LESSON 7. International Trade, Investment, and Exchange Rates

Transcription

1 LESSON 7 International Trade, Investment, and Exchange Rates Assigned Reading 1. Mankiw, N. Gregory, et al Principles of Macroeconomics (5 th Canadian Edition). Toronto: Thomson Nelson. Chapter 12: Open-Economy Macroeconomics: Basic Concepts Recommended Reading 1. Mankiw, N. Gregory, et al Study Guide for use with the Principles of Macroeconomics, (5 th Canadian Edition). Toronto: Thomson Nelson. Chapter 12: Open-Economy Macroeconomics: Basic Concepts Learning Objectives After studying this lesson, students should be able to: 1. Discuss how the international flow of goods and services is measured by net exports. 2. Discuss how the international flow of capital is measured by net capital outflow. 3. Explain why net exports must always equal net capital outflow. 4. Explain the relationship between saving, domestic investment, and net capital outflow. 5. Recognize the difference between the nominal exchange rate and the real exchange rate. 6. Explain the law of one price and its limitations. 7. Describe how purchasing-power parity is a theory of real exchange rates. 8. Explain how local interest rates are determined in a small open economy with perfect capital mobility. Instructor's Comments This lesson presents the measures of international trade and finance and the economic variables that govern them. The chapter presents the basic open-economy concepts: net exports, net capital outflow, real and nominal exchange rates, interest rate parity, and purchasing-power parity. The goal of the chapter is to show how domestic savings, investment, net exports, and net capital outflow are all determined together, with these relationships governed by equilibrium in the markets for foreign currency (exchange rates) and by the requirement that after controlling for differences in risk and tax differences, real interest rates should be equal across countries (interest rate parity). 7.1

2 Lesson 7 At the heart of this lesson are two basic outcomes that relate to the operation of the macro-economy from national income accounting. First, net exports (NX) must equal net capital outflow (NCO). Second, domestic savings must equal domestic investment + NCO. The first point is one that is often lost in public debates over foreign trade policy. For instance, there is much pride that Canada runs a trade surplus with the United States, and at the same time concern that capital flows south from Canada to be invested in the US, either as foreign direct investment in factories or Florida and Arizona real estate for snowbirds, or into US stock markets as foreign portfolio investment. Yet, we cannot have one without the other. Canada's positive net exports with the US mean that we accumulate dollars, which we can either hold here as foreign currency reserves, which is a form of foreign portfolio investment by holding cash, or invest back into the US. If we want capital to flow from the US to Canada, we need to have negative net exports with the US, i.e., run a trade deficit. However, this is likely to be perceived as a crisis by national pundits. The basics of national income accounting are that you cannot have a trade surplus (positive net exports) simultaneously with capital inflow (negative net capital outflow). The second point emphasizes that when domestic savings exceed the local use of those savings through domestic investment, then the excess is invested abroad through net capital outflow. The reverse of this applies to fast growing countries, where domestic savings may be insufficient to meet the demand for investment in their rapidly expanding economies. In this case, capital inflow, negative net capital outflow, supplements domestic savings to ensure that the following equations hold: S = I + NCO ø S! NCO = I Real estate offers certain exceptions to the principle of purchasing power parity. As the text points out, purchasing power parity determines equilibrium real exchange rates. The basis of this theory is the "law of one price", which argues that exchange rates must adjust so that there is no opportunity for people to profit from arbitrage, buying in low price areas and selling in high price areas for positive economic profits. This works well for tradeable commodities such as lumber, but what about land and structures? Structures are less of a problem, because in equilibrium, prior to depreciation, the value of a structure should reflect the cost of the labour and materials that went into building it. And materials are tradeables for which the law of one price will hold. However, there is no way to take advantage of arbitrage in land. Even though house prices in Vancouver and Toronto are high, one cannot move land to those cities from lower priced Halifax and Winnipeg to take advantage of these differences. The only way for house prices to adjust across cities is through movements in population. When real estate prices get too high in a city compared to wages, people look to lower priced cities, where they can obtain a higher standard of living for what they receive in wages. With migration, demand for real estate falls in the city that people are leaving, lowering prices, and demand rises in the destination city, leading to higher real estate prices. Of course, this process takes much longer than it does to ship a truck or boatload of softwood lumber from one city to another. The next lesson builds an open-economy macroeconomic model that shows how these variables are determined simultaneously. Review and Discussion Questions 1. How do the nominal exchange rate and the real exchange rate differ? 2. What is the logic behind the theory of purchasing power parity? 3. Can purchasing power parity be used to explain the fact that the Canadian dollar has depreciated by more than 300% against the German mark since 1970, but has appreciated by almost 100% against the Italian lira during the same period? 7.2

3 International Trade, Investment, and Exchange Rates 4. What would you expect to happen to Canadian net capital outflow under each of the following situations? Real interest rates on French, German, and Italian government bonds increase. Real interest rates on Canadian government bonds increase. Civil wars break out in the countries of the former Soviet Union and Eastern Europe. Parliament passes legislation limiting foreign ownership of Canadian assets. 5. Identify four reasons why the Canadian economy has engaged in an increasing amount of trade over the last 40 years. 6. In terms of the real exchange rate, what three variables should change to make Canada more competitive internationally? 7. Why might the interest rate in Canada be higher than the interest rate prevailing in world financial markets? 8. Suppose the nominal exchange rate is 100 yen per dollar. Further, suppose the price of a tonne of Canadian corn is $5 and the price of a tonne of Japanese corn is 750 yen. (e) What is the real exchange rate between Japan and Canada in terms of corn? Does a dollar have purchasing-power parity in Canada and Japan? Explain. Is there a profit opportunity that you could explain with arbitrage? Where would you buy and where would you sell? If the nominal exchange rate stayed the same, what should happen to the price of corn in Canada and Japan? Explain. Suppose prices move as you have suggested in part. What has happened to the real exchange rate? 9. How would the following transactions affect Canada's exports, imports, and net exports? (e) A Canadian art professor spends the summer touring museums in Europe. Students in Paris flock to Montreal to see the latest Celine Dion concert. Your uncle buys a new Volvo. The student bookstore at Oxford University sells a pair of Bauer hockey skates. A Canadian citizen shops at a store in northern Vermont to avoid Canadian sales taxes. 7.3

4 Lesson Would each of the following groups be happy or unhappy if the Canadian dollar appreciated? Explain. Dutch pension funds holding Canadian government bonds. Canadian manufacturing industries. Australian tourists planning a trip to Canada. A Canadian firm trying to purchase property overseas. 11. What is happening to Canada's real exchange rate in each of the following situations? Explain. The Canadian nominal exchange rate is unchanged, but prices rise faster in Canada than abroad. The Canadian nominal exchange rate is unchanged, but prices rise faster abroad than in Canada. The Canadian nominal exchange rate declines, and prices are unchanged in Canada and abroad. The Canadian nominal exchange rate declines, and prices rise faster abroad than in Canada. 12. A case study in the chapter analyzed purchasing-power parity for several countries using the price of a Big Mac. Here are data for a few more countries: Country Price of a Big Mac Predicted ($US) Exchange Rate Actual ($US) Exchange Rate South Korea 3,400 won? won 1,135 won Britain 2.29 pounds? pounds.625 pounds Mexico pesos? pesos pesos Denmark 32 kroner? kroner 5.35 kroner For each country, compute the predicted exchange rate of the local currency per US dollar. (Recall that the US price of a Big Mac is $3.73) How well does the theory of purchasingpower parity explain exchange rates? According to purchasing-power parity, what is the predicted exchange rate between the South Korean won and the British pound? What is the actual exchange rate? Which of these countries offers the cheapest Big Mac? Why do you think that might be the case? 7.4

5 International Trade, Investment, and Exchange Rates ASSIGNMENT 7 CHAPTER 12: Open-Economy Macroeconomics: Basic Concepts Marks: 1 mark per question 1. On April 5 th, 2011, the exchange rate between the Japanese Yen (-) and the British Pound (,) was /,. On April 7, 2011, the same exchange rate was quoted at /,. From this we can conclude that: (1) on April 5, 2011, one Japanese Yen was worth British Pounds. (2) over the two days the British pound has gained value against the Japanese Yen. (3) on April 7, 2011, one Japanese Yen was worth less than British Pounds. (4) all of the above. 2. Statistics from the mid 1980s show that the price of the Canadian Dollar in terms of US Dollars fell somewhat, while the price of the Canadian dollar rose in terms of British Pounds. This: (1) made it easier for Canadian exporters to sell their goods in Britain, but made it more difficult for them to compete in the United States. (2) made British goods more expensive in Canada. (3) shows that the price of the US Dollar in terms of British Pounds must have fallen. (4) made it easier for Canadian importers to buy their goods from Britain, but made it more difficult for them to buy from the United States. 3. According to the textbook, which of the following has NOT been a major factor of increased international trade since the 1960s? (1) Improvements in transportation (2) Advances in telecommunications (3) Government trade policies such as the Auto Pact (4) Government trade policies such as tariffs 4. A depreciation of the dollar implies Canadian consumers will buy: (1) more domestic goods and fewer foreign goods. (2) fewer domestic goods and more foreign goods. (3) more domestic goods and more foreign goods. (4) fewer domestic goods and fewer foreign goods. 5. According to the text, given the fact that Canadian citizens are not saving much, it is better to: (1) reduce Canadian domestic investment. (2) force Canadian citizens to save more. (3) prevent foreigners from investing in the Canadian economy. (4) have foreigners invest in the Canadian economy, rather than no one at all. ***Assignment 7 continued on next page*** 7.5

6 Lesson 7 6. If Canada puts restrictions on foreign ownership of Canadian assets, interest rates paid on Canadian government bonds would likely: (1) increase. (2) decrease. (3) be unaffected. (4) fall to zero. 7. When a country's central bank increases the money supply, a unit of money: (1) loses value in terms of the goods and services it can buy and gains value in terms of other currencies it can buy. (2) loses value in terms of the goods and services it can buy and in terms of other currencies it can buy. (3) increases in value. (4) has an unchanged value. 8. When Haaken, a native of Norway, buys a box of chocolates produced in Belgium, Belgian net exports and Norwegian net exports. (1) increase, decrease (2) increase, are unaffected (3) are unaffected, decrease (4) decrease, increase 9. Bob, a US citizen, is considering the purchase of a Canadian government bond. A similar bond issued by the US government pays an interest rate of 8% for one year. Bob believes that over the next year the Canadian dollar will depreciate by 2% relative to the US dollar. If he chooses to buy the Canadian government bond, Bob must be receiving a interest rate of at least: (1) 8% (2) 10% (3) 6% (4) 4% 10. If the exchange rate is 110 yen = $1 Canadian, a radio that costs 2,750 yen in Japan will cost: (1) $20 in Canada. (2) $25 in Canada. (3) $22 in Canada. (4) $27 in Canada. 11. If Lululemon opens a store in Japan, this is an example of a: (1) foreign direct investment. (2) foreign portfolio investment. (3) net foreign investment. (4) net capital outflow. 7.6 ***Assignment 7 continued on next page***

7 International Trade, Investment, and Exchange Rates 12. If the dollar appreciates relative to the Euro, Canadian net exports to Germany will and German net exports to Canada will. (1) rise, fall (2) fall, rise (3) rise, rise (4) fall, fall 13. If a Peruvian company sells anchovies to a Canadian company, Canada's net exports and Canada's net capital outflow. (1) increase, increases (2) increase, decreases (3) decrease, decreases (4) decrease, increases 14. Most economists believe that perfect capital mobility is a characteristic of the Canadian economy. As a result we should expect that: (1) the real interest rate in Canada should equal the real interest rate in Russia. (2) the real interest rate in Canada will move independently of the US interest rate. (3) changes in the real interest rate in Canada will closely match changes in the US real interest rate. (4) the real interest rate in Canada will remain more or less constant over time. 15. If Canada sells fewer goods and services abroad than it purchases from foreign countries, Canadian exports are than imports, and net exports are. (1) greater, negative (2) greater, positive (3) smaller, positive (4) smaller, negative 16. Canada is said to be a "small" open economy because: (1) an increase in the domestic demand or supply of internationally traded goods has negligible effects on world prices. (2) Canada is just one member of the North American Free Trade Agreement (NAFTA). (3) Canada's GDP is small relative to US GDP. (4) of recent cutbacks to federal government expenditures. 17. If the purchasing power of the dollar is always the same at home and abroad then the real exchange rate: (1) will increase. (2) will decrease. (3) cannot change. (4) There is not enough information to answer this question. ***Assignment 7 continued on next page*** 7.7

8 Lesson One reason that Russia has been able to attract foreign investors to its government bonds is that: (1) the bonds are less risky than are Canadian and other government bonds. (2) foreign investors are lending as a humanitarian gesture. (3) the bonds pay a higher rate than do Canadian and other government bonds. (4) none of the above. 19. If one six-pack of Czech beer costs 150 Czech crowns, one six-pack of Canadian beer costs 12 Canadian dollars and the real exchange rate is 1.44 six-pack of Czech beer per six-pack of Canadian beer. What is the nominal exchange rate? (1) 20 (2) 18 (3) (4) The theory of interest rate determination says that the real interest rate on comparable financial assets should be the same in all economies with full access to the world markets. This is known as: (1) purchasing-power parity. (2) interest rate parity. (3) interest rate discovery. (4) real exchange rate. 20 Total Marks 7.8 ***End of Assignment 7***