Transcript Chapter 7

Openness in Goods and Financial Markets
Opening the Economy to International Transactions
Two dimensions of openness:
1. Openness in Goods Markets
2. Openness in Financial Markets
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Chapter 18: Openness in Goods and Financial Markets
Slide #1
Openness in Goods Markets
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Chapter 18: Openness in Goods and Financial Markets
Slide #2
Openness in Goods Markets
Observations of U.S. Exports and Imports
 Exports and imports in the U.S. were 5% of GDP in
1960, are 12% (11.2% exports, 13% imports) of GDP
today.
 Decline in exports and imports from 1929-1936 due
in large part to Smoot-Hawley Act of 1930.
 Large trade surpluses of the 1940s and large trade
deficits of the 1980s.
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Chapter 18: Openness in Goods and Financial Markets
Slide #3
Openness in Goods Markets
Measuring the Degree of Openness
 Volume of Trade:
Ratio of exports or imports to
GDP (U.S. = 12%)
 Tradable Goods Ratio: Percent of output that
competes in foreign markets
(U.S. = 60%)
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Chapter 18: Openness in Goods and Financial Markets
Slide #4
Openness in Goods Markets
A Look Around the World
Country Export Ratio (%)
Country Export Ratio (%)
United States
12
Switzerland
40
Japan
10
Austria
38
Germany
23
Belgium
73
United Kingdom
29
Luxembourg
91
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Chapter 18: Openness in Goods and Financial Markets
Slide #5
Openness in Goods Markets
What Do You Think...
Can exports exceed GDP?
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Chapter 18: Openness in Goods and Financial Markets
Slide #6
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Real Exchange Rates: Price of foreign goods in
terms of domestic goods
Nominal Exchange Rates: The relative
prices of currencies
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Chapter 18: Openness in Goods and Financial Markets
Slide #7
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Nominal Exchange Rates: Two Views
1.
The price of domestic currency in terms of foreign
currency.
2.
The price of foreign currency in terms of domestic
currency.
For Example:
November 2000: Nominal exchange between U.S. dollar
and German Deutschemark (DM)
$ in terms of DM:
DM in terms of $s:
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1$ = 2.29 DM
1DM = 0.44$
Chapter 18: Openness in Goods and Financial Markets
Slide #8
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Nominal Exchange Rates--Choosing a Definition:
Nominal exchange rates (E): price of foreign
currency in terms of
domestic currency
For Example:
E between the U.S. (domestic) and Germany
(foreign) is the price of DM in terms of $
E = .44
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Chapter 18: Openness in Goods and Financial Markets
Slide #9
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Measuring Changes in the Nominal Exchange
Rate (E)
• Appreciation of domestic currency
corresponds to a decrease in E
• Depreciation of domestic currency
corresponds to an increase in E
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Chapter 18: Openness in Goods and Financial Markets
Slide #10
Openness in Goods Markets
The Nominal Exchange Rate, Appreciation, and
Depreciation: Germany and the United States*
Nominal Exchange Rate, E (Price of DM in terms of dollars)
Appreciation of the dollar
Depreciation of the dollar
Price of dollars in DM increases
Equivalently:
Price of dollars in DM decreases
Equivalently:
Price of DM in dollars decreases
Equivalently:
Price of DM in dollars increases
Equivalently:
Exchange rate decreases: E
Exchange rate increases: E
*From the point of view of the
United States
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Chapter 18: Openness in Goods and Financial Markets
Slide #11
Openness in Goods Markets
The Nominal Exchange Rate between the DM and the Dollar
1978 - 1998
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Chapter 18: Openness in Goods and Financial Markets
Slide #12
Openness in Goods Markets
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Chapter 18: Openness in Goods and Financial Markets
Slide #13
Openness in Goods Markets
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Chapter 18: Openness in Goods and Financial Markets
Slide #14
Openness in Goods Markets
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Chapter 18: Openness in Goods and Financial Markets
Slide #15
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Question:
Does a decrease in E of U.S. $s for DMs
necessarily mean U.S. citizens can buy more
German goods with their dollars?
Hint: What is the inflation rate in Germany?
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Chapter 18: Openness in Goods and Financial Markets
Slide #16
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Calculating Real Exchange Rates
The price of one German good (Mercedes SL) in terms of one
U.S. Good (Cadillac Seville)
1. Convert the price of the Mercedes from DM to $s
PDM = 100,000
DM = .60$s
P$s = 100,000 x .60 = $60,000
2. Compute the ratio of the $ price of the Mercedes to the
Cadillac (Cadillac price = $40,000)
Real exchange rate between U.S. & Germany =
$60,000
 1.5
$40,000
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Chapter 18: Openness in Goods and Financial Markets
Slide #17
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Expanding the Real Exchange Rate Calculation to the Entire Economic
System
If:
P = U.S. GDP Deflator
P* = German GDP Deflator
E = DM-dollar nominal exchange rate
Then:
Price of German goods in $s = EP*
Real exchange rate () = EP*
P
NOTE:
Real exchange rates () are index numbers and measure
only relative change.
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Chapter 18: Openness in Goods and Financial Markets
Slide #18
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
The Construction of the Real Exchange Rate
Price of German
goods in DM
P*
Price of German
goods in dollars
EP*
Price of U.S.
goods in dollars
P
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Real exchange
rate
 = EP*
P
Chapter 18: Openness in Goods and Financial Markets
Slide #19
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Real and Nominal Exchange Rates
Between Germany and the U.S., 1975-1998
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Chapter 18: Openness in Goods and Financial Markets
Slide #20
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
The Country Composition of U.S. Merchandise Trade, 1998
Countries
Canada
Western Europe
Japan
Mexico
Asia*
OPEC**
Others
Total
Exports to
$ Billions Percent
156
159
57
78
126
15
80
671
23
24
8
12
19
2
11
100
Imports from
$ Billions Percent
177
193
121
95
247
19
67
919
19
21
13
11
27
2
7
100
*Not including Japan.
**OPEC: Organization of Petroleum Exporting Countries.
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Chapter 18: Openness in Goods and Financial Markets
Slide #21
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Real Multilateral Exchange Rates
•
The real exchange rate when considering many countries
•
Calculate by using each country’s share of trade as the
weight for that country
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Chapter 18: Openness in Goods and Financial Markets
Slide #22
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
The U.S. Effective Real Exchange Rate, 1975 - 1998
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Chapter 18: Openness in Goods and Financial Markets
Slide #23
Openness in Financial Markets
Foreign Exchange:
Buying and selling foreign currency
• 1997 daily volume of foreign exchange
equaled $2.5 trillion.
• 80% of the 1997 value involved dollars on
one side of the exchange.
• Volume of foreign exchange transactions is
20 times greater than in 1980.
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Chapter 18: Openness in Goods and Financial Markets
Slide #24
Openness in Financial Markets
The Relation Between Trade and Financial Flows
The U.S. Balance of Payments, 1998
Current Account
Exports
931
Imports
Trade balance (deficit = -) (1)
Investment income received
Investment income paid
Net investment income (2)
Net transfers received (3)
Current account balance (deficit = -) (1)+(2)+(3)
Capital Account
Increase in foreign holdings of U.S. assets
Increase in U.S. holdings of foreign assets
Net increase in foreign holdings/net capital flow to the U.S.
Statistical discrepancy
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1100
-169
242
265
-23
-41
-233
542
305
Chapter 18: Openness in Goods and Financial Markets
237
4
Slide #25
Openness in Financial Markets
The Balance of Payments
• The Current Account Balance (+,-) = Capital Account Balance (+,-)
• A Current Account Deficit increases foreign holdings of U.S.
assets and vice versa.
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Chapter 18: Openness in Goods and Financial Markets
Slide #26
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
An Example: Choose between U.S. and German 1 yr. bonds
• US Bonds
• it = U.S. nominal interest rate
• (1+it) = Return next year /$purchase of U.S. bonds
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Chapter 18: Openness in Goods and Financial Markets
Slide #27
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets (Continued)
An Example: Choose between U.S. and German 1 yr. bonds
• German Bonds
• Et = nominal exchange between the $ and DM
• (1/Et) DM = DM/$1
• i*t = One year nominal interest rate on German Bonds
(in DM)
•(1/Et)(1+i*t) = Return/DM invested
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Chapter 18: Openness in Goods and Financial Markets
Slide #28
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets (Continued)
An Example: Choose between U.S. and German 1 yr. bonds
• German Bonds
• Eet+1 = expected exchange rate next year
•(1/Et)(1+i*t)Eet+1 = return/$ invested
Note:
Interest rates and exchange rates influence the choice
between domestic and foreign assets.
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Chapter 18: Openness in Goods and Financial Markets
Slide #29
Openness in Financial Markets
 Example:
 $1000
to invest in the US or Germany
 igermany
= 0.08
 ius
= .10
 Et=.40
 Et+1=.45
 Where
do you want to invest?
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Chapter 18: Openness in Goods and Financial Markets
Slide #30
Openness in Financial Markets
 If you invest in the US:

Amt Received = $1000 (1 +.10) = $1100
 If you invest in Germany:

Amt Received = ($1000)/.4 * (1+.08) * .45 = $1215
 How would your answer change if the
exchange rate was not expected to change?
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Chapter 18: Openness in Goods and Financial Markets
Slide #31
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
If:
Investors will hold only the asset with the highest rate of
return.
Then: To hold both U.S. and German bonds, they must have
the same return.
Or:
1
e
1  it   (1  i *t )( E t 1 )
 Et 
U.S. Bond =
Return
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German Bond
Return
Chapter 18: Openness in Goods and Financial Markets
Slide #32
Openness in Financial Markets
A little reorganizing:
The Interest Parity Condition:
E e t 1
1  i t  (1  i *t )
Et
Under
these conditions, what is the interest parity rate of
interest in the US:
igermany
= 0.08
Et=.40
Et+1=.45
1 + it = (1+.08)*.45/.40
it= .215
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Chapter 18: Openness in Goods and Financial Markets
Slide #33
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
Is the assumption that investors hold only assets with the
highest expected return realistic?
Some other considerations:
-- Transaction Costs
-- Exchange Rate Risk
Observation:
The interest parity condition is a good approximation for
developed countries with open, well-organized financial
markets.
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Chapter 18: Openness in Goods and Financial Markets
Slide #34
Openness in Financial Markets
U.S. & German One-Year Nominal Interest Rates, 1975-1998
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Chapter 18: Openness in Goods and Financial Markets
Slide #35
Openness in Markets
Goods
• Openness allows choice between domestic goods and foreign
goods.
• Which goods are chosen depends primarily on the exchange
rate.
Financial 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
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Chapter 18: Openness in Goods and Financial Markets
Slide #36
IS-LM-FE Analysis
 IS is the locus of points r and y that yield
equilibrium in the goods market

Y=C+I+G+X-Q

Y = C(Y) + I(i) +G0 + X0 - Q(Y,e)
 LM is the locus of points r and y that yield
equilibrium in the money market

M0 = Mdt + Mds

M0 = Mdt(y) + Mds(i)
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Chapter 18: Openness in Goods and Financial Markets
Slide #37
IS-LM-FE Analysis
 FE is the locus of points r and y that yield
equilibrium in the balance of payments.

BOP = BCA + BKA

BOP = BCA (Y, e) + BKA (i)
 Now we need to put IS, LM and FE together.
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Chapter 18: Openness in Goods and Financial Markets
Slide #38
IS-LM-FE Analysis
i
FE
LM
 IS and LM are
fairly easy
 FE presents a
problem
IS
y
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 Should FE be
vertical?
Chapter 18: Openness in Goods and Financial Markets
Slide #39
IS-LM-FE Analysis
r
FE
LM
IS
IS and LM are
fairly easy
 FE presents a
problem
 Should FE be

– vertical
– steeper than LM
y
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Chapter 18: Openness in Goods and Financial Markets
Slide #40
IS-LM-FE Analysis
r
LM
FE
IS
y
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IS and LM are
fairly easy
 FE presents a
problem
 Should FE be

– vertical
– steeper than LM
– flatter than LM
Chapter 18: Openness in Goods and Financial Markets
Slide #41
IS-LM-FE Analysis
r
LM
FE
IS
y
Blanchard: Macroeconomics
IS and LM are
fairly easy
 FE presents a
problem
 Should FE be

–
–
–
–
vertical
steeper than LM
flatter than LM
horizontal
Chapter 18: Openness in Goods and Financial Markets
Slide #42
IS-LM-FE Analysis
 The slope of the FE will depend upon the
sensitivity of capital flows to changes in
interest rates.

if capital flows are not sensitive to interest rates,
the FE line will be vertical

if capital flows are perfectly sensitive to interest
rates, the FE line will be horizontal

the more sensitive are capital flows to interest
rates, the flatter will be the FE line.
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Chapter 18: Openness in Goods and Financial Markets
Slide #43