Transcript Lecture 9

Foreign trade
• In the next two lectures we will develop versions
of the IS-LM and AD-AS models for an open
economy.
• An open economy can have several meanings:
– Goods market: trades goods and services
– Financial market: allow the flow of investment capital
– Factor market: allows the free movement of
companies and people
• In this class we will focus on the first two:
openness in goods and financial markets.
How open is the Australian
economy?
120000
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80000
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40000
20000
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94
Million A$
• You could measure
the size of imports or
exports (why not
both?) in the
Australian economy.
• But this would lead to
the same problems as
measuring GDP in
nominal terms.
Exports Imports
Importance of external trade
40
Ratio to GDP (percent)
35
Imports/GDP
30
25
20
15
10
Exports/GDP
5
0
1901
1911
1921
1931
1941
1951
1961
1971
1981
1991
2001
Globalization?
• Much is made of the “new” impact of
globalization in the world economy.
• But from the previous graph, the Australian
economy is as dependent (even less) on the rest
of the world as it was one century ago.
• “Globalization” must be referring to something
else instead- the free flow of people and ideas
across the world- rather than goods and
services.
Trade balance
• We define a term “net exports”, which is just
exports minus imports, X – M.
• If X>M, we say we are in a “trade surplus” and if
X<M, we say we are in a “trade deficit”.
• The trade deficit in Australia has grown large in
nominal terms in the last twenty years, but as a
percentage of GDP, it has stayed constant (or
even fallen).
• Later, we will explore what an Australian trade
deficit means.
Millions A$
0
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-4000
-9
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-12000
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-10000
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-24
% of GDP
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95
Australian trade deficit
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6
2000
3
0
-2000
-3
Nominal exchange rates
• When we talk of “exchange rates”, we have to be
cautious, as there are many types of “exchange rates”
that are used.
• The “nominal exchange rate” is the rate at which the
Australian dollar (A$) trades for other currencies- the
“price of the Australian dollar”.
• Example: If the Australian dollar trades for $0.80, we
mean that A$1 is worth US$0.80.
• Note that there will be as many nominal exchange rates
as there are other currencies.
• For Australia, the reference currencies are usually US$
and the Japanese Yen.
Price of the A$
1.60
US$ per A$
1.40
US$/A$
1.20
1.00
0.80
0.60
0.40
1960
1965
1970
1975
1980
1985
1990
1995
2000
Appreciation and depreciation
• When we talk of an “appreciation of the A$”, we
mean that the price of the A$ in terms of another
currency has increased, so the A$ was
appreciating in 1973.
• When we talk of a “depreciation of the A$”, we
mean that the price of the A$ in terms of
another currency has decreased, so the A$ has
generally depreciated against the US$ since the
mid 1970s.
• But these are nominal terms, and don’t signify
much in reality.
Real exchange rate
• We would like to have an exchange rate that got
rid of the effects of prices and concentrated on
“real” effects, just as we do with real GDP.
• We would like instead to talk simply in terms of
how Australian goods trade for American goods.
• Example: Harry Potter and the Half-Blood Prince
sells for US$17.99 at www.amazon.com, while at
www.dymocks.com.au it sells for A$29.95.
• What is the real exchange rate between Potter in
Australia and Potter in the US?
Real exchange rate
• We need to translate the prices into a common
currency, so we will use the Australian $. The
nominal exchange rate, E, is US$0.78/$A1.
• One US Potter goes for US$17.99, which is
US$17.99/E
US$17.99/(US$0.78/A$1) = A$23.06
• The real exchange rate is
A$29.95/A$23.06 = 1.30.
• But let’s say we want a real exchange rate for
the whole economy, not just for copies of Potter.
• We use the general
price levels (or GDP
deflators) in the two
countries. Let P be
the Australian price
level, and P* be the
US price level.
• Real exchange rate
e = P / (P*/E)
e = EP/P*
Australian goods in terms of US goods
Real exchange rate
1.60
Nominal
exchange rate,
1.40
1.20
1.00
0.80
0.60
Real exchange
rate, e
0.40
1960
1965
1970
1975
1980
1985
1990
1995
2000
Real exchange rate
• The real exchange rate then expresses how
average prices are moving in Australia with
respect to other countries, such as the US.
• The nominal exchange rate of the A$, E, fell
against the US$, but the real exchange rate did
not fall as much. Why?
• Answer: Average inflation in Australia was higher
than in the US, so P grew faster than P*
balancing out the drop in E.
Multilateral exchange rates
• The higher is e, the cheaper US goods are
compared to Australian goods.
• So far we have been considering only exchange
rates between Australia and the US, but
Australia trades with many countries. What if
the A$ falls against the US$, but rises against
the Japanese Yen?
• Multilateral exchange rates show the price of the
A$ compared to a weighted average of the
currencies of our trading partners, where the
weight of a currency depends on the percentage
of our trade it composes.
What determines E?
• The nominal exchange rate (say US$/A$) is
determined in a market for A$, where you have
both supply and demand for A$. E is the price in
this market.
• Who demands A$?
– Exporters who buy Australian goods to sell overseas.
– Foreign investors who buy Australian assets.
• Who supplies A$?
– Importers who want to buy overseas goods.
– Australian investors who buy foreign assets.
Market for A$
Exchange rate
(cost of 1 A$ in
terms of US$)
Supply of A$
•Domestic investors
•Importers
Demand for A$
•Foreign investors
•Exporters
Amount of A$
Market for A$
• The nominal exchange rate is then affected both
by changes in the goods market and also the
financial markets.
• But the volume of A$ traded on the world
financial markets was A$75 billion per day in
2001, while the volume of goods trade was
A$0.7 per day in 2001. Goods trade was only
1% of financial trading in the A$.
• In the short-term, the price of the A$ is
determined by changes in financial markets.
Financial market openness
• Openness in financial markets means that
investors are free to put their money where they
wish.
• Australian investors are free to invest overseas,
and foreign investors are free to invest in
Australia.
• In this case, investors will put their money where
they think it will earn the highest returns.
• In equilibrium that means that expected asset
returns must be the same in Australia as
overseas.
Domestic and foreign assets
• Return on A$1 invested in Australia for a year:
1+ it
• Return on A$1 invested in the US:
A$1 becomes US$Et
US$Et becomes US$(1+ it*)Et
US$(1+ it*)Et becomes US$(1+ it*)Et / Et+1e
• As you have to buy a US asset, earn the US
interest rate, i*, and then turn the US$ back into
A$ in a year.
Interest parity
• For returns on the two assets to be the same,
we will have:
1+ it = US$(1+ it*) Et / Et+1e
• Manipulating this and taking logs, it becomes the
condition:
it = it* - [(Et+1e - Et)/ Et]
• The domestic interest rate must be equal to the
foreign interest rate less the expected rate of
appreciation.
• Or it - it* = Expected appreciation of A$.
Interest parity
16.0
14.0
Australian interest rate
12.0
Per cent
• Another way of thinking
about this is to remember
that you earn money on
foreign assets either
because of foreign
interest rates or because
of exchange rate
movements.
• If I expect my currency to
depreciate, I will need a
high interest rate to keep
my money in the country.
10.0
8.0
6.0
U.S. interest rate
4.0
2.0
1971
1976
1981
1986
1991
1996
2001
Imports and exports
• We assume that Australian consumers will
consume more imports as their income rises and
as imports become cheaper (e rises):
IM = IM(Y, e)
(+ , +)
• We assume that foreign consumers will
consume more Australian exports as foreign
income rises and as exports become cheaper (e
falls):
X = X(Y*, e)
(+, -)
The new IS equation
• Exports are measured in Australian goods, but
imports are foreign goods, so we have to
translate into Australian good through the real
exchange rate, e, so net exports are:
NX = X(Y*, e) – IM(Y, e)/e
• This becomes a component of our AD, so
equilibrium in the goods market requires:
Y = C(Y-T) + I(Y, r) + G + NX
Y = C(Y-T) + I(Y, r) + G + X(Y*, e) – IM(Y, e)/e
The new IS equation
• We have a new IS curve which depends on Y
and r, and has G, T, Y* and e as parameters.
• An increase in Y* will shift the IS curve to the
right, as export demand rises, but what happens
when e rises?
• When e rises, perhaps because E rises, X falls
and IM rises, as Australian goods are now more
expensive. But what happens to IM/e- the value
of imports? It is ambiguous.
• Marshall-Lerner condition: A rise in e will lead to
a drop in NX.
The J curve
• Typically prices move much faster than
goods supply and demand- ie. firms order
goods in advance.
• In this case, X and IM will not move when
e falls. But that means that NX will initially
fall if e falls, even if the Marshall-Lerner
condition is satisfied. Eventually however
the X and IM will react and NX will rise.
• We saw this in the early 80s in Australia.
Real exchange rate (1995=100)
140
Real exchange
rate (scale at
left)
130
4
Trade deficit/GDP
(scale at right)
3
120
2
110
1
100
0
90
-1
1980
1985
1990
1995
2000
Ratio of trade deficit to GDP (percent)
Paul Keating’s J curve