Openness in Goods and Financial Markets

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Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
2

Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
3

Observations of U.S. Exports and Imports

Openness in Goods Markets


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.

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
4

Measuring the Degree of Openness

Openness in Goods Markets


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%)

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
5

A Look Around the World

Openness in Goods Markets


Country

Export Ratio (%)

Country

Export Ratio (%)

United States

12

Switzerland

40

Japan

10

Austria

38

Germany

23

Belgium

73

United Kingdom

29

Luxembourg

91

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
6

Openness in Goods Markets

What Do You Think...

Can exports exceed GDP?

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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$

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
11

Openness in Goods Markets

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




䕸chagera瑥icreases㨠
E











The Nominal Exchange Rate, Appreciation, and

Depreciation: Germany and the United States*

*From the point of view of the


United States

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
12

Openness in Goods Markets

The Nominal Exchange Rate between the DM and the Dollar


1978
-

1998

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
13

Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
14

Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
15

Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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?

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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


P
DM

= 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 =


Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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 (

⤠=
䕐E





P

N佔䔺


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⤠慲攠ind數enumb敲猠慮d m敡eure


only relative change.

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
20

Openness in Goods Markets

The Choice Between Domestic and Foreign Goods

Real and Nominal Exchange Rates

Between Germany and the U.S., 1975
-
1998

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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

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.

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
23

Openness in Goods Markets

The Choice Between Domestic and Foreign Goods

The U.S. Effective Real Exchange Rate, 1975
-

1998

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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.

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
25

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 Relation Between Trade and Financial Flows

The U.S. Balance of Payments, 1998

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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.

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
27

Openness in Financial Markets

The Choice Between Domestic and Foreign Assets



US Bonds



i
t

= U.S. nominal interest rate



(
1+i
t
) = Return next year /$purchase of U.S. bonds

An Example: Choose between U.S. and German 1 yr. bonds

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
28

Openness in Financial Markets

The Choice Between Domestic and Foreign Assets
(Continued)



German Bonds



E
t

= nominal exchange between the $ and DM



(
1/E
t
) DM = DM/$1



i*
t
=
One year nominal interest rate on German Bonds


(in DM)


(
1/E
t
)(
1+i*
t
) = Return/DM invested

An Example: Choose between U.S. and German 1 yr. bonds

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
29

Openness in Financial Markets

The Choice Between Domestic and Foreign Assets
(Continued)



German Bonds



E
e
t+1

= expected exchange rate next year


(
1/Et
)(
1+i*
t
)
E
e
t+1

=
return/$ invested

An Example: Choose between U.S. and German 1 yr. bonds

Note:

Interest rates and exchange rates influence the choice


between domestic and foreign assets.

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
30

Openness in Financial Markets


Example:


$1000 to invest in the US or Germany


i
germany

= 0.08


i
us

= .10


E
t
=.40


E
t+1
=.45


Where do you want to invest?

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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?


Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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.

Or:

U.S. Bond

Return

German Bond

Return

=

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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:


i
germany

= 0.08


E
t
=.40


E
t+1
=.45

1 + i
t

= (1+.08)*.45/.40

i
t
= .215

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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.

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
35

Openness in Financial Markets

U.S. & German One
-
Year Nominal Interest Rates, 1975
-
1998

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
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) +G
0

+ X
0

-

Q(Y,e)


LM is the locus of points r and y that yield
equilibrium in the money market


M
0

= Mdt + Mds


M
0

= Mdt(y) + Mds(i)

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
38


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

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
39


IS and LM are
fairly easy


FE presents a
problem


Should FE be
vertical?


i

y

IS

LM

IS
-
LM
-
FE Analysis

FE

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
40


IS and LM are
fairly easy


FE presents a
problem


Should FE be


vertical


steeper than LM

r

y

IS

LM

FE

IS
-
LM
-
FE Analysis

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
41


IS and LM are
fairly easy


FE presents a
problem


Should FE be


vertical


steeper than LM


flatter than LM

r

y

IS

LM

FE

IS
-
LM
-
FE Analysis

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
42


IS and LM are
fairly easy


FE presents a
problem


Should FE be


vertical


steeper than LM


flatter than LM


horizontal

r

y

IS

LM

FE

IS
-
LM
-
FE Analysis

Chapter 18: Openness in Goods and Financial Markets

Blanchard: Macroeconomics

Slide #
43


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.

IS
-
LM
-
FE Analysis