Transcript Open Economy Macroeconomics

FIN 30220: Macroeconomic
Analysis
Open Economy Macroeconomics
Open economy macroeconomics looks at the interactions between the US
and the rest of the world
Exports
Imports
2005
Exports = $1,740,894M
Imports = $2,545,843M
Net Exports = - $804,949
The current account keeps
track of the flow of goods
and services in and out of
the US
2005 US Current Account (in Millions)
Merchandise
Services
Income
Unilateral Transfers
Total
Exports
$892,619
$379,603
Imports
Net
$1,674,261 - $781,642
$321,577
$58,026
$468,672
$467,111
$1,561
$82,894
- $82,894
$1,740,894 $2,545,843 - $804,949
In 2005, the deficit in merchandise increased by 17% as imports grew
faster than exports
The surplus in services increased by 21% in 2005 as receipts grew
faster than payments
The surplus in income decreased by 94% as payments increased
faster than receipts
What’s the meaning of a trade deficit? To answer this,
lets look back at the national accounting identities…
Y = C + I + G + NX
A trade deficit
signifies that we as a
country are spending
beyond our current
income
Solving for Net Exports, we get
NX = Y – (C + I + G)
Aggregate Expenditures
National Income
Alternatively,
S = I + (G-T) + CA
A deficit signifies that we are borrowing
more than we are saving
National Savings
CA = S – [I + (G-T)]
Aggregate
Borrowing
A trade deficit implies that the US is borrowing from the rest of the world
(currently, we are borrowing at the rate of $2B per day). A equivalent
statement is that the rest of the world is acquiring US assets
Suppose that, while on vacation in France, you buy a
case of French wine for $1,000. You pay for the wine
with cash
The French wine maker uses the $1,000 to buy a computer from Dell –
Net exports equals zero (no change in asset holdings).
The French wine maker uses the $1,000 to buy a US Treasury – Net
exports are negative (Increase in French holdings of US assets).
The French wine maker uses the $1,000 to buy stock in a French
company from an American– Net exports are negative (Decrease in
US holdings of French assets).
Changes in Assets are recorded in the Capital and Financial Account
2005 US Capital & Financial Account (in Millions)
(1) Capital Account Transactions
- $5,647
(2) Change in US owned Assets Abroad
- $491,731
US Official Reserve Assets
$14,096
US Government Assets
$7,580
US Private Assets
- $513,407
Foreign Direct Investment
- $21,483
Securities
- $491,924
(3) Change in Foreign Ownership of US Assets
$1,292,697
Foreign Official Assets
$220,676
Private Foreign Assets
$1,072,021
Foreign Direct Investment
$128,632
Currency
$19,416
Securities
$923,973
Total (1) + (2) + (3)
$795,319
Current Account
Merchandise
Capital & Financial Account
Change in US owned Assets Abroad
Services
US Official Reserve Assets
Income
US Government Assets
Unilateral Transfers
US Private Assets
Foreign Direct Investment
Note that every credit (+)
has to be matched with a
debit (-).
Securities
Change in Foreign Ownership of US Assets
Foreign Official Assets
Remember this: any
transaction that involves
money flowing into the
US is a (+)
Private Foreign Assets
Foreign Direct Investment
Currency
Securities
Current Account
Merchandise
- $20M
Capital & Financial Account
Change in US owned Assets Abroad
Services
US Official Reserve Assets
Income
US Government Assets
Unilateral Transfers
US Private Assets
Foreign Direct Investment
Example #1
Suppose that Wall Mart buys
$20M worth or goods from a
Chinese supplier. The
Chinese company uses the
$20M to buy stock in IBM.
Securities
Change in Foreign Ownership of US Assets
Foreign Official Assets
Private Foreign Assets
Foreign Direct Investment
Currency
Securities
$20M
Current Account
Merchandise
Capital & Financial Account
$40B
Services
Income
Change in US owned Assets Abroad
US Official Reserve Assets
$30B
Unilateral Transfers - $80B
US Government Assets
US Private Assets
Foreign Direct Investment
Example #2
Suppose that the US spends
$80B on a foreign aid
package to Iraq. The Iraqi
government uses $40B to
buy computers from Dell,
$30B goes to pay employees
of Haliburton, and $10B is
deposited in a US bank.
Securities
Change in Foreign Ownership of US Assets
Foreign Official Assets
Private Foreign Assets
Foreign Direct Investment
Currency
Securities
$10B
Current Account
Merchandise
Capital & Financial Account
$20B
Change in US owned Assets Abroad
Services
US Official Reserve Assets
Income
US Government Assets
Unilateral Transfers
US Private Assets
Foreign Direct Investment - $50B
Example #3
Suppose that Nike spends
$50M on a production facility
in Korea - $20M is used to
buy equipment from US
suppliers, $30M is used
elsewhere.
Securities
Change in Foreign Ownership of US Assets
Foreign Official Assets
Private Foreign Assets
Foreign Direct Investment
Currency
Securities
$30B
As the US trade (current account) deficit worsens, it is matched by an
equally large capital account surplus – that is, capital is flowing into
the US as foreigners acquire our assets. By definition, the Balance of
Payments (KFA + CA) should equal zero.
250
200
150
100
50
0
Jan-80
-50
Jan-88
Jan-96
-100
-150
-200
Current Account
FKA
With trading centers in New York City, London, Tokyo and Sydney, currency
markets operate 24 hours a day, 5 days a week.
Eastern Time
12
AM
3
AM
8
AM
12
PM
5
PM
9
PM
Australia: 5PM - 2AM
8PM - 5AM
30000
Tokyo
London: 3AM -11AM
New York City: 8AM -5PM
Transactions/Hour
25000
20000
15000
10000
5000
0
12:00AM
4:00AM
8:00AM
12:00AM
4:00PM
8:00PM
11
PM
The foreign exchange market is unique not just because of its geographic
dispersion, but also because of its extreme liquidity and tremendous
volume – around $1.9T PER DAY!!
Name
% of Volume
$600B in Spot market
Deutsche Bank
17
Transactions
UBS
12.5
$1.3T in Derivative Market
Citigroup
7.5
Transactions
HSBC
6.4
 $200B in Forwards
Barclays
5.9
 $1T in Swaps
Merrill Lynch
5.7

$100B in Options
JP Morgan Chase
5.3
Goldman Sachs
4.4
ABN Amro
4.2
Morgan Stanley
3.9
The ten most active traders account for 73% of the volume
USD/GBP
11%
USD/CHF
5%
USD/CAD
4%
USD/AUD
4%
USD/Other
17%
EUR/All
8%
USD/JPY
20%
USD/EUR
31%
US currency was involved in 89% of transactions, followed by the Euro
(37%), the yen (20%) and sterling (17%).
An exchange rate is generally defined as the domestic currency price of
a foreign currency, but be careful…
Most currencies are quoted two ways:
US Dollar Equivalent ($/-)
Currency per US Dollar (-/$)
The Euro is currently
trading at 1.601
The Euro is currently
trading at .6246
An increase in the US
dollar equivalent rate
signifies a
depreciation of the
dollar
An increase in the
currency per US dollar
rate signifies an
appreciation of the
dollar
The dollar has had quite a wild ride against the Euro since it began
circulating in 1999.
1.4000
Recession
Dollars per Euro
1.3000
1.2000
1.1000
1.0000
0.9000
0.8000
Jan-99
Jul-00
Jan-02
Jul-03
Jan-05
Suppose that a dealer were offering Euro at $1.22 in New York City
while a dealer in London was offering Euro at $1.24
1
Sell Euro short in London
3
Use your newly acquired
Euro to pay off your short
position
2
Use the proceeds to buy
Euro in New York
Arbitrage insures that currency prices will be the same at different
locations around the world. (Arbitrage will raise the price in NYC and
lower the price in London)
Suppose that a dealer in New York City was offering the following
prices:
Euro/USD = $1.25
USD/JPY = Y115
Euro/JPY = Y135
2
1
Use the
dollars to
buy Yen at
Y115
3
Sell Euro
short at $1.25
Use the Yen
to buy Euro
at Y135
Repay your short position
The USD/JPY, and Euro/JPY rates imply a Euro/USD rate
USD/JPY = Y115
Euro/JPY = Y135
Y135
Euro/USD =
Y115
= $1.17
Recall that in a closed economy, all borrowing had to be supplied by
domestic savings – the domestic interest rate will insure that this
happens.
At the equilibrium
interest rate
r
S
r
I  G  T 
I, S
I *  G  T   S *
In the global economy, interest rates are determined in an integrated global
capital market. The world interest rate equates world saving with world
borrowing.
At the world equilibrium
interest rate
At the equilibrium world interest
rate, the US is running a trade
deficit
r
I W  G  T   S W
W
r
S
SW
r
I  G  T 
I, S
CA
I W  G  T 
W
I W , SW
The extent to which a country can effect global interest rates depends on size.
The US controls 35% of the global economy.
An increase in world
investment demand has a
negligible impact on
world interest rates
The increase in domestic
investment demand increases
the domestic trade deficit
r
r
S
SW
r
I  G  T 
I, S
New Deficit
I W  G  T 
W
I W , SW
One method for valuing exchange rates is known as Purchasing Power
Parity. This simply states that the same good should cost the same
everywhere when its price is expressed in the same currency.
Suppose we have the following gold
prices in the US and England. The
current exchange rate is $1.15/L
P = $500/oz
P = L 400/oz
Given these prices, you could make money by shorting gold in the US,
converting your dollars to pounds, and then buying gold in England to
cover your short position.
The ‘PPP’ Exchange Rate should be
$500
= $1.25/L
L400
The PPP method values exchange rates by looking at price indices
across countries. For example, consider the US and England
PPP Exchange Rate
e=
USA
CPI = 199.8
(March 2006)
=
CPI (USA)
CPI (UK)
England
199.8
195.0
CPI = 195.0
(March 2006)
= $1.025/L
Currently, the British Pound is trading at $1.786
$1.786 – $1.025
$1.205
X 100 = 74%
Is the British pound really
overvalued by 74%?
The PPP method values exchange rates by looking at price indices
across countries. For example, consider the US and England
PPP Exchange Rate
e=
USA
CPI = 199.8
(March 2006)
=
CPI (USA)
CPI (UK)
England
199.8
195.0
CPI = 195.0
(March 2006)
= $1.025/L
Problems:
1.
The CPI in the US and Britain are different bundles of goods
2.
The CPI in the US and Britain are benchmarked by different
base years
A better method is to look at changes rather than levels
The PPP method values exchange rates by looking at price indices
across countries. For example, consider the US and England
%e     *
USA
Inflation = 3.4%
(12 months)
 3.4  2.4
 1%
The dollar should depreciate
by 1% against the pound
England
Inflation = 2.4%
(12 months)
12 months ago, the British pound was trading at $1.904
$1.904 ( 1.01) = $1.923
$1.786 – $1.923
$1.923
X 100 = -7.1%
Now, it looks like the British
pound is undervalued
The real exchange rate is the price level adjusted exchange rate. Its
meant to capture the relative value of goods and services across
countries
P
RER  e
 P
*



Foreign CPI
Nominal Exchange Rate
Domestic CPI
By definition, the PPP explanation of exchange rates assumes that
the real exchange rate is constant (and equal to one)
Empirically, real exchange rates are clearly not constant. In fact, the
correlation between real and nominal exchange rates is nearly one. This
casts some serious doubt on PPP.
300
250
200
150
100
50
Jan-85
Jan-89
Jan-93
Yen/$
Real
Jan-97
One difficulty with PPP is that it requires arbitrage of goods, which can be
costly (shipping costs, tariffs, taxes, etc). Arbitrage with assets is
relatively costless.
Suppose we have the following interest
rates in the US and England. The
current exchange rate is $1.25/L and the
brtish pound is expected to appreciate
by 10% to $1.375/L over the next year.
i = 6%
1
4
i = 4%
Short $1,000 in T-Bills
(You will owe $1,060
in one year)
Convert to dollars at
$1.375 (You will have
$1,144) and pay off loan
2
Buy Pounds at $1.25 (you will
get L800) and buy British
bonds
3
On maturity, your British
bonds pay L832 (4%)
Interest Rate Parity is an arbitrage condition for assets. It states that
assets with similar risk characteristics should produce the same common
currency yield.
Interest Parity
% e  i  i
 3.2  4.59
 1.39%
i = 3.20%
(March 2005)
*
The dollar should appreciate
by 1.39% against the pound
12 months ago, the British pound was trading at $1.904
$1.904 ( .986) = $1.877
$1.786 – $1.877
$1.877
X 100 = -4.8%
i = 4.59%
(March 2005)
Interest parity fails just as miserably as PPP does for predicting
exchange rate movements…actually, if you look closely, they are
actually the same condition.
% e  i  i *
Interest Parity Condition
The nominal interest rate equals the
real interest rate plus inflation

%e  r     r  
rr
*
%e     *
*
*

Integrated world capital markets insure that
the real return is equalized across countries
Purchasing Power Parity
So, if both interest parity and purchasing power parity
fail, then how are we supposed to predict movements
in exchange rates?
FIN 40500: International Finance
Coming soon to a theatre near you!!