1. 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

2. Openness in Goods Markets

3. 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 due in large part to Smoot-Hawley Act of 1930.
Large trade surpluses of the 1940s and large trade deficits of the 1980s.

4. 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%)

5. 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

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

7. 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

8. 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 $s: 1DM = 0.44$

9. 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

10. 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

11. 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

12. Openness in Goods Markets
The Nominal Exchange Rate between the DM and the Dollar

13. Openness in Goods Markets

14. Openness in Goods Markets

15. Openness in Goods Markets

16. 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?

17. 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 =

18. 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.

19. 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

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

21. 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 Western Europe Japan Mexico Asia* OPEC** Others Total
*Not including Japan. **OPEC: Organization of Petroleum Exporting Countries.

22. 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

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

24. 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.

25. Openness in Financial Markets
The Relation Between Trade and Financial Flows The U.S. Balance of Payments, 1998
Current Account
Exports 931
Imports Trade balance (deficit = -) (1) -169
Investment income received 242 Investment income paid 265 Net investment income (2) 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 Statistical discrepancy 4

26. 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.

27. 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

28. 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

29. 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.

30. 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?

31. 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?

32. 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:

33. 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

34. 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.

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

36. 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

37. 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)

38. 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.

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

40. 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

41. 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

42. 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

43. 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.