ECON FINAL CHAPTER TWELVE

Canadian nominal interest rates have no historically been equal to US nominal interest rates. How is this possible, given the theory of interest rate parity?

-Interest rate parity applies to real, not nominal interest rates -Countries with greater risk or less advantageous tax treatment must offer higher real interest rates to compensate

Interest rate parity

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

Purchasing Power Theory

A theory that states that a unit of any given currency should be able to buy the same quantity of goods in all countries

PPP Exchange rate=

Canadian Exchange Rate/ Local Price

Use the idea of purchasing power parity and the real exchange rate equation from Chapter 12 to identify the impact domestic inflation would have a country's nominal exchange rate.

Inflation and the nominal exchange rate are linked by the long run need for purchasing power parity. Since purchasing power parity implies: 1 = (e x P)/P* domestic inflation [i.e. a continuous increase in P], all other things equal, must be matched by a continues decrease in the nominal exchange rate [e] [i.e. a continuous depreciation of the domestic currency].

Why is interest rate parity expected?

Interest rate parity is expected because in order to find someone to whom to lend money, Canadian savers would have to offer their savings at the world interest rate. As long as the Canadian and the foreign assets are close substitutes, the difference in interest rates provides an arbitrage opportunity for either borrowers or savers.

What is the relationship between NCO and NX?

NCO=NX

Real exchange rate equation

Nominal exchange rate x Domestic price / Foreign price

Interest rate parity equation

Rdomestic=rworld + a + B Domestic interest rate= World interest rate + Real interest rate demanded by lenders who face risk + Real interest rate demanded by lenders who face tax burden

What does saving equal?

Saving= Domestic Investment + Net Capital Outflow

How might economists explain the existence of an actual difference over the reported time periods?

The actual difference in real interest rates can be explained by different tax treatments between the two countries [e.g. tax on real interest income may have been higher in Canada than in the US, necessitating a correspondingly greater real interest rate in Canada to overcome the tax disadvantage] or greater perceived political risk in Canada [e.g. uncertainty surrounding Quebec's potential future separation from the rest of Canada may have necessitated a risk premium for lending to Canada].

What might explain the shrinking of this difference as noted in the quote above?

The difference would shrink if tax treatment became more harmonized or if differences in political risk were reduced.

Real exchange rate

The rate at which a person can trade goods and services of one country for the goods and services of another

Nominal exchange rate

The rate at which a person can trade the currency of one country for the currency of another

Explain S=I+NCO

This equation shows that a nation's saving must equal its domestic investment plus its net capital outflow. In other words, when Canadian citizens save a dollar of their income for the future, that dollar can be used to finance accumulation of domestic capital or it can be used to finance the purchase of capital abroad.

Why does NCO always = NX?

This identity is true because every international transaction is an exchange. When a seller country transfers a good or service to a buyer country, the buyer country gives up some asset to pay for this good or service. The value of that asset equals the value of the good or service sold. When we add everything up, the net value of goods and services sold by a country (NX) must equal the net value of assets acquired (NCO).

Is it possible for Mexico to run a trade surplus against Canada while at the same time receiving a net inflow of capital fromCanada? Explain.

This is not possible. In an open economy, it must be the case that NX = NCO. If Mexico runs a trade surplus against Canada, Mexico experiences positive NX. However, if Mexico receives a net inflow of capital from Canada, it experiences negative NCO. These two outcomes are irreconcilable - negative NCO must imply Mexico experiences negative [not positive] NX.

Nominal exchange rate equation

[Foreign to domestic/ EG 4 rubles to 1 dollar]

Holding national saving constant, does an increase in net capital outflow [NCO] increase, decrease, or have no effect on domestic investment [I]? Explain.

In an open economy, it must be the case that S = I + NCO. If S is constant and NCO increases, I must decrease to maintain the identity. In other words, if a nation wishes to maintain its saving level while at the same time sending more saving to other nations, it must [holding everything else constant] accept the fact that there will be less funds for domestic investment.

A Big Mac costs 42 baht in Thailand and $3.00 in Canada. What must be the baht-dollar exchange rate for purchasing power parity to hold?

Purchasing power parity implies the real exchange rate [R] equals 1. The real exchange rate is determined by the equation: R = (e x P)/P*, where: e = the nominal exchange rate [i.e. number of baht per Canadian dollars] P = the domestic price of a Big Mac P* = the foreign price of a Big Mac Therefore: 1 = (ex$3)/42baht Purchasing power parity implies the real exchange rate [R] equals 1. The real exchange rate is determined by the equation: R = (e x P)/P*, where: e = the nominal exchange rate [i.e. number of baht per Canadian dollars] P = the domestic price of a Big Mac P* = the foreign price of a Big Mac Therefore: 1 = (ex$3)/42baht e = 14bahtper$1

"Over the 24-year period of 1984-2006, the real interest rates paid on long-term government debt in Canada was ... 4.7 percent ... and 3.7 percent in the United States. ... Since 1996 the difference in interest rates has grown much smaller. ... [T]he difference ... averaged 0.7 percent." In theory, why might economists expect to see no difference between the real interest rates paid on long-term government debt in Canada and the United States?

Since Canada is a small open economy with perfect capital mobility, economists would expect to observe real interest rate parity between Canada and the United States.