Openness in Goods and Financial Markets Opening the Economy to International Transactions Two dimensions of openness: 1. Openness in Goods Markets 2. Openness in Financial Markets

Openness in Goods Markets

Openness in Goods Markets Observations of U.S. Exports and Imports Exports and imports in the U.S. were 5% of GDP in 1960, are 12% (11.2% exports, 13% imports) of GDP today. Decline in exports and imports from 1929-1936 due in large part to Smoot-Hawley Act of 1930. Large trade surpluses of the 1940s and large trade deficits of the 1980s.

Openness in Goods Markets Measuring the Degree of Openness Volume of Trade: Ratio of exports or imports to GDP (U.S. = 12%) Tradable Goods Ratio: Percent of output that competes in foreign markets (U.S. = 60%)

Openness in Goods Markets A Look Around the World Country Export Ratio (%) Country Export Ratio (%) United States 12 Switzerland 40 Japan 10 Austria 38 Germany 23 Belgium 73 United Kingdom 29 Luxembourg 91

Openness in Goods Markets What Do You Think... Can exports exceed GDP?

Openness in Goods Markets The Choice Between Domestic and Foreign Goods Real Exchange Rates: Price of foreign goods in terms of domestic goods Nominal Exchange Rates: The relative prices of currencies

Openness in Goods Markets The Choice Between Domestic and Foreign Goods Nominal Exchange Rates: Two Views 1. The price of domestic currency in terms of foreign currency. 2. The price of foreign currency in terms of domestic currency. For Example: November 2000: Nominal exchange between U.S. dollar and German Deutschemark (DM) $ in terms of DM: 1$ = 2.29 DM DM in terms of $s: 1DM = 0.44$

Openness in Goods Markets The Choice Between Domestic and Foreign Goods Nominal Exchange Rates--Choosing a Definition: Nominal exchange rates (E): price of foreign currency in terms of domestic currency For Example: E between the U.S. (domestic) and Germany (foreign) is the price of DM in terms of $ E = .44

Openness in Goods Markets The Choice Between Domestic and Foreign Goods Measuring Changes in the Nominal Exchange Rate (E) Appreciation of domestic currency corresponds to a decrease in E Depreciation of domestic currency corresponds to an increase in E

Openness in Goods Markets The Nominal Exchange Rate, Appreciation, and Depreciation: Germany and the United States* *From the point of view of the United States Nominal Exchange Rate, E (Price of DM in terms of dollars) Appreciation of the dollar Depreciation of the dollar Price of dollars in DM increases Price of dollars in DM decreases Equivalently: Equivalently: Price of DM in dollars decreases Price of DM in dollars increases Equivalently: Equivalently: Exchange rate decreases: E Exchange rate increases: E

Openness in Goods Markets The Nominal Exchange Rate between the DM and the Dollar 1978 - 1998

Openness in Goods Markets

Openness in Goods Markets

Openness in Goods Markets

Openness in Goods Markets The Choice Between Domestic and Foreign Goods Question: Does a decrease in E of U.S. $s for DMs necessarily mean U.S. citizens can buy more German goods with their dollars? Hint: What is the inflation rate in Germany?

Openness in Goods Markets The Choice Between Domestic and Foreign Goods Calculating Real Exchange Rates The price of one German good (Mercedes SL) in terms of one U.S. Good (Cadillac Seville) 1. Convert the price of the Mercedes from DM to $s PDM = 100,000 DM = .60$s P$s = 100,000 x .60 = $60,000 2. Compute the ratio of the $ price of the Mercedes to the Cadillac (Cadillac price = $40,000) Real exchange rate between U.S. & Germany =

Openness in Goods Markets The Choice Between Domestic and Foreign Goods Expanding the Real Exchange Rate Calculation to the Entire Economic System If: P = U.S. GDP Deflator P* = German GDP Deflator E = DM-dollar nominal exchange rate Then: Price of German goods in $s = EP* Real exchange rate () = EP* P NOTE: Real exchange rates () are index numbers and measure only relative change.

Openness in Goods Markets The Choice Between Domestic and Foreign Goods The Construction of the Real Exchange Rate Price of German goods in DM P* Price of German goods in dollars EP* Price of U.S. goods in dollars P Real exchange rate  = EP* P

Openness in Goods Markets The Choice Between Domestic and Foreign Goods Real and Nominal Exchange Rates Between Germany and the U.S., 1975-1998

Openness in Goods Markets The Choice Between Domestic and Foreign Goods The Country Composition of U.S. Merchandise Trade, 1998 Exports to Imports from Countries $ Billions Percent $ Billions Percent Canada 156 23 177 19 Western Europe 159 24 193 21 Japan 57 8 121 13 Mexico 78 12 95 11 Asia* 126 19 247 27 OPEC** 15 2 19 2 Others 80 11 67 7 Total 671 100 919 100 *Not including Japan. **OPEC: Organization of Petroleum Exporting Countries.

Openness in Goods Markets The Choice Between Domestic and Foreign Goods Real Multilateral Exchange Rates The real exchange rate when considering many countries Calculate by using each country’s share of trade as the weight for that country

Openness in Goods Markets The Choice Between Domestic and Foreign Goods The U.S. Effective Real Exchange Rate, 1975 - 1998

Openness in Financial Markets Foreign Exchange: Buying and selling foreign currency 1997 daily volume of foreign exchange equaled $2.5 trillion. 80% of the 1997 value involved dollars on one side of the exchange. Volume of foreign exchange transactions is 20 times greater than in 1980.

Openness in Financial Markets The Relation Between Trade and Financial Flows The U.S. Balance of Payments, 1998 Current Account Exports 931 Imports 1100 Trade balance (deficit = -) (1) -169 Investment income received 242 Investment income paid 265 Net investment income (2) -23 Net transfers received (3) -41 Current account balance (deficit = -) (1)+(2)+(3) -233 Capital Account Increase in foreign holdings of U.S. assets 542 Increase in U.S. holdings of foreign assets 305 Net increase in foreign holdings/net capital flow to the U.S. 237 Statistical discrepancy 4

Openness in Financial Markets The Balance of Payments The Current Account Balance (+,-) = Capital Account Balance (+,-) A Current Account Deficit increases foreign holdings of U.S. assets and vice versa.

Openness in Financial Markets The Choice Between Domestic and Foreign Assets An Example: Choose between U.S. and German 1 yr. bonds US Bonds it = U.S. nominal interest rate (1+it) = Return next year /$purchase of U.S. bonds

Openness in Financial Markets The Choice Between Domestic and Foreign Assets (Continued) An Example: Choose between U.S. and German 1 yr. bonds German Bonds Et = nominal exchange between the $ and DM (1/Et) DM = DM/$1 i*t = One year nominal interest rate on German Bonds (in DM) (1/Et)(1+i*t) = Return/DM invested

Openness in Financial Markets The Choice Between Domestic and Foreign Assets (Continued) An Example: Choose between U.S. and German 1 yr. bonds German Bonds Eet+1 = expected exchange rate next year (1/Et)(1+i*t)Eet+1 = return/$ invested Note: Interest rates and exchange rates influence the choice between domestic and foreign assets.

Openness in Financial Markets Example: $1000 to invest in the US or Germany igermany = 0.08 ius = .10 Et=.40 Et+1=.45 Where do you want to invest?

Openness in Financial Markets If you invest in the US: Amt Received = $1000 (1 +.10) = $1100 If you invest in Germany: Amt Received = ($1000)/.4 * (1+.08) * .45 = $1215 How would your answer change if the exchange rate was not expected to change?

Openness in Financial Markets The Choice Between Domestic and Foreign Assets If: Investors will hold only the asset with the highest rate of return. Then: To hold both U.S. and German bonds, they must have the same return. U.S. Bond Return German Bond Return = Or:

Openness in Financial Markets A little reorganizing: The Interest Parity Condition: Under these conditions, what is the interest parity rate of interest in the US: igermany = 0.08 Et=.40 Et+1=.45 1 + it = (1+.08)*.45/.40 it= .215

Openness in Financial Markets The Choice Between Domestic and Foreign Assets Is the assumption that investors hold only assets with the highest expected return realistic? Some other considerations: -- Transaction Costs -- Exchange Rate Risk Observation: The interest parity condition is a good approximation for developed countries with open, well-organized financial markets.

Openness in Financial Markets U.S. & German One-Year Nominal Interest Rates, 1975-1998

Openness in Markets Goods Openness allows choice between domestic goods and foreign goods. Which goods are chosen depends primarily on the exchange rate. Financial Assets Openness allows choice between domestic and foreign assets. Which assets are chosen depends primarily on: Relative rates of return Expected rate of depreciation of the domestic currency

IS-LM-FE Analysis IS is the locus of points r and y that yield equilibrium in the goods market Y = C + I + G + X - Q Y = C(Y) + I(i) +G0 + X0 - Q(Y,e) LM is the locus of points r and y that yield equilibrium in the money market M0 = Mdt + Mds M0 = Mdt(y) + Mds(i)

IS-LM-FE Analysis FE is the locus of points r and y that yield equilibrium in the balance of payments. BOP = BCA + BKA BOP = BCA (Y, e) + BKA (i) Now we need to put IS, LM and FE together.

IS-LM-FE Analysis IS and LM are fairly easy FE presents a problem Should FE be vertical? IS y

IS-LM-FE Analysis IS and LM are fairly easy FE presents a problem Should FE be vertical steeper than LM r FE LM IS y

IS-LM-FE Analysis IS and LM are fairly easy FE presents a problem Should FE be vertical steeper than LM flatter than LM r LM FE IS y

IS-LM-FE Analysis IS and LM are fairly easy FE presents a problem Should FE be vertical steeper than LM flatter than LM horizontal r LM FE IS y

IS-LM-FE Analysis The slope of the FE will depend upon the sensitivity of capital flows to changes in interest rates. if capital flows are not sensitive to interest rates, the FE line will be vertical if capital flows are perfectly sensitive to interest rates, the FE line will be horizontal the more sensitive are capital flows to interest rates, the flatter will be the FE line.