P=$300
Make 1 more for $300
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# made
ATC-$
TC
199
199
39601
200
200
40000
201
201
40401
You have made 200 doses
╥
??? of making unit 201 if P=$300
 ╥= -$101
P<MC
PPP-Law of 1 price
 A good must sell for the same price in all
locations.
 If the law were not true, unexploited profit
opportunities would exist, allowing someone
to earn riskless profits by purchasing low in
one market and selling high in another.
 Called arbitrage.
 Some goods are not easily traded or
shipped from one country to another. Limits.
PPP LIMITATIONS
 Nonetheless, PPP works well in many
cases, especially as an explanation of longrun trends.
 For example, PPP implies:
the greater a country’s inflation rate,
the faster its currency should depreciate
(relative to a low-inflation countries like
Canada and the US).
PPP example
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Assume C$1=US$1 =1 bushel of wheat
This is PPP: equal real value of money
Assume PdotC= 10% US=0
Therefore Pcw=$1.10
>>C$1 Buys 0.9 bushel US$1 buys 1 bu.
C$ must fall to restore equality
1C$ = US$0.90 =9/10 bushel
SOE
 By “small” we mean an economy that is a
small part of the world economy. By itself it
will have only a negligible effect on the
prices of goods and services and interest
rates in the rest of the world.
 Price taker—particularly with interest rates
and MKT for loanable funds.
Perfect Capital Mobility in a Small
Open Economy
 By “perfect capital mobility” we mean that
Canadians have full access to world
financial markets and people in the rest of
the world have full access to the Canadian
financial market. LF
Perfect Capital Mobility in a Small
Open Economy
 Implication of perfect capital mobility:
The real interest rate in Canada should
equal the interest rate prevailing in world
financial markets. Rc=Rw
 Government policy choices can affect the
size of risk and therefore Canadian interest
rates relative to world interest rates.
CHAPTER SUMMARY
 Net exports equal exports minus imports.
Net capital outflow equals domestic residents’
purchases of foreign assets minus foreigners’
purchases of domestic assets.
 Every international transaction involves the
exchange of an asset for a good or service,
so net exports equal net capital outflow. NX=NCO
 Saving can be used to finance domestic
investment or to buy assets abroad. Thus, saving
equals domestic investment plus net capital
outflow. S=I+NCO
Summary
 The nominal exchange rate is the relative
price of the currency of two countries.
 The real exchange rate is the relative price
of the goods and services of the two
countries.
Real x rate = e*P/P*
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P= domestic price
P*= foreign price
e = nominal x rate
Real=nominal if P=P*
Consider PPP again
Same product—same price everywhere.
e x P = P*
Cdn price*e= foreign price
OR e=P/P*
PPP-Big Mac Index
PPP—1 good
 A Big Mac costs C$3.00 but 250 yen in Japan
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PPP implies x rate is P/P* Nominal
3.00/250= 83 (inverse to get yen rate)
Implied PPP rate is 83 yen per C$
Actual rate is 84 yen
Big Mac gives good estimate
Another example
A Ford Escape SUV sells for $24,000 in Canada and
720,000 rubles in Russia.
If purchasing-power parity holds, what is the
nominal exchange rate (rubles per dollar)?
P* = 720,000 rubles
P = $24,000
e = P*/P = 720000/24000 = 30 rubles per dollar