Openness in goods and financial markets Chapter 18
Illustration: exchange between the US and Ethiopia See videos: Black Gold and Life and Debt US goods market Electronics exports (+); coffee imports from Ethiopia (-) Coffee exports (+); electronics imports from the US (-) Ethiopia goods market US financial market Loans to Ethiopia (-); purchase of US assets by Ethiopians (+) Borrowing from US (+); purchase of US assets (-) Ethiopia financial market Good: electronics, etc. Currency: dollar Good: coffee, etc. Currency: Birr 2 of 40
Openness in Goods and Financial Markets Openness has three distinct dimensions: 1. Openness in goods markets. Trade restrictions include tariffs and quotas. 2. Openness in financial markets. Capital controls place restrictions on the ownership of foreign assets (e.g., foreign currency-denominated bank accounts; private borrowing in foreign currency; purchase of foreign assets; etc.) 3. Openness in factor markets = The ability of firms to choose where to locate production, and of workers to choose where to work. The North American Free Trade Agreement (NAFTA) is an example of this.
18-1 Openness in Goods Markets Exports and Imports Figure 18-1 U.S. Exports and Imports as Ratios of GDP since 1960 Since 1960, exports and imports have more than doubled in relation to GDP.
Exports and Imports Table 18-1 Ratios of Exports to GDP for Selected OECD Countries, 2006 Country Export Ratio (%) Country Export Ratio (%) United States 11 Switzerland 54 Japan 18 Austria 62 United Kingdom 30 Netherlands 80 Germany 48 Belgium 92 The main factors behind differences in export ratios are: geography, especially distance from other markets, and country size (GDP)
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. Nominal Exchange Rates: Nominal exchange rates between two currencies can be quoted in one of two ways: As the price of the domestic currency in terms of the foreign currency. As the price of the foreign currency in terms of the domestic currency.
Nominal Exchange Rates The nominal exchange rate is the price of the foreign currency in terms of the domestic currency. An appreciation of the domestic currency is an increase in the value of the domestic currency in terms of the foreign currency. A depreciation of the domestic currency is a decrease in the value of the domestic currency in terms of the foreign currency.
Nominal Exchange Rates Figure 18-2 The Nominal Exchange Rate between the Dollar and the Pound since 1970 There have been large swings in the nominal exchange rate between the two currencies, especially in the 1980s.
Nominal Exchange Rates The figure illustrates the following: A trend increase in the exchange rate: there was an appreciation of the dollar vis-á-vis the pound over the period. Large fluctuations in the exchange rate: there was a very large appreciation of the dollar in the first half of the 1980s, followed by a large depreciation later in the decade.
From Nominal to Real Exchange Rates Let s look at the real exchange rate between the United States and the UK. If the price of a Cadillac in the US is $30,000, and a dollar is worth 0.50 pounds, then the price of a Cadillac in pounds is $30,000 X 0.50 = 15,000. If the price of a Jaguar in the UK is 30,000, then the price of a Cadillac in terms of Jaguars would be 15,000/ 30,000 = 0.5 (one cadillac = 1/2 jaguar) In this example, the real exchange rate = 0.5; An increase in this rate means real appreciation of the dollar; a decrease in the rate means real depreciation of the dollar To generalize this example to all goods in the economy, we use a price index for the economy, or the GDP deflator.
From Nominal to Real Exchange Rates Figure 18-3 The Construction of the Real Exchange Rate E = nominal exchange rate; = real exchange rate 1. P = price of U.S. goods in dollars 2. P* = price of British goods in pounds EP * P Real exchange rate = nominal exchange rate multiplied by domestic price/foreign price In the example on the previous slide, the real exchange rate was 0.5
Movements in the Real Exchange Rates Like nominal exchange rates, real exchange rates move over time: An increase in the relative price of domestic goods in terms of foreign goods is called a real appreciation (you buy more units of foreign goods with one unit of US goods) A decrease in the relative price of domestic goods in terms of foreign goods is called a real depreciation (you buy less units of foreign goods with one unit of US goods)
From Nominal to Real Exchange Rates Figure 18-4 Real and Nominal Exchange Rates between the United States and the United Kingdom since 1970 Nominal and the real exchange rates have moved largely together since 1970.
Two things have happened since 1970. First, nominal exchange rate (E) has increased. The dollar has gone up in terms of pounds. Second, US relative price P/P* has decreased. The price level has increased less in the United States than in the UK. Appreciation of the US dollar against the UK pound.
8.2 Openness in Financial Markets The purchase and sale of foreign assets implies buying or selling foreign currency called foreign exchange. With openness in financial markets : Financial investors are able to diversify to hold both domestic and foreign assets and speculate on foreign interest rate movements. Countries are able to run trade surpluses and deficits. A country that buys more than it sells (has a current account deficit) must pay for the difference by borrowing from the rest of the world (meaning capital inflows exceeding capital outflows, so it has a capital account surplus).
The Balance of Payments The balance of payments summarizes a country s transactions with the rest of the world. Two components: A) Current account: trade in goods and services: exports (+), imports (-) Investment income received (+) and paid (-) Transfers received (+) and paid (-) B) Capital account US holdings of foreign assets (-) Foreign holdings of US assets (+) The current account balance and the capital account balance should be equal, but because of errors in data gathering, they are rarely perfectly equal. For this reason, the account shows a statistical discrepancy, called Net Errors and Omissions
The Balance of Payments Table 18-3 The U.S. Balance of Payments, 2006 (in billions of U.S. dollars) Current Account Exports 1,436 Imports 2,200 Trade balance (deficit = ) (1) -763 Investment income received 620 Investment income paid 629 Net investment income (2) -9 Net transfers received (3) -84 Current account balance (deficit = -) (1) + (2) + (3) -856 Capital Account Increase in foreign holdings of U.S. assets (4) 1,764 Increase in U.S. holdings of foreign assets (5) 1,049 Capital account balance (deficit = -) (4) (5) 715 Statistical discrepancy 141
The Choice between Domestic and Foreign Assets Investing in the US vs. UK 2012 (today) 2013 (tomorrow) Exchange rate dollar/pound 1.30 1.10 (=16% depreciation rate of the pound) US interest rate 0.05 UK interest rate 0.08 US Capital investment $100 UK capital investment equivalent Value of US investment in 2012 Value of UK investment in 2012 Dollar equivalent of UK investment in 2012 without change in exchange rate 100/1.30= 76.92 $100*(1+0.05)=$105 76.92*(1+0.08)= 83 83*1.30$/ =$108 (= an 8% return) Dollar equivalent of UK investment in 2012 with change in exchange rate 83*1.10$/ =$91 (= an 8% loss, which is equal to UK interest rate depreciation of pound)
The decision whether to invest abroad or at home depends not only on the interest rate differential, but also on your expectation of what will happen to the nominal exchange rate at maturity of the investment. Figure 18-6 Expected Returns from Holding One-Year U.S. Bonds or One-Year U.K. Bonds
If U.K. bonds and U.S. bonds are to be held simultaneously, they must have the same expected rate of return. So the following arbitrage relation must hold: 1 * (1 + i) ( E)( 1 + i ) t t t e E t 1 The uncovered interest parity relation, or interest parity condition is: E t 1 + 1 + i e E t 1 * ( i ) ( ) t t
A good approximation of the equation above is given by: i t i t * e E t 1 E t E t This relation says: Arbitrage implies that the domestic interest rate must be (approximately ) equal to the foreign interest rate minus the expected depreciation rate of the domestic currency. If e E t E 1 t (that is, no expected depreciation), then it i * t
So, should you hold U.K. bonds or U.S. bonds? It depends on whether you expect the pound to depreciate vis-á-vis the dollar over the coming year. In our earlier example where i=5% and i*=8%, if you expect the pound to depreciate by more than 3%, then investing in U.K. bonds is less attractive than investing in U.S. bonds. If you expect the pound to depreciate by less than 3%, or to appreciate, then U.K. bonds are more attractive than U.S. bonds.
Domestic and Foreign Interest Rates Figure 18-7 Three-Month Nominal Interest Rates in the United States and in the United Kingdom since 1970 U.S. and U.K. nominal interest rates have largely moved together over the past 38 years.
Summary: Agents choices in an open economy: 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, foreign interest rates, and on the expected depreciation/appreciation of the domestic currency.
The twin deficits There is a close relationship between the budget deficit and the current account deficit; In an open-economy, when a country s budget deficit rises, the current account deficit is also likely to rise, hence the term twin deficits. How does it work?
Budget deficit and trade balance Budget deficit and current account deficit Government expenditure increases US Budget deficit rises US interest rate rises The dollar appreciates US exports become more expensive; imports become cheaper; US assets become more attractive US Current Account deficit rises Imports increase Trade deficit But there are limits: when the budget deficit is too high, this raises the risk of default, discouraging foreigners interest in US assets and reducing the value of the US dollar 26 of 40