Openness in goods and financial markets II. Balance of payments. Uncovered interest rate parity. Goods market equilibrium in the open economy.

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1 Openness in goods and financial markets II Balance of payments. Uncovered interest rate parity. Goods market equilibrium in the open economy.

2 Openness in financial markets: The purchase and sale of foreign assets implies buying or selling foreign currency. Financial market openness allows financial investors to diversify hold both domestic and foreign assets. Some degree of financial market openness is necessary if countries run trade surpluses and deficits: Deficits: consume now, pay later by borrowing from abroad.

3 Balance of payments The balance of payments account summarizes a country s transactions with the rest of the world. Transactions above the line are current account transactions. Transactions below the line are capital account transactions. Net capital flows (the capital account surplus) should equal the current account deficit. i.e. running a current account deficit increases our net indebtedness net capital flows are positive. Data gathering errors create statistical discrepancy.

4 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 Net investment income (2) 14 Net transfers received (3) Current account balance (1) + (2) + (3) 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) Statistical discrepancy

5 Domestic vs foreign bonds: Investor should decide between holding foreign and domestic bonds based on expected rates of return. Example: Spend $1 on U.S. bond and get (1+i(t)) gross nominal return next year. Spend $1 to buy 1/E(t) British bonds and get (1+ i*(t))/e(t) pounds in return next year where i*(t) denotes the nominal interest rate paid on British bonds. If the expected exchange rate at t+1 is E e (t+1) then the dollar denominated nominal return on British bonds is (1+i t *)(E e (t+1)/e(t)).

6 Uncovered interest parity Arbitrage in financial markets implies that riskadjusted expected rates of return between domestic and foreign bonds are equalized. This implies the uncovered interest parity condition: 1 + i(t) = (1+ i*(t))e e (t+1)/e(t) We can approximate this as: i(t) = i*(t) + (E e (t+1)-e(t)) /E(t)

7 Implications of uncovered interest parity. Arbitrage implies that the domestic interest rate equals foreign interest rate plus the expected depreciation rate of the domestic currency. If U.S. interest rates are lower (higher) than European rates, dollar is expected to appreciate (depreciate) relative to Euro. Ex: i=1% and i*=2% then domestic currency expected to appreciate 1%.

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9 Goods market in open economy: Demand for domestically produced goods: Z = C(Y-T) + I(Y,r) + G - e IM +X IM denotes the quantity of imports. e is the real exchange rate. e IM is the value of imports in terms of domestic goods. Assume that domestic demand for domestic goods (DD) is independent of exchange rate: DD = C(Y-T) + I(Y,r) + G

10 Import and export demand Domestic demand for foreign goods (imports) depends positively on domestic income and positively on the real exchange rate: IM = IM(Y,e) + + Foreign demand for domestic goods (exports) depends positively on foreign income and negatively on the exchange rate: X = X(Y*,e) + -

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13 Goods market equilibrium Goods market is in equilibrium when demand for domestic goods equals domestic output: Y = C(Y-T) + I(Y,r) + G - e IM(Y,e) + X(Y *,e) At equilibrium Y, we can have either a trade surplus or deficit. Given exchange rates, as output increases, the trade balance deteriorates Import demand is an increasing function of domestic output.

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15 Increase in domestic demand: Suppose govt. spending increases. Output increases. Trade balance deteriorates. Increase in domestic output is smaller than in closed economy case. Intuition: Income-expenditure multiplier is smaller in the openeconomy Part of induced demand satisfied through demand for foreign goods. The rise in demand for foreign goods does not generate further increases in domestic income to produce further rounds of spending.

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17 Increase in foreign demand An increase in foreign income increases demand for U.S. exports. U.S. output increases. Trade balance improves: Import demand increases but not by enough to offset rise in export demand.

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19 Summary: Domestic spending raises output but reduces trade balance. Foreign spending raises output and increases trade balance. Govts dislike trade deficits and prefer to stimulate demand through exports rather than increases in domestic spending if possible.

20 Games that countries play: Coordination issues: In a world-wide recession, a country may wait for other countries to adopt expansionary policies that stimulate demand through exports. If everyone waits, the recession lasts longer. Implication: there may be benefits to coordinating macroeconomic policy across countries.