CHAPTER CHAPTER18. Openness in Goods. and Financial Markets. Openness in Goods, and Financial Markets. Openness in Goods,

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1 Openness in Goods and Financial Markes CHAPTER CHAPTER18 Openness in Goods, and Openness has hree disinc dimensions: 1. Openness in goods markes. Free rade resricions include ariffs and quoas. 2. Openness in financial markes. Capial conrols place resricions on he ownership of foreign asses. 3. Openness in facor markes. The abiliy of firms o choose where o locae producion, and workers o choose where o work. The Norh American Free Trade Agreemen (NAFTA) is an example of his. 2of Openness in Goods, and Figure 18-1 U.S. Expors and Impors as Raios of GDP since 1960 Expors and impors, which were equal o 5% of GDP in he 1960s, are now equal o abou 12% of GDP. 3of 40 1

2 Expors and Impors The behavior of expors and impors in he Unied Saes is characerized by: The U.S. economy is becoming more open over ime, and rades more han wice as much (relaive o is GDP) wih he res of he world as i did jus 40 years ago. Alhough impors and expors have followed broadly he same upward rend, hey have also diverged for long periods of ime, generaing susained rade surpluses and rade deficis. 4of 40 Expors and Impors A good index of openness is he proporion of aggregae oupu composed of radable goods or goods ha compee wih foreign goods in eiher domesic markes or foreign markes. Esimaes are ha radable goods represen around 60% of aggregae oupu in he Unied Saes oday. Can Expors Exceed GDP? The key o he answer is o realize ha expors and impors may include expors and impors of inermediae goods. 5of 40 Expors and Impors Table 18-1 Counry Unied Saes Japan Germany Unied Kingdom Raios of Expors o GDP for Seleced OECD Counries, 2003 Expor Raio (%) Counry Expor Raio (%) Swizerland Ausria Neherlands Belgium The main facors behind differences in expor raios are geography and counry size. Counries can have expor raios larger han he value of heir GDP because expors and impors may include expors and impors of inermediae goods of 40 2

3 The Choice Beween Domesic Goods and Foreign Goods When goods markes are open, domesic consumers mus decide no only how much o consume and save, bu also wheher o buy domesic goods or o buy foreign goods. Cenral o he second decision is he price of domesic goods relaive o foreign goods, or he real exchange rae. 7of 40 Nominal Exchange Raes Nominal exchange raes beween wo currencies can be quoed in one of wo ways: As he price of he domesic currency in erms of he foreign currency. As he price of he foreign currency in erms of he domesic currency. 8of 40 Nominal Exchange Raes The nominal exchange rae is he price of he foreign currency in erms of he domesic currency. An appreciaion of he domesic currency is an increase in he price of he domesic currency in erms of he foreign currency, which corresponds o a increase in he exchange rae. A depreciaion of he domesic currency is a decrease in he price of he domesic currency in erms of he foreign currency, or a decrease in he exchange rae. 9of 40 3

4 Nominal Exchange Raes When counries operae under fixed exchange raes, ha is, mainain a consan exchange rae beween hem, wo oher erms used are: Revaluaions, raher han appreciaions, which are decreases in he exchange rae, and Devaluaions, raher han depreciaions, which are increases in he exchange rae. 10 of 40 Nominal Exchange Raes Figure 18-2 The Nominal Exchange Rae Beween he Dollar and he Pound since 1970 Alhough he dollar has srongly appreciaed vis-ávis he pound over he pas 33 years, his appreciaion has come wih large swings in he nominal exchange rae beween he wo counries, especially in he 1980s. 11 of 40 Nominal Exchange Raes Noe he wo main characerisics of he figure: The rend increase in he exchange rae. Pu anoher way, here was an appreciaion of he dollar vis- á- vis he pound over he period. The large flucuaions in he exchange rae. Pu anoher way, here was a very large appreciaion of he dollar in he firs half of he 1980s, followed by a large depreciaion laer in he decade. 12 of 40 4

5 From Nominal o Real Exchange Raes Le s look a he real exchange rae beween he Unied Saes and he UK. If he price of a Cadillac in he US is $40,000, and a dollar is worh 0.55 pounds, hen he price of a Cadillac in pounds is $40,000 X 0.55 = 22,000. If he price of a Jaguar in he UK is 30,000, hen he price of a Cadillac in erms of Jaguars would be 22,000/ 30,000 = To generalize his example o all of he goods in he economy, we use a price index for he economy, or he GDP deflaor. 13 of 40 From Nominal o Real Exchange Raes Figure 18-3 The Consrucion of he Real Exchange Rae The real exchange rae equals he nominal exchange rae imes he foreign price level, divided by he domesic price level. ε EP P * P = price of U.S. goods in dollars P* = price of Briish goods in pounds 14 of 40 From Nominal o Real Exchange Raes Like nominal exchange raes, real exchange raes move over ime: An increase in he relaive price of domesic goods in erms of foreign goods is called a real appreciaion, which corresponds o a decrease in he real exchange rae, ε. A decrease in he relaive price of domesic goods in erms of foreign goods is called a real depreciaion, which corresponds o an increase in he real exchange rae, ε. 15 of 40 5

6 From Nominal o Real Exchange Raes Figure 18-4 Real and Nominal Exchange Raes Beween he Unied Saes and he Unied Kingdom since 1970 Excep for he difference in rend reflecing higher average inflaion in he Unied Kingdom han in he Unied Saes, he nominal and he real exchange raes have moved largely ogeher since of 40 From Nominal o Real Exchange Raes Noe he wo main characerisics of Figure 18-4 While he nominal exchange rae wen up during he period, he real exchange rae wen down. The large flucuaions in he nominal exchange rae also show up in he real exchange rae. 17 of 40 From Nominal o Real Exchange Raes Two hings have happened since Firs, E has increased. The dollar has gone up in erms of pounds. Second, P/P* has decreased. The price level has increased less in he Unied Saes han in he UK. 18 of 40 6

7 From Bilaeral o Mulilaeral Exchange Raes Table 18-2 The Counry Composiion of U.S. Merchandise Trade, 2003 Canada Mexico Wesern Europe China Japan Res of Asia* Ohers Proporion of Expors o (%) * Asia, excluding Japan and China OPEC: Organizaion of Peroleum Exporing Counries. 13 Proporion of Impors from (%) This able shows he geographic composiion of U.S. rade for boh expors and impors. The numbers refer only o merchandise rade expors and impors of goods of 40 From Bilaeral o Mulilaeral Exchange Raes Bilaeral exchange raes are exchange raes beween wo counries. Mulilaeral exchange raes are exchange raes beween several counries. For example, o measure he average price of U.S. goods relaive o he average price of goods of U.S. rading parners, we use he U.S. share of impor and expor rade wih each counry as he weigh for ha counry, or he mulilaeral real U.S. exchange rae. 20 of 40 From Bilaeral o Mulilaeral Exchange Raes Equivalen names for he relaive price of foreign goods vis á vis U.S. goods are: The real mulilaeral U.S. exchange rae. The U.S. rade- weighed real exchange rae. The U.S. effecive real exchange rae. 21 of 40 7

8 From Nominal o Real Exchange Raes Figure 18-5 The U.S. Mulilaeral Real Exchange Rae since 1973 The large real appreciaion of U.S. goods in he firs half of he 1980s was followed by a large real depreciaion in he second half of he 1980s. This large swing in he 1980s is someimes called he dance of he dollar. 22 of Openness in The purchase and sale of foreign asses implies buying or selling foreign currency someimes called foreign exchange. Openness in financial markes allows: Financial invesors o diversify o hold boh domesic and foreign asses and speculae on foreign ineres rae movemens. Allows counries o run rade surpluses and deficis. A counry ha buys more han i sells mus pay for he difference by borrowing from he res of he world. 23 of 40 The Balance of Paymens The balance of paymens accoun summarizes a counry s ransacions wih he res of he world. Transacions above he line are curren accoun ransacions. Transacions below he line are capial accoun ransacions. The curren accoun balance and he capial accoun balance should be equal, bu because of daa gahering errors hey don. For his reason, he accoun shows a saisical discrepancy. 24 of 40 8

9 The Balance of Paymens Table 18-2 The U.S. Balance of Paymens, 2003, in Billions of U.S. Dollars Curren Accoun Expors 1,018 Impors 1,508 Trade balance (defici = ) (1) -490 Invesmen income received 275 Invesmen income paid 258 Ne invesmen income (2) 17 Ne ransfers received (3) -68 Curren accoun balance (defici = -) (1) + (2) + (3) -541 Capial Accoun Increase in foreign holdings of U.S. asses (4) 856 Increase in U.S. holdings of foreign asses (5) 277 Capial accoun balance (defici = -) (4) (5) Saisical discrepancy of 40 The Curren Accoun The ransacions above he line record paymens o and from he res of he world are called curren accoun ransacions: The firs wo lines record he expors and impors of goods and services. U.S. residens receive invesmen income on heir holdings of foreign asses and vice versa. Counries give and receive foreign aid; he ne value is recorded as ne ransfers received. 26 of 40 The Curren Accoun The sum of ne paymens in he curren accoun balance can be posiive, in which case he counry has a curren accoun surplus, or negaive a curren accoun defici. 27 of 40 9

10 The Capial Accoun Transacions below he line are called capial accoun ransacions. The capial accoun balance, also known as ne capial flows can be posiive (negaive) if foreign holdings of U.S. asses are greaer (less) han U.S. holdings of foreign asses, in which case here is a capial accoun surplus (defici). The numbers for curren and capial accoun ransacions are consruced using differen sources; alhough hey should give he same answers, hey ypically do no. The difference beween he wo is call he saisical discrepancy. 28 of 40 The Choice Beween Domesic and Foreign Asses The decision wheher o inves abroad or a home depends no only on ineres rae differences, bu also on your expecaion of wha will happen o he nominal exchange rae. 29 of 40 The Choice Beween Domesic and Foreign Asses Figure 18-6 Expeced Reurns from Holding 1-Year U.S. Bonds or 1-Year U.K. Bonds 30 of 40 10

11 Expecaions, Consumpion, and Invesmen Decisions If boh U.K. bonds and U.S. bonds are o be held, hey mus have he same expeced rae of reurn, so ha he following arbirage relaion mus hold: * 1 ( 1+ i ) = ( E )( 1+ i ) E e + 1 Rearranging he equaion, we obain he uncovered ineres pariy relaion, or ineres pariy condiion: * E ( 1+ i ) = ( 1+ i ) E e of 40 Expecaions, Consumpion, and Invesmen Decisions The assumpion ha financial invesors will hold only he bonds wih he highes expeced rae of reurn is obviously oo srong, for wo reasons: I ignores ransacion coss. I ignores risk. 32 of 40 GDP Versus GNP: The Example of Kuwai Gross domesic produc (GDP) is he measure ha corresponds o value added domesically. Gross naional produc (GNP) corresponds o he value added by domesically owned facors of producion. Table 1 GDP, GNP, and Ne Facor Paymens in Kuwai, Year GDP GNP Ne Facor Paymens ,143 9,616 2, ,328 7,560 2, ,131 4,669 1, ,826 7,364 1, ,231 8,386 1, ,380 8, All numbers are in millions of Kuwaii dinars, wih 1 dinar=$3.3 ( of 40 11

12 Ineres Raes and Exchange Raes The relaion beween he domesic nominal ineres rae, he foreign nominal ineres rae, and he expeced rae of depreciaion of he domesic currency is saed as: * ( 1+ i ) ( 1+ i ) = e [ + ( E E )/ E )] A good approximaion of he equaion above is given by: E + E i i E e * 1 34 of 40 Ineres Raes and Exchange Raes e E E * + 1 i i E This is he relaion you mus remember: Arbirage implies ha he domesic ineres rae mus be (approximaely ) equal o he foreign ineres rae plus he expeced depreciaion rae of he domesic currency. e If E + 1 = E, hen i = i * Buying Brazilian Bonds Shouldn you be buying Brazilian bonds wih an ineres rae of 36.9%? 35 of 40 Ineres Raes and Exchange Raes Should you hold U.K. bonds or U.S. bonds? I depends wheher you expec he pound o depreciae vis- á-vis he dollar over he coming year. If you expec he pound o depreciae by more hen 3.0%, hen invesing in U.K. bonds is less aracive han invesing in U.S. bonds. If you expec he pound o depreciae by less han 3.0% or even o appreciae, hen he reverse holds, and U.K. bonds are more aracive han U.K. bonds. 36 of 40 12

13 Ineres Raes and Exchange Raes Figure 18-7 Three-Monh Nominal Ineres Raes in he Unied Saes and in he Unied Kingdom since 1970 U.S. and U.K. nominal ineres raes have largely moved ogeher over he las 33 years. 37 of Conclusions and a Look Ahead We have se he sage for he sudy of an open economy: The choice beween domesic goods and foreign goods depends primarily on he real exchange rae. The choice beween domesic asses and foreign asses depends primarily on heir relaive raes of reurn, which depend on domesic ineres raes and foreign ineres raes, and on he expeced depreciaion of he domesic currency. 38 of 40 Key Terms openness in goods markes, ariffs quoas openness in financial markes capial conrols openness in facor markes Norh American Free Trade Agreemen (NAFTA) radable goods real exchange rae nominal exchange rae appreciaion (nominal, real) depreciaion (nominal, real) fixed exchange raes revaluaion devaluaion real appreciaion real depreciaion merchandise rade bilaeral exchange rae mulilaeral exchange rae mulilaeral real U.S. exchange rae rade-weighed real exchange rae coninued 39 of 40 13

14 Key Terms effecive real exchange rae foreign exchange balance of paymens above he line, below he line curren accoun invesmen income ne ransfers received curren accoun balance curren accoun surplus curren accoun defici capial accoun ne capial flows capial accoun balance capial accoun surplus, defici saisical discrepancy gross domesic produc (GDP) versus gross naional produc (GNP) uncovered ineres pariy relaion, or ineres pariy condiion, 40 of 40 14