Openness in goods and financial markets

• Chapter 18

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40

• Ethiopia financial market

• US financial market

• Ethiopia goods market

• US goods market

Electronics exports (+);

coffee imports from Ethiopia (-)

Coffee exports (+); electronics

imports from the US (-)

Borrowing from US (+); purchase of US assets (-)

Loans to Ethiopia (-); purchase of US assets by

Ethiopians (+)

Illustration: exchange between the US and Ethiopia

Good: electronics, etc.

Currency: dollar Good: coffee, etc.

Currency: Birr

See videos: “Black Gold” and “Life and Debt”

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

Since 1960, exports and

imports have more than

doubled in relation to GDP.

U.S. Exports and

Imports as Ratios of

GDP since 1960

Figure 18 - 1

•The main factors behind differences in export ratios are: geography, especially distance from other markets, and country size (GDP)

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

Exports and Imports

•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.

The Choice between Domestic Goods and Foreign Goods

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.

•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

Nominal Exchange Rates

There have been large swings

in the nominal exchange rate

between the two currencies,

especially in the 1980s.

The Nominal Exchange

Rate between the Dollar

and the Pound since

1970

Figure 18 - 2

•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.

Nominal 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

1. P = price of U.S. goods in dollars

2. P* = price of British goods in pounds

*

EP

P

From Nominal to Real Exchange Rates

The Construction of the

Real Exchange Rate

Figure 18 - 3 E = nominal exchange rate;

= real exchange rate

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

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)

Movements in the Real Exchange Rates

From Nominal to Real Exchange Rates

Nominal and the real

exchange rates have moved

largely together since 1970.

Real and Nominal

Exchange Rates

between the United

States and the United

Kingdom since 1970

Figure 18 - 4

•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.

•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).

8.2 Openness in Financial Markets

•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 Balance of Payments

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

100/1.30=£76.92

Value of US investment in 2012

$100*(1+0.05)=$105

Value of UK investment in 2012

£76.92*(1+0.08)=£83

Dollar equivalent of UK investment in 2012 – without change in exchange rate

£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)

Investing in the US vs. UK

The Choice between Domestic and Foreign Assets

•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.

Expected Returns from

Holding One-Year U.S.

Bonds or One-Year U.K.

Bonds

Figure 18 - 6

•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 + 1 + t

ett

t

Ei i

E

*

1

1) ( )( )(1 + 1 + ett t

t

i E iE

The uncovered interest parity relation, or interest

parity condition is:

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 (that is, no expected depreciation),

then

1

e

t tEE

*

tti i

*1

e

t t

t t

t

Ei i

E

E

A good approximation of the equation above is given by:

•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

U.S. and U.K. nominal interest

rates have largely moved

together over the past 38

years.

Three-Month Nominal

Interest Rates in the

United States and in the

United Kingdom since

1970

Figure 18 - 7

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?

26 of 40

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

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

Budget deficit and trade balance

Budget deficit and current account deficit

Government expenditure increases

Imports increase

Trade deficit