Copyright © 2010 Pearson Education Canada. 6.1 Chapter 6 Openness in Goods and Financial Markets The Short Run Power Point Presentation Brian VanBlarcom

6.1Copyright © 2010 Pearson Education Canada.

Chapter 6Chapter 6

Openness in Goods and Financial Markets

The Short Run

Power Point PresentationPower Point Presentation

Brian VanBlarcomBrian VanBlarcom

Acadia UniversityAcadia University


Openness in GoodsOpenness in Goodsand Financial Marketsand Financial Markets

Opening the Economy to International TransactionsOpening the Economy to International TransactionsOpening the Economy to International TransactionsOpening the Economy to International Transactions

Three dimensions of openness:

1. Openness in Goods Markets

2. Openness in Financial Markets

3. Openness in Factor Markets


Openness in Goods MarketsOpenness in Goods Markets


Observations of Canadian Exports and ImportsObservations of Canadian Exports and Imports


Exports and imports in Canada were around 15% of GDP in 1960, are around 40% of GDP today.

For most of the last 40 years Canada had a trade surplus.

The trade surplus was large in 1970 and 1971,1982 to 1985 and very large from 1997 –2007 (with a peak of 5% of GDP).


Measuring the Degree of OpennessMeasuring the Degree of Openness


Export Ratio: Ratio of exports to GDP (Currently for Canada, exports are about 40% of GDP)


A Look Around the WorldA Look Around the World



What Do You Think...What Do You Think...

Can exports exceed GDP?Can exports exceed GDP?



The Choice Between Domestic and Foreign GoodsThe Choice Between Domestic and Foreign Goods

Nominal Exchange Rates:

Price of foreign currency in terms of domestic currency

Real Exchange Rates: Price of foreign goods in terms of domestic goods




Nominal Exchange Rates: Two Views

1. The price of domestic currency in terms of foreigncurrency.

2. The price of foreign currency in terms of domesticcurrency.

For Example:For Example:

2007: $1 C = $0.9310 US or $1 US = 1/0.9310 = $1.0741 C




Nominal Exchange Rates--Choosing a Definition:

Nominal exchange rates (E): price of foreign currency in terms of domestic currency

For Example:For Example:

E between Canada (domestic) and the US (foreign)is the price of US$ in terms of C$

E = 1.0741 (2007)




Measuring Changes in the Nominal Exchange Rate (E)

• Appreciation of domestic currency corresponds toa decrease in E

• Depreciation of domestic currency corresponds toan increase in E



Nominal Exchange Rate, E (Price of US$ in terms of C$)

Appreciation of the Canadian dollar

Price of C$ in US$ increases Equivalently:

Price of US$ in C$ decreases Equivalently:

Exchange rate decreases: E

Depreciation of the Canadian dollar

Price of C$ in US$ decreases Equivalently:

Price of US$ in C$ increases Equivalently:

Exchange rate increases: E

The Nominal Exchange Rate, Appreciation, andDepreciation: The United States and Canada*The Nominal Exchange Rate, Appreciation, andDepreciation: The United States and Canada*

*From the point of view of Canada






Observations on E between Canada and the United States:

• From 1970-1975, 1US$ cost roughly 1C$

• For the last 30 years there has been a sustained depreciation of the C$

• From 1988 to 1991 the CS appreciated.

• At end of 1987 US$1 = C$1.31, by Oct 1991, US$1 = C$1.13

• A significant appreciation from 2002 (US$1 = C$1.50) to 2007 (C$1.07)

• Appreciation continued into 2008.




Question:Question:

Does a decrease in E of C$s for US$s necessarilymean Canadian citizens can buy more US goods withtheir dollars?

Hint: What is the inflation rate in the United States?




Calculating Real Exchange RatesCalculating Real Exchange Rates

The price of one U.S. good (SUV) in terms of oneCanadian Good (Minivan)

1. Convert the price of the SUV from US$s to C$sPUS = 40,000US$ = 1.5 C$sPC$s = 40,000 x 1.5 = $60,000

2. Compute the ratio of the US$ price of the SUV to theMinivan (Minivan price = $40,000)

Real exchange rate between Canada & United States =

5.1000,40$000,60$




Expanding the Real Exchange Rate Calculation to the Entire EconomicSystemExpanding the Real Exchange Rate Calculation to the Entire EconomicSystem

If: P = Canadian GDP Deflator P* = U.S. GDP Deflator

E = US$- C$ nominal exchange rate

Then: Price of US goods in C$s = EP*Real exchange rate () = EP*

P

NOTE:Real exchange rates () are index numbers and measureonly relative change.











The Real and Nominal Exchange Rates Between United Statesand Canada 1970-2008Observations:Observations:


The real 1970 exchange was roughly the same as in 1984. E and P both rose, so remained unchanged.

1992-2002 the nominal and real exchange rate depreciated.

In the 1990s Canada had a lower average inflation rate than the US. The P*/P ratio actually increased.

From 1987-1991 the C$ appreciated 15% versus the US$.





Country Composition of Canadian Merchandise Trade, 2007

Observations:Observations:

• United States is the dominant Canadian trading partner.

• Large trade surplus with U.S in 2007: Exports to U.S. = $356 Billion Imports from = $270 Billion




Real Multilateral Exchange RatesReal Multilateral Exchange Rates

• The real exchange rate when considering many countries

• Calculate by using each country’s share of trade as theweight for that country

Openness in Financial MarketsOpenness in Financial Markets



Foreign Exchange:Foreign Exchange:

Buying and selling foreign currency

• 2005 world daily volume of foreign exchange equaled $1.9 trillion.

• 90% of the value involved US$ dollars on one side of the exchange.

• Volume of foreign exchange transactions in New York doubled between 2001 and 2005. This increase reflects an increase in financial transactions rather than an increase in trade.






Openness in Financial MarketsOpenness in Financial MarketsThe Balance of Payments 2007

The Current Account (Above the Line)

All recorded payments to and from the rest of the world

1. Trade in Goods and Services* Exports: Payments from the rest of the world $530.2 Billion* Imports: Payments to the rest of the world $501.5 Billion

2. Investment Income* Canadian residents receive income on their holdings of foreign assets $71.4Billion* Foreign residents receive income on their holdings of Canadian assets

$85.6 Billion




The Balance of Payments 2007 (Continued)

The Current Account (Above the Line)

All recorded payments to and from the rest of the world

3. Foreign Aid ($1.1) Billion

* Net transfers received The difference between foreign aid received and given

4. Current account balance (+,-)= 1+2+3= 13.4 Billion (2007)




The Balance of Payments 2007

The Capital Account

1. Increase in foreign holdings of Canadian assets $148.1 Billion

2. Increase in Canadian holdings of foreign assets ($170.0) Billion

3. Net capital flows = 2-1$148.1 Billion - $170.0 Billion = (21.9 Billion)

Statistical discrepancy = $8.5b Accounts for differences in data sources.




The Balance of Payments

• The Current Account Balance (+,-) = Capital Account Balance (+,-)

• A Current Account Surplus increases Canadian holdings of foreign assets and vice versa.




The Choice Between Domestic and Foreign Assets

• Canadian Bonds

• it = Canadian nominal interest rate

• (1+it) = Return next year /C$ purchase of Canadian bonds

An Example: Choose between Canadian and U.S. 1 yr. bonds




The Choice Between Domestic and Foreign Assets (Continued)

• U.S. Bonds

• Et = nominal exchange between the C$ and US$

• (1/Et) US = US$/C$

• i*t = One year nominal interest rate on U.S. bonds (in US$)

•(1/Et)(1+i*t) = Return/US$ invested






• U.S. Bonds

• Eet+1 = expected exchange rate next year

•(1/Et)(1+i*t)Eet+1 = return/US$ invested


Note: Interest rates and exchange rates influence the choicebetween domestic and foreign assets.








If: Investors will hold only the asset with the highest rate ofreturn.

Then: To hold both Canadian and U.S. bonds, they must havethe same return.

Or: ))(*1(1

1 1

t

e

t

t

tEi

Ei

Canadian Bond Return

U.S. BondReturn

=





))(*1(1

1 1

t

et

tt Ei

Ei

Canadian BondReturn

US BondReturn

=

A little reorganizing:

t

te

tt E

Eii

1)*1(1

The Interest Parity Condition:





Is the assumption that investors hold only assets with thehighest expected return realistic?

Some other considerations:-- Transaction Costs-- Exchange Rate Risk

Observation:

The interest parity condition is a good approximation fordeveloped countries with open, well-organized financialmarkets.





Adjusting the interest rate parity condition for changes in thevalue of the domestic currency

t

te

tt E

Eii

1)*1(1

The Interest Parity Condition:

Or:

t

tte

tt EEE

ii1

1)*1(1

t

tte

E

EE 1= Expected rate of depreciation of the domestic currency





An approximation:

t

tte

tt E

EEii

1

*





t

tte

tt E

EEii

1

*OR:

Remember!Remember! Arbitrage implies: The domestic interest rate mustbe (approximately) equal to the foreign interestrate plus the expected depreciated rate of thedomestic currency.





It’s September 1993...It’s September 1993...• Brazilian bonds pay a monthly interest of 36.9%

• U.S. bonds pay a monthly interest of 0.2%

Buy Brazilian?Buy Brazilian?What about currency (Cruziero) depreciation?

July 1993: 100,000 Cruzieros = $1.01 August 1993: 100,000 Cruzieros = $0.75





U.S. vs. Brazil?U.S. vs. Brazil? Do not forget: Risk and Transaction Costs

month U.S.per 0.2% vs.Brazilmonth per%6.1

...1016.101.1

75.0)369.1()*1(

1

t

te

t E

Ei






Some ConclusionsSome Conclusions

GoodsGoods

• Openness allows choice between domestic goods and foreign goods.

• Which goods are chosen depends primarily on the real exchange rate.

Financial AssetsFinancial Assets

• Openness allows choice between domestic and foreign assets.

• Which assets are chosen depends primarily on:

• Relative rates of return

• Expected rate of depreciation of the domestic currency



End of ChapterEnd of Chapter

Openness in Goods Openness in Goods and Financial Marketsand Financial Markets

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Copyright © 2010 Pearson Education Canada. 6.1 Chapter 6 Openness in Goods and Financial Markets The Short Run Power Point Presentation Brian VanBlarcom