Transcript Chapter 18: The Open Economy

CHAPTER
18
The Open Economy
Prepared by:
Fernando Quijano and Yvonn Quijano
And Modified by Gabriel Martinez
The Open Economy
 Openness has three distinct dimensions:
1. Openness in goods markets. Free trade
restrictions include tariffs and quotas.
2. Openness in financial markets. Capital
controls place restrictions on the ownership of
foreign assets.
3. Openness in factor markets—the ability of
firms to choose where to locate production,
and workers to choose where to work.
1. The North American Free Trade
Agreement (NAFTA) is an example of this.
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18-1
Openness in Goods
Markets
U.S. Exports and
Imports as Ratios
of GDP, 1960-2000
2
1.8
20%
Percentage of GDP
Exports and imports,
which were equal to
5% of GDP as
recently as the
1960s, now stand
around 13% of GDP.
25%
1.6
Imports
1.4
15%
1.2
1
Exports
10%
0.8
0.6
5%
0.4
0.2
0%
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2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1960
0
Olivier Blanchard
Exports and Imports
 The behavior of exports and imports in the
United States is characterized by:
 A sharp decline in both exports and imports
between 1929 and 1936 as a result of the
Smoot-Hawley Act of 1930.
 Three episodes of surpluses and deficits:
 The trade surpluses of the 1940s.
 The trade deficits of the mid-1980s, and
 The current trade deficit, which reached 6.63% of
GDP in Q2 2006—a historical record.
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Openness in Goods
Markets
U.S. Current
Account Deficit as
a ratio of GDP,
1960-2006
2
2%
1 .8
1%
1 .6
0%
-2%
2005
2002
1999
1996
1993
1990
1987
1 .2
1
-3%
0.8
-4%
0.6
-5%
0.4
-6%
0.2
-7%
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1984
1981
1978
1975
1972
1969
1966
1963
-1%
1 .4
1960
Percentage of GDP
Exports and imports,
which were equal to
5% of GDP as
recently as the
1960s, now stand
around 13% of GDP.
3%
0
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Exports and Imports
Table 18-1
Country
Ratios of Exports to GDP for Selected OECD
Countries, 2000
Export Ratio (%)
Country
Export Ratio (%)
United States
11
Switzerland
45
Japan
10
Austria
48
Germany
33
Netherlands
74
United Kingdom
27
Belgium
84
 The main factors behind differences in export ratios are
geography and country size.
 Countries can have export ratios larger than the value of
their GDP because exports and imports may include
exports and imports of intermediate goods.
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Exports and Imports
 A good index of openness is the proportion
of aggregate output composed of tradable
goods—goods that compete with foreign
goods in either domestic markets or foreign
markets.
 Estimates are that tradable goods represent
around 60% of aggregate output in the
United States today.
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The Choice Between Domestic
Goods and Foreign Goods
 When goods markets are open, domestic
consumers must decide not only how much
to consume and save, …
 … but also whether to buy domestic goods
or to buy foreign goods.
 Central to the second decision is the price of
domestic goods relative to foreign goods, or
the real exchange rate.
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Nominal Exchange Rates
 The nominal exchange rate is the price of the
foreign currency in terms of the domestic currency.
units of domesticcurrency
E
1 unit of foreign currency
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Nominal Exchange Rates
 An appreciation of the domestic currency is an
increase in the price of the domestic currency in terms
of the foreign currency, which corresponds to a
decrease in the exchange rate.
 Fewer units of domestic currency are needed to buy 1 unit of
foreign currency.
units of domesticcurrency
E
1 unit of foreign currency
 A depreciation of the domestic currency is a decrease
in the price of the domestic currency in terms of the
foreign currency, or an increase in the exchange rate.
 More units of domestic currency are needed to buy 1 unit of
foreign currency.
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Nominal Exchange Rates
 Suppose countries operate under fixed
exchange rates, that is, maintain a
constant exchange rate between them.
If the government changes the value of
the currency, we say that
 Revaluations are decreases in the
exchange rate, and
 Devaluations are increases in the
exchange rate.
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Nominal Exchange Rates
The Nominal
Exchange Rate
Between the
Dollar and the
Pound (from the
Point of View of
the United States):
Appreciation and
Depreciation
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Nominal Exchange Rates
The Nominal Exchange
Rate Between the Dollar
and the Pound, 19752000
While the dollar has
strongly appreciated
vis-á-vis the pound over
the past 25 years, this
appreciation has come
with large swings in the
nominal exchange rate
between the two
countries, especially in
the 1980s.
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From Nominal to
Real Exchange Rates
U.S. cars
$10 million
U.K. cars
$10 million
PUS 
$10m/PUS=
$20,000
1 car
500 cars
500 cars
 £ 13,333 

PUK  
 1 car 
£  $10million 
Et = $1.5/£

1.5
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£ 6.67million

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From Nominal to
Real Exchange Rates
$10m/PUS=
U.S. cars
$10 million
U.K. cars
$10 million
$20,000
1 car
500 cars
375 cars
 £ 13,333 

PUK  
 1 car 
£  $10million 
Et = $2/£

2
£ 5 million

A nominal depreciation of the dollar reduces demand for British imports.
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From Nominal to
Real Exchange Rates
$10m/PUS=
U.S. cars
$10 million
U.K. cars
$10 million
$20,000
1 car
500 cars
444 cars
 £ 15,000 

PUK  
 1 car 
£  $10million 
Et = $1.5/£

1.5
£ 6.67 million

An increase in British prices, at the same E, reduces demand for
British imports.
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From Nominal to
Real Exchange Rates
 If the price of a Jaguar is £30,000, and a
pound is worth 1.5 dollars, then the price of
the Jaguar in dollars is £30,000 x $1.5 =
$45,000.
 If a Cadillac is $40,000, then the relative
price of a Jaguar in terms of Cadillacs is
$45,000/$40,000 = 1.12
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From Nominal to
Real Exchange Rates
 The Real Exchange Rate
 It is the concept that tells us how much the US’s
production is worth in terms of UK production.
 How much of UK GDP can I buy with 1 unit of US
GDP.
 To take into account all of the goods in a
nation’s economy, we use a price index for the
economy, or the GDP deflator.
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From Nominal to
Real Exchange Rates
The Construction of
the Real Exchange
Rate
The real exchange rate
equals the nominal
exchange rate times the
foreign price level,
divided by the domestic
price level.
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EP *

P
P* = price of British goods in pounds
E = price of pounds in terms of dollars
EP* = price of British goods in dollars
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From Nominal to
Real Exchange Rates
 If the US price is $20,000,
 And the UK price is £15,000,
 A consumer is indifferent between the two if
RER = 1.
 ($10m / $20,000) = (1/Et)($10m / £15,000)
 $20,000 = Et £15,000
 RER = 1 = Et £15,000 / $20,000
 RER = 1 = Et (P* / P)
  Et = $1.33 £.
 If Et=1.5, the $ must appreciate.
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From Nominal to
Real Exchange Rates
 An increase in the relative price of domestic
goods in terms of foreign goods:
 a real appreciation,
 a decrease in the real exchange rate, .
 A decrease in the relative price of domestic
goods in terms of foreign goods
 a real depreciation,
 an increase in the real exchange rate, .
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From Nominal to
Real Exchange Rates
The Real Exchange Rate
Between U.S. Goods and
U.K. Goods (from the
Point of View of the
United States) Real
Appreciation and Real
Depreciation
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Real
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From Nominal to
Real Exchange Rates
Real and Nominal
Exchange Rates
Between the United
States and the United
Kingdom, 1975-2000
Except for the
difference in trend
reflecting higher
average inflation in the
United Kingdom than
in the United States,
the nominal and the
real exchange rates
have moved largely
together since 1975.
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From Bilateral to
Multilateral Exchange Rates
Table 18-2 The Country Composition of U.S.
Merchandise Trade, 2000
Exports to
Countries
$ Billions
Imports from
Percent
$ Billions
Percent
Canada
179
23
232
19
Western Europe
178
23
243
20
Japan
64
8
146
12
Mexico
86
11
136
11
Asia*
130
17
340
28
OPEC
20
3
42
3
Others
116
15
83
7
Total
773
100
1222
100
* Not including Japan.
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OPEC:
of Petroleum
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From Bilateral to
Multilateral Exchange Rates
 Bilateral exchange rates are exchange rates
between two countries. Multilateral exchange
rates are exchange rates between several
countries.
 For example, to measure the average price of U.S.
goods relative to the average price of goods of
U.S. trading partners, we use the U.S. share of
import and export trade with each country as the
weight for that country, or the multilateral real
U.S. exchange rate.
Share of trade with CAN * 
can
 Share of trade with MEX *  mex
 Share of trade with JAP *  jap
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From Bilateral to
Multilateral Exchange Rates
 Equivalent names for the relative price of
foreign goods vis á vis U.S. goods are:
 The real multilateral U.S. exchange rate.
 The U.S. trade-weighted real exchange rate.
 The U.S. effective real exchange rate.
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From Nominal to
Real Exchange Rates
The U.S. Effective
Real Exchange Rate,
1975-2000
The large real
appreciation of U.S.
goods in the first half of
the 1980s was
followed by an even
larger real depreciation
in the second half of
the 1980s. This large
swing in the 1980s is
sometimes called the
“dance of the dollar.”
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18-2
Openness in
Financial Markets
 The purchase and sale of foreign assets implies
buying or selling foreign currency
 sometimes called foreign exchange.
 Openness in financial markets allows:
 Financial investors to diversify—to hold both domestic
and foreign assets and speculate on foreign interest rate
movements.
 Allows countries to run trade surpluses and deficits. A
country that buys more than it sells must pay for the
difference by borrowing from the rest of the world.
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The Balance of Payments
 The balance of payments account
summarizes a country’s transactions with
the rest of the world.
 Transactions in goods or services are
current account transactions.
 Transactions involving only goods (not services)
are counted in the trade balance, which is a part
of the current account.
 Trade deficit: Imports > Exports
 Trade surplus: Exports > Imports
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The Balance of Payments
 The balance of payments account
summarizes a country’s transactions with
the rest of the world.
 Transactions involving flows of funds are
capital account transactions.
 The current account balance and the capital
account balance should add up to zero, but
because of data gathering errors they don’t.
For this reason, the account shows a
statistical discrepancy.
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The Balance of Payments
Table 18-2 The U.S. Balance of Payments, 2000 (billions)
Current Account
Exports
1070
Imports
1437
Trade balance (deficit = ) (1)
367
Investment income received
345
Investment income paid
359
 14
Net investment income (2)
Net transfers received (3)
42
53
Current account balance (1) + (2) + (3)
83
434
Capital Account
Increase in foreign holdings of U.S. assets (4)
952
Increase in U.S. holdings of foreign assets (5)
553
Capital account balance (4)  (5)
399
Statistical discrepancy
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The Balance of Payments
 The sum of net payments in the current
account balance can be positive, in which case
the country has a current account surplus …
…or negative—a current account deficit.
 The capital account balance can be positive if
the change in foreign holdings of U.S. assets
are greater than U.S. holdings of foreign assets,
in which case there is a capital account
surplus.
 If foreign holding of US assets grows faster than US
holding of foreign assets, there is a capital account
deficit.
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The Choice Between
Domestic and Foreign Assets
The Choice Between
Domestic and Foreign Assets
 The decision whether to invest abroad or at
home depends not only on interest rate
differences, but also on your expectation of
what will happen to the nominal exchange
rate.
 If both U.K. bonds and U.S. bonds are to be
held, they must have the same expected rate of
return.
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The Choice Between
Domestic and Foreign Assets
Expected Returns from
Holding One-Year U.S.
Bonds or U.K. Bonds
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Expectations, Consumption,
and Investment Decisions
 If both U.K. bonds and U.S. bonds are to be
held, they must have the same expected rate of
return, so that the following arbitrage relation
must hold:
 1
*
e


1  it 
(1  i t )( E t 1 )
 Et 
 Rearranging the equation, we obtain the uncovered
interest parity relation, or interest parity condition:
e

E
t 1 
*

1  it  (1  i t )
 Et 
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Interest Rates and Exchange
Rates
 The relation between the domestic nominal
interest rate, the foreign nominal interest rate,
and the expected rate of depreciation of the
domestic currency is stated as:
e

E t 1  E t 
*

1  it  (1  i t ) 1 
Et


 A good approximation of the equation above is given
by:
e
*
t 1
t
t
t
t
i i 
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E
E
E
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Interest Rates and Exchange
Rates
it  i 
*
t
 Et
Et
e
t 1
E
 This is the relation you must remember:
Arbitrage implies that the domestic interest
rate must be (approximately ) equal to the
foreign interest rate plus the expected
depreciation rate of the domestic currency.
 If E e t 1  E t , then it  i * t
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Interest Rates and Exchange
Rates
One-Year Nominal Interest
Rates in the United States
and in the United Kingdom,
1975-2000
U.S. and U.K. nominal
interest rates have
largely moved together
over the last 25 years.
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18-3
Conclusions and
a Look Ahead
 The choice between domestic goods and
foreign goods depends primarily on the real
exchange rate.
 The choice between domestic assets and
foreign assets depends primarily on their
relative rates of return, which depend on
domestic interest rates and foreign interest
rates, and on the expected depreciation of
the domestic currency.
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Olivier Blanchard