Week 6: Open Economy

Question 1

Financial Inflows

Answer 1

Investments by foreigners into Canada

Question 2

Financial Outflows

Answer 2

Investments by Canadians into Foreign Countries

Question 3

3 Types of Financial Investment

Answer 3

1. Foreign Direct Investment (physical capital and IP)
2. Portfolio Investment (stocks and bonds)
3. Deposits & Loans

Question 4

Balance of Payments

Answer 4

a country’s transactions with the rest of the world

Question 5

What 2 sets of transactions are part of the balance of payments

Answer 5

1. Current account balance
2. Financial Account Balance

Question 6

Define Current account balance

Answer 6

Difference between income that Canadians receive from abroad and income that Canadians pay to people abroad

Question 7

Define Financial account balance

Answer 7

Difference between financial inflows and financial outflows

Question 8

Define Balance of Payments on goods and services

Answer 8

difference between its exports and its imports of goods and services

Question 9

Define Merchandise trade balance

Answer 9

difference between a country’s exports + imports of goods

Question 10

Define foreign exchange market

Answer 10

the market where currencies are bought + sold

Question 11

Demand for Canadian dollars

Answer 11

1. Trade flows: foreigners buying CAD exports
2. foreigners investing in Canada

Question 12

Supply of Canadian Dollars

Answer 12

1. Trade Flows - Canadians buying imports
2. Financial outflow: Canadians investing abroad

Question 13

Floating Exchange Rate Regime:

Answer 13

The exchange rate fluctuates in response to market forces.

Question 14

Fixed Exchange Rate Regime: .

Answer 14

The exchange rate is set by the government and never (or rarely) changes

Question 15

Managed Exchange Rate Regime:

Answer 15

The government buys and sells currency to reduce volatility and/or to keep the currency cheap.

Question 16

Exchange Market intervention

Answer 16

Government purchases or sales of currency in the foreign exchange market

Question 17

Foreign exchange reserves

Answer 17

stocks of foreign currency that governments maintain to buy their own currency on the foreign exchange market.

Question 17

Define devaluation

Answer 17

reduction in the value of a currency that is set under a fixed exchange rate regime.

Question 17

Foreign exchange controls

Answer 17

licensing systems that limit the right of individuals to buy foreign currency.

Question 17

Define revaluation

Answer 17

an increase in the value of a currency that is set under a fixed exchange rate regime.

Question 18

Benefits of fixed exchange rate

Answer 18

1. a stable and predictable foreign exchange environment (good for foreign investment and trade agreements)
2. Helps keep export prices competitive, especially if fixed with its main trading partner(s).
3. Imposes fiscal and monetary discipline on countries that have a history of excessive government spending and/or excess inflation.
4. Improves a country’s integration to global markets. For example, a fixed exchange rate with the Euro will lead to more participation in European markets.

Question 18

Disadvantages of a fixed exchange rate

Answer 18

1. Exchange market intervention requires large case reserves + exchange controls distort economic incentives.
2. ncreases transmission of business cycles because economies are more integrated.
3. Can’t use monetary policy to stabilize economy in recessions/booms

Question 19

purchasing power parity

Answer 19

the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country.