Chapter 18
2. US citizen sells Canadian stocks
- (A) domestic purchase of foreign assets decreases -US NCO decreases
NCO EX. 1. A US citizen buys Canadian stocks
- (A) domestic purchase of foreign assets increases - US NCO increases
4. A Canadian citizen buys US stocks
- (B) foreign purchases of domestic assets decreases -US NCO increases
3. A Canadian citizen buys US stock
- (B) foreign purchases of domestic assets increases -US NCO decreases
How would the following transactions affect US NCO? Also, state whether each involves FDI or FPI. 1. AN american cellular phone company establishes an office in the Czech republic
- FDI - US purchase; US NCO increases -funds flow from US to Czech -capital outflow. NCO rises
2. Harrods of London sells stock to the General Eclectic pension fund
- FPI -negative foreign purchase of US assets; US NCO rises -funds flow from US to london (GE pays for the UK stocks) -capital outflow. NCO rises
If two countries have different inflation rates, the nominal exchange rate will change over time A. if inflation is higher in Mexico than in the US
- P* rises faster than P -e rises -US dollar appreciates against the peso
Who is more likely to engage in foreign portfolio investment?
- an individual investor
Limitations of PPP theory - even after converted to a common currency, goods in different countries do not have the same price because... 1.
- there are many non traceable goods (haircuts) -cannot be arbitraged, so law of one price does not apply
Case 1 Canada experiences a recession (falling incomes, rising unemployment)
-Canadians buy less of everything including US goods and services -Canadian imports fall -US exports fall --> US net exports fall
4. Ford exchanges 20,000 euros for $$ at European bank
-Europe's holding of $$ decreases (worth 20,000 euros) -US NCO up by 20,000 euros
3. Honda expands its factory in Marysville, Ohio
-FDI -foreign purchase of US assets; NCO falls -funds flow from Japan to US - capital inflow, NCO Falls
4. A fidelity mutual fund (US firm) sells its Volkswagen stock to a french investor
-FPI -negative US purchase of foreign assets; US NCO falls -funds flow from France to US -capital inflow, NCO falls
What affects Net Exports?
-If US consumers' behavior changes= US imports -if Foreign consumers behavior changes= US exports
Case 3. Prices of goods produced in Mexico rise faster than prices of goods produced in the US
-Mexican goods become more expensive than US goods -US goods become cheaper relative to Mexican goods -US people buy less Mexican goods, Mexicans buy more US goods -exports rise and imports fall --> US net exports rise
Net Capital Outflow (NCO)
-NCO= (A) domestic purchase of foreign assets - (B) Foreign purchases of domestic assets -purchase- buying; positive purchase, selling; negative purchase
C. The sony pension fund buys bonds from the US treasury and pays with Japanese Yen
-No goods and services transaction. NX unchanged -NCO must remain unchanged also -Japans purchases of US assets increase. US NCO falls. -Japan pays for it with Yen. This is just like US purchasing foreign assets. US NCO increases. -these two offset each other, US NCO remains unchanged
B. If inflation is higher in the US than in Mexico
-P rises faster than P* -e falls -US dollar depreciates against the peso
Physical assets VS financial assets
-Physical assets; physical capital: factories, equipments (Foreign direct investment) -Financial assets; stocks, bonds, foreign currencies ( Foreign portfolio investment) *******Domestic currency is NOT considered as a financial asset
Case 2. US consumers decide to be patriotic and buy more products "made in the USA"
-This reduces US purchase of foreign goods -US imports fall --> US net exports rise
C. The US nominal exchange rate declines, and prices are unchanged in the United States and abroad
-US RER falls - US goods and services become cheaper
B. the US nominal exchange rate is unchanged, but prices rise faster abroad then in the United States
-US RER falls -US goods and services become cheaper
D. The US nominal exchange rate declines, and prices rise faster abroad than in the United States
-US RER falls -US goods and services become cheaper
What is happening to the US real exchange rate in each of the following situations? A. the US nominal exchange rate is unchanged, but prices rise faster in the United States than abroad.
-US RER rises -US goods and services become more expensive
Case 1. Real interest rates on US assets rise compared to the rates on foreign assets
-US assets are more attractive -US purchases of foreign assets fall -foreign purchases of US assets rise --> NCO falls at home (NCO rises abroad) -real interest rates paid on foreign and domestic assets
D. A worker at a Sony plant in Japan buys some Georgia peaches from an American farmer using Japanese Yen
-US exports. NX increase -NCO must increasE -japan pays for the peaches. US NCO increase
3. Ford exchanges 20,000 euros for $$ at US bank
-US holding of Euro increases, now the bank holds it -US NCO up by 20,000 euros
2. Ford buys European stocks worth 20,000 euros
-US holding of European stock increases -US NCO up by 20,000
EX; ford sells a car in France, receives 20,000 euros --> NX increases by 20,000 what about NCO? 1. Ford keeps 20,000
-US holding of euro increases -US NCO up by 20,000
Net Capital outflow of US increases if
-US residents buy foreign assets -Foreigners sell US assets (negative purchase)
Case 2. The perceived risk of Euro and European assets in general rises compared to the risk level of US assets
-Us assets become more attractive -people buy less European assets, perhaps buy more US assets -US NCO decreases -NCOs for European countries increases -perceived risks of holding foreign assets
Purchasing Power Parity (PPP)
-a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries -this requires the cost of consumption basket to be equal across countries -real exchange rate measures the quantity of consumption basket of one country per consumption basket to the other country, PPP implies that this should be ONE E = 1
Who is more likely to engage in foreign direct investment?- a corporation or and individual investor?
-corporation -individual investor has much less internet in managing a foreign firm
Two Types of NCO 2. Foreign Portfolio Investment (FPI)
-domestic residents buy foreign stocks, bonds, or currencies -foregin physical capital stock rises because FPI supplies loanable funds to foreign firms (eg. a fidelity mutual fund sells its Volkswagen stock to a french investor)
2.
-foreign and domestic goods are not perfect substitutes -Italian shirts VS Chinese shirts -even the corolla in Japan and US are not perfect substitute (due to different safety standards
NCO measures the imbalance in a country's asset
-if NCO>0 "capital Outflow" -if NCO <0 "capital inflow"
Arbitrage
-if prices are different in two locations, one can always make profit by buying the goods at a cheaper location and sell it at a more expensive location - this will raise the demand at cheaper location and lowers demand at more expensive location util two locations have the same price -this requires ZERO transportation cost
Net exports VS Net capital outflow
-net exports are always equal to net capital outflow NX= NCO -this is because every movement of goods and service, there is movement of money for the corresponding transaction
B. An american buys a share of Sony stock, pays with USD
-no goods and services transaction. NX unchanged -NCO must remain unchanged as well -US purchases of foreign assets increase. NCO increases -US pays for the stocks. NCO decreases. -These offset each other, so NCO remains unchanged
Two Types of NCO 1. Foreign Direct Investment (FDI)
-purchase of physical capital in foreign country -domestic residents actively manage the foreign investment (eg honda expands its factory in Marysville, OH) -
What affects NCO??
-real interest rates paid of foreign and domestic assets -perceived risks of holding foreign assets (political and economic stability) -government policies affecting foreign ownership of domestic assets (restrictions on asset holding by foreigners)
What affects Net Exports??
-the incomes of consumers at home and abroad -the tastes on consumers for domestic and foreign goods government policies toward international trade (import tariffs and quota : affects US imports only) -** The nominal exchange rates between two countries
Real exchange rate
-the rate at which the goods and services of one country trade for those of another -it measures the number of foreign baskets of goods and services that is comparable to one US basket -nominal exchange rate corrected for price levels of two countries
Case 3. In 1992, South Korea opens its stock market for foreigners
-this allows foreigners to freely acquire shares of Korean firms. Foreigners start buying Korean assets -Money goes into Korea, an inflow for Korea -Korean NCO falls - if US investors start purchasing Korean stocks, this will cause an increases in NCO in the US -government policies on foreign ownership of domestic assets
What affects NCO?
1. US assets become more attractive (foreign assets become less attractive) -both US people and foreigners buy more US assets -US NCO falls, foreign NCO rises 2. US assets become less attractive -both US people and foreigners buy more foreign assets -US NCO rises, foreign NCO falls
PPP example; A Big Mac costs $2.5 is US, 400 yen in Japan, if PPP holds, what is the nominal exchange rate ( e yen/ $) between USD and Japanese Yen?
1. the cost of a big mac should be the same in US and japan 2. conversion Japanese big mac = 400 yen US big mac $2.5 = $2.5 x e (yen/$) = Yen 2.5 x e 2.5 x e = 400 3. so the nominal exchange rate (e) should be... e= 400 yen/ $2.5 = 160
Q2: How much is a Japanese Big Mac in Japanese yen?
400 Yen
National Savings (NS)=
= Y - C - G S= I + NX
Depreciation
A decrease in the value of a currency (weakening)
How would the following transactions affect US exports, imports, and net exports?
A. An american art professor spends the summer tottering museums in Europe (US imports --> US NX falls) B. students in Paris flock to see the latest movie from hollywood at a theatre in Paris (US exports --> US NX rises) C. Your uncle buys a new Volvo (made in Sweden) (US imports --> US NX falls) D. A Canadian citizen shops at a store in northern Vermont to avoid Canadian sales tax (US exports --> US NX rises)
According to PPP, real exchange rate should be 1. FORMULA
E = eP / p* = 1 ---> e= P*/ P -PPP has direct implication on the nominal exchange rate; the nominal exchange rate between two countries should equal the ratio of price levels
A can of soda cost $.75 in the US and 12 pesos in Mexico a. what would the peso-dollar exchange rate be if PPP holds?
E= eP / P* = 1 e= P* / P 12 pesos / .75 dollar = 16 pesos / USD
Net Exports (NX)
Exports- Imports
Q2: Net capital outflow is foreign purchase of domestic assets minus the our purchase of foreign assets
False: the opposite
Q3: If a country's net exports fall, then its net capital outflow rises
False; NX= NCO. they move together
Q1: A country with negative net exports has a trade surplus
False; it has a trade deficit
Balanced Trade
If exports=imports
Higher domestic inflation
Lowers the value of domestic currency
Trade deficit (NX < 0)
NCO < 0: capital inflow S > I: not saving enough to fund investments (excess demand for loanable funds) -domestic investment is funded by foreign money through capital inflow -closely linked to domestic saving shortage -the current US trade deficit in the US is largely driven by the large government budget deficit
Trade surplus ( NX > 0)
NCO > 0: Capital outflow S > I: the country saves more than it invests (excess supply of loanable funds) - the excess supply of loanable funds flows abroad to finance investment of foreign countries
Real exchange rate formula
Real Exchange Rate (E)= eP/p* e: nominal exchange rate written as the amount of foreign currency per unit of domestic currency p: domestic price index P*: foreign price index
S - I = NCO
S (domestic supply of loanable funds) - I (domestic demand for loanable funds) = NCO ( excess supply of loanable funds from domestic market) -will be used toward investment in foreign country (FDI or FPI)
NX = NCO. replace in ( S - I = NX)
S - I = NCO
Investment to the left
S - I = NX
Exchange rate review; Q1; if the exchange rate is 10 pesos per US dollar, it is also 1/10 US dollars per peso
True
Q3; If prices in the US rise faster than prices in the UK then according to the doctrine of purchasing power parity the US nominal exchange rate should fall
True
Q4: In an open economy, national savings can be less than investment
True: S = I + NCO, so S<I if NCO is negative. this is when domestic investment is financed by foreign money (capital inflow)
Move C and G to the left
Y - C - G= I +NX
Saving, investment and initial transactions
Y= C + I + G + NX
Devaluation
deliberate lowering of the value of a currency through currency market intervention
Exports
domestically produced goods and services purchased by foreigners
A Big Mac cost $2.50 in US, 400 Yen in japan. Nominal exchange rate: e= 120 Yen / $ Q1: How much is a US Big Mac in Japanese yen?
e x P = 120 (Yen / $) x $2.5 = 300 Yen
b. if a monetary expansion caused all prices in Mexico to double, so that soda rose to 24 pesos, what would happen to the peso- dollar exchange rate?
e= P* / P 24 pesos / .75 dollar = 32 pesos/ USD -USD appreciates against pesos -peso depreciate -confirms: inflation causes depreciation
Q3: How many Japanese Big Macs can you get by bringing one US Big Mac?
eP / P* 300 Yen / 400 Yen = .75 This is the real exchange rate
Imports
foreign goods and services purchased by us
Trade surplus
if Exports > Imports (NX> 0)
Trade deficits
if exports < imports
Appreciation
increase in the value of a currency (strengthening)
if one investor acquires at least 10% off one firm....
it is categorized as "acquisition" - of the firm, which means acquisition of the structures and equipment that the firm owns (FDI!!!) - less than 10% of share of a firm- FPI -equal or more than 10% share of a firm- FDI
Higher foreign inflation
raises the value of domestic currency (reduces the value of foreign currency)
Law of One price
the notion that a good should sell for the same price in all market
Nominal exchange rates
the rate at which one country's current trades for another
Q2 the theory of purchasing power parity states that a unit of a contras currency should be able to buy the same quantity of goods in foreign countries as it does domestically
true