Consider how to define net exports and net capital outflow

CHP 12: OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS Context

Chapter 12 is the first chapter in a two-chapter sequence dealing with open-economy macroeconomics. The purpose of the sequence is to show how government policies and international events impact productivity and living standards in a small, open economy. The chapters are a more realistic extension of the closed-economy analysis developed in Chapter 8. Chapter 12 develops the basic concepts and vocabulary associated with macroeconomics in an international setting: trade flows, capital flows, real and nominal exchange rates, purchasing-power parity, and real interest rate parity. It a a a a a a , why the nominal exchange rate adjusts to price level differences between countries [purchasing power parity], and why real interest rates are expected [after accounting for differential risk and tax treatment ] to be equal across countries. These concepts and relationships are put to work in Chapter 13, which builds an open-economy macroeconomic model capable of predicting the productivity effects of various government policies and international events.

Main Messages

Net exports are the value of domestic goods and services sold abroad minus the value of foreign goods and services sold domestically. Net capital outflow is the acquisition of foreign-held assets by domestic residents minus the acquisition of domestic-held assets by foreigners. Because every international transaction involves an exchange of an a a , a a a a a a . A a a a a a a a . T , a a a a domestic investment plus net capital outflow. The nominal exchange rate is the relative price of the currency of two countries, and the real exchange rate is the relative price of the goods and services of two countries. When the nominal exchange rate changes so that each dollar buys more foreign currency, the dollar is said to appreciate or strengthen. When the nominal exchange rate changes so that each dollar buys less foreign currency, the dollar is said to depreciate or weaken. According to the theory of purchasing-power parity [PPP], a dollar (or a unit of any other currency) should be able to buy the same quantity of goods in all countries. This is equivalent to saying that the real exchange rate between two countries should equal 1. PPP also implies that the nominal exchange rate between the currencies of two countries should reflect the price levels in those two countries. As a result, countries with relatively high inflation should have depreciating currencies, and countries with relatively low inflation should have appreciating currencies. Most economists prefer to use a model that describes Canada as a small open economy with perfect capital mobility. In such economies, real interest rate parity is expected to hold. Real interest rate parity is a theory that predicts real interest rates in Canada will equal those in the rest of the world. The theory does not always hold true - differences in tax rates and concerns about default risk mean that real interest rates in Canada can differ from those in the rest of the world. However, we expect Canadian real interest rates to move in step with world real interest rates.

Learning Objectives

After studying this chapter and the supplementary notes, you should be able to: 1. Define the key concepts. 2. Explain why net exports must always equal net capital outflows. 3. Explain how national saving, domestic investment and net capital outflows are related. 4. Explain the relationship between the nominal exchange rate, price levels, and the real exchange rate; that is,

explain why economists a a . 5. Explain how long-run real interest rates are determined in a small, open economy with perfect capital mobility;

a , a a a a a a , n economy and the rest of the world.

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Key Concepts

Closed economy: an economy that does not trade goods, services, or financial assets [i.e. stocks, bonds, and currency] with other economies in the world. Open economy: an economy that trades goods, services and financial assets with other economies around the