c h a p t e r prepared by: fernando quijano and yvonn quijano and modified by gabriel martinez the...

C H A P T E RC H A P T E R

Prepared by:Prepared by:

Fernando Quijano and Yvonn Fernando Quijano and Yvonn QuijanoQuijano

And Modified by Gabriel MartinezAnd Modified by Gabriel Martinez

The Open EconomyThe Open Economy

1818

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

The Open EconomyThe Open Economy

Openness has three distinct dimensions:Openness has three distinct dimensions:1.1. Openness in goods markets. Free trade Openness in goods markets. Free trade

restrictions include restrictions include tariffstariffs and and quotasquotas..

2.2. Openness in financial markets. Openness in financial markets. Capital Capital controlscontrols place restrictions on the ownership of place restrictions on the ownership of foreign assets.foreign assets.

3.3. Openness in factor markets—the ability of Openness in factor markets—the ability of firms to choose where to locate production, firms to choose where to locate production, and workers to choose where to work.and workers to choose where to work.

1.1. The The North American Free Trade North American Free Trade Agreement (NAFTA)Agreement (NAFTA) is an example of this. is an example of this.


Openness in GoodsOpenness in GoodsMarketsMarkets

U.S. Exports and U.S. Exports and Imports as Ratios Imports as Ratios of GDP, 1960-2000of GDP, 1960-2000

Exports and imports, which were equal to 5% of GDP as recently as the 1960s, now stand around 13% of GDP.

18-1

0%

5%

10%

15%

20%

25%

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

Perc

enta

ge o

f GDP

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

Imports

Exports


Exports and ImportsExports and Imports

The behavior of exports and imports in the The behavior of exports and imports in the United States is characterized by:United States is characterized by: A sharp decline in both exports and imports A sharp decline in both exports and imports

between 1929 and 1936 as a result of the Smoot-between 1929 and 1936 as a result of the Smoot-Hawley Act of 1930.Hawley Act of 1930.

Three episodes of surpluses and deficits:Three episodes of surpluses and deficits: The trade surpluses of the 1940s.The trade surpluses of the 1940s. The trade deficits of the mid-1980s, andThe trade deficits of the mid-1980s, and The current trade deficit, which reached 6.63% of GDP The current trade deficit, which reached 6.63% of GDP

in Q2 2006—a historical record.in Q2 2006—a historical record.


Openness in GoodsOpenness in GoodsMarketsMarkets

U.S. Current U.S. Current Account Deficit as Account Deficit as a ratio of GDP, a ratio of GDP, 1960-20061960-2006

Exports and imports, which were equal to 5% of GDP as recently as the 1960s, now stand around 13% of GDP.

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

Per

cent

age

of G

DP

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2



The main factors behind differences in export ratios are The main factors behind differences in export ratios are geography and country size.geography and country size.

Countries can have export ratios larger than the value of Countries can have export ratios larger than the value of their GDP because exports and imports may include their GDP because exports and imports may include exports and imports of intermediate goods.exports and imports of intermediate goods.

Table 18-1 Ratios of Exports to GDP for Selected OECD Countries, 2000

Country Export Ratio (%) Country Export Ratio (%)

United StatesUnited States 1111 SwitzerlandSwitzerland 4545

JapanJapan 1010 AustriaAustria 4848

GermanyGermany 3333 NetherlandsNetherlands 7474

United KingdomUnited Kingdom 2727 BelgiumBelgium 8484



A good index of openness is the proportion A good index of openness is the proportion of aggregate output composed of of aggregate output composed of tradable tradable goodsgoods—goods that compete with foreign —goods that compete with foreign goods in either domestic markets or foreign goods in either domestic markets or foreign markets.markets.

Estimates are that tradable goods represent Estimates are that tradable goods represent around 60% of aggregate output in the around 60% of aggregate output in the United States today.United States today.


The Choice Between DomesticThe Choice Between DomesticGoods and Foreign GoodsGoods and Foreign Goods

When goods markets are open, domestic When goods markets are open, domestic consumers must decide not only how much consumers must decide not only how much to consume and save, …to consume and save, …

… … but also whether to buy domestic goods but also whether to buy domestic goods or to buy foreign goods.or to buy foreign goods.

Central to the second decision is the price of Central to the second decision is the price of domestic goods relative to foreign goods, or domestic goods relative to foreign goods, or the the real exchange ratereal exchange rate..


Nominal Exchange RatesNominal Exchange Rates

The The nominal exchange ratenominal exchange rate is the price of the is the price of the foreign currency in terms of the domestic currency.foreign currency in terms of the domestic currency.

currencyforeign ofunit 1

currency domestic of unitsE



An An appreciationappreciation of the domestic currency is an of the domestic currency is an increase in the price of the domestic currency in terms increase in the price of the domestic currency in terms of the foreign currency, which corresponds to a of the foreign currency, which corresponds to a decreasedecrease in the exchange rate. in the exchange rate. Fewer units of domestic currency are needed to buy 1 unit of Fewer units of domestic currency are needed to buy 1 unit of

foreign currency.foreign currency.

A A depreciationdepreciation of the domestic currency is a decrease of the domestic currency is a decrease in the price of the domestic currency in terms of the in the price of the domestic currency in terms of the foreign currency, or an foreign currency, or an increaseincrease in the exchange rate. in the exchange rate. More units of domestic currency are needed to buy 1 unit of More units of domestic currency are needed to buy 1 unit of

foreign currency.foreign currency.

currencyforeign ofunit 1

currency domestic of unitsE



Suppose countries operate under Suppose countries operate under fixed fixed exchange ratesexchange rates, that is, maintain a , that is, maintain a constant exchange rate between them. constant exchange rate between them. If the If the governmentgovernment changes the value of changes the value of the currency, we say thatthe currency, we say that RevaluationsRevaluations are decreases in the are decreases in the

exchange rate, andexchange rate, and Devaluations Devaluations are increases in the are increases in the

exchange rate. exchange rate.



The Nominal The Nominal Exchange Rate Exchange Rate Between the Between the Dollar and the Dollar and the Pound (from the Pound (from the Point of View of Point of View of the United States): the United States): Appreciation and Appreciation and DepreciationDepreciation



The Nominal Exchange The Nominal Exchange Rate Between the Dollar Rate Between the Dollar and the Pound, 1975-and the Pound, 1975-20002000

While the dollar has strongly appreciated vis-á-vis the pound over the past 25 years, this appreciation has come with large swings in the nominal exchange rate between the two countries, especially in the 1980s.


From Nominal toFrom Nominal toReal Exchange RatesReal Exchange Rates

U.K. cars $10 million

U.S. cars $10 million

$10m/PUS=

500 carscar

PUS

1

000,20$

£

5.1

10$ million£ 6.67million

500 cars

carPUK 1

333,13£

Et = $1.5/£


375 cars

carPUK 1

333,13£


U.S. cars

U.K. cars

$10 million

$10 million

car1

000,20$

£

2

10$ million£ 5 million

Et = $2/£

A nominal depreciation of the dollar reduces demand for British imports.

$10m/PUS=

500 cars



U.S. cars

U.K. cars

$10 million

$10 million 444 cars

car1

000,20$

£

5.1

10$ million£ 6.67 million

An increase in British prices, at the same E, reduces demand for British imports.

Et = $1.5/£

$10m/PUS=

500 cars

carPUK 1

000,15£



If the price of a Jaguar is If the price of a Jaguar is £30,000, and a £30,000, and a pound is worth 1.5 dollars, then the price of pound is worth 1.5 dollars, then the price of the Jaguar the Jaguar in dollarsin dollars is £30,000 x $1.5 = is £30,000 x $1.5 = $45,000.$45,000.

If a Cadillac is $40,000, then the relative If a Cadillac is $40,000, then the relative price of a price of a Jaguar in terms of CadillacsJaguar in terms of Cadillacs is is $45,000/$40,000 = 1.12$45,000/$40,000 = 1.12



The Real Exchange RateThe Real Exchange Rate It is the concept that tells us It is the concept that tells us how much the US’s how much the US’s

production is worth in terms of UK production.production is worth in terms of UK production. How much of UK GDP can I buy with 1 unit of US How much of UK GDP can I buy with 1 unit of US

GDP.GDP.

To take into account all of the goods in a To take into account all of the goods in a nation’s economy, we use a price index for the nation’s economy, we use a price index for the economy, or the GDP deflator.economy, or the GDP deflator.



The Construction of The Construction of the Real Exchange the Real Exchange RateRate

PP* = price of British goods in pounds* = price of British goods in pounds

EE = price of pounds in terms of dollars = price of pounds in terms of dollars

EPEP* = price of British goods in dollars* = price of British goods in dollars

EP

P

*

The real exchange rate equals the nominal exchange rate times the foreign price level, divided by the domestic price level.



If the US price is $20,000,If the US price is $20,000, And the UK price is And the UK price is £15,000, A consumer is indifferent between the two if

RER = 1. ($10m / $20,000) = (1/Et)($10m / £15,000) $20,000 = Et £15,000 RER = 1 = Et £15,000 / $20,000 RER = 1 = Et (P* / P)

Et = $1.33 £. If Et=1.5, the $ must appreciate.



An increase in the relative price of domestic An increase in the relative price of domestic goods in terms of foreign goods:goods in terms of foreign goods: a a real appreciationreal appreciation, , a decrease in the real exchange rate, a decrease in the real exchange rate, ..

A decrease in the relative price of domestic A decrease in the relative price of domestic goods in terms of foreign goodsgoods in terms of foreign goods a a real depreciationreal depreciation,, an increase in the real exchange rate, an increase in the real exchange rate, ..



The Real Exchange Rate The Real Exchange Rate Between U.S. Goods and Between U.S. Goods and U.K. Goods (from the U.K. Goods (from the Point of View of the Point of View of the United States) Real United States) Real Appreciation and Real Appreciation and Real DepreciationDepreciation

Real



Real and Nominal Real and Nominal Exchange Rates Exchange Rates Between the United Between the United States and the United States and the United Kingdom, 1975-2000Kingdom, 1975-2000

Except for the difference in trend reflecting higher average inflation in the United Kingdom than in the United States, the nominal and the real exchange rates have moved largely together since 1975.


From Bilateral toFrom Bilateral toMultilateral Exchange RatesMultilateral Exchange Rates

Table 18-2 The Country Composition of U.S. Merchandise Trade, 2000

Exports toExports to Imports fromImports from

CountriesCountries $ Billions$ Billions PercentPercent $ Billions$ Billions PercentPercent

Canada 179 23 232 19

Western Europe 178 23 243 20

Japan 64 8 146 12

Mexico 86 11 136 11

Asia* 130 17 340 28

OPEC 20 3 42 3

Others 116 15 83 7

Total 773 100 1222 100

* Not including Japan.OPEC: Organization of Petroleum Exporting Countries.



Bilateral exchange ratesBilateral exchange rates are exchange rates are exchange rates between two countries. between two countries. Multilateral exchange Multilateral exchange ratesrates are exchange rates between several are exchange rates between several countries.countries.

For example, to measure the average price of U.S. For example, to measure the average price of U.S. goods relative to the average price of goods of goods relative to the average price of goods of U.S. trading partners, we use the U.S. share of U.S. trading partners, we use the U.S. share of import and export trade with each country as the import and export trade with each country as the weight for that country, or the weight for that country, or the multilateral real multilateral real U.S. exchange rateU.S. exchange rate..

jap

mex

can

*JAP with tradeof Share

*MEX with tradeof Share

*CAN with tradeof Share



Equivalent names for the relative price of Equivalent names for the relative price of foreign goods vis foreign goods vis á vis U.S. goods are:á vis U.S. goods are: The The real multilateral U.S. exchange rate.real multilateral U.S. exchange rate. The The U.S. trade-weighted real exchange rate.U.S. trade-weighted real exchange rate. The The U.S. effective real exchange rate.U.S. effective real exchange rate.



The U.S. Effective The U.S. Effective Real Exchange Rate, Real Exchange Rate, 1975-20001975-2000

The large real appreciation of U.S. goods in the first half of the 1980s was followed by an even larger real depreciation in the second half of the 1980s. This large swing in the 1980s is sometimes called the “dance of the dollar.”


Openness in Openness in Financial MarketsFinancial Markets

18-2

The purchase and sale of foreign assets implies The purchase and sale of foreign assets implies buying or selling foreign currencybuying or selling foreign currency sometimes called sometimes called foreign exchangeforeign exchange..

Openness in financial markets allows:Openness in financial markets allows: Financial investors to diversify—to hold both domestic Financial investors to diversify—to hold both domestic

and foreign assets and speculate on foreign interest rate and foreign assets and speculate on foreign interest rate movements.movements.

Allows countries to run trade surpluses and deficits. A Allows countries to run trade surpluses and deficits. A country that buys more than it sells must pay for the country that buys more than it sells must pay for the difference by borrowing from the rest of the world.difference by borrowing from the rest of the world.


The Balance of PaymentsThe Balance of Payments

The The balance of paymentsbalance of payments account account summarizes a country’s transactions with summarizes a country’s transactions with the rest of the world.the rest of the world. Transactions in goods or services are Transactions in goods or services are

current accountcurrent account transactions. transactions. Transactions involving Transactions involving onlyonly goods (not services) goods (not services)

are counted in the are counted in the trade balancetrade balance, which is a part , which is a part of the current account.of the current account.

Trade deficit: Imports > ExportsTrade deficit: Imports > Exports Trade surplus: Exports > ImportsTrade surplus: Exports > Imports



The The balance of paymentsbalance of payments account account summarizes a country’s transactions with summarizes a country’s transactions with the rest of the world.the rest of the world. Transactions involving flows of funds are Transactions involving flows of funds are

capital accountcapital account transactions. transactions.

The current account balance and the capital The current account balance and the capital account balance should add up to zero, but account balance should add up to zero, but because of data gathering errors they don’t. because of data gathering errors they don’t. For this reason, the account shows a For this reason, the account shows a statistical discrepancystatistical discrepancy..



Table 18-2 The U.S. Balance of Payments, 2000 (billions)

Current AccountCurrent Account

Exports 1070

Imports 1437

Trade balance (deficit = ) (1) 367

Investment income received 345

Investment income paid 359

Net investment income (2) 14

Net transfers received (3) 42 53

Current account balance (1) + (2) + (3) 83 434

Capital AccountCapital Account

Increase in foreign holdings of U.S. assets (4) 952

Increase in U.S. holdings of foreign assets (5) 553

Capital account balance (4) (5) 399

Statistical discrepancy 35


The Balance of PaymentsThe Balance of Payments The sum of net payments in the The sum of net payments in the current current

account balanceaccount balance can be positive, in which case can be positive, in which case the country has a the country has a current account surpluscurrent account surplus … ………or negative—a or negative—a current account deficitcurrent account deficit..

The The capital account balancecapital account balance can be positive if can be positive if the change in foreign holdings of U.S. assets the change in foreign holdings of U.S. assets are greater than U.S. holdings of foreign assets, are greater than U.S. holdings of foreign assets, in which case there is a in which case there is a capital account capital account surplus.surplus. If foreign holding of US assets grows faster than US If foreign holding of US assets grows faster than US

holding of foreign assets, there is a capital account holding of foreign assets, there is a capital account deficit.deficit.

The Choice BetweenThe Choice BetweenDomestic and Foreign AssetsDomestic and Foreign Assets



The decision whether to invest abroad or at The decision whether to invest abroad or at home depends not only on interest rate home depends not only on interest rate differences, but also on your expectation of differences, but also on your expectation of what will happen to the nominal exchange what will happen to the nominal exchange rate.rate. If both U.K. bonds and U.S. bonds are to be If both U.K. bonds and U.S. bonds are to be

held, they must have the same expected rate of held, they must have the same expected rate of return.return.



Expected Returns from Expected Returns from Holding One-Year U.S. Holding One-Year U.S. Bonds or U.K. BondsBonds or U.K. Bonds


Expectations, Consumption,Expectations, Consumption,and Investment Decisionsand Investment Decisions

If both U.K. bonds and U.S. bonds are to be held, If both U.K. bonds and U.S. bonds are to be held, they must have the same expected rate of return, they must have the same expected rate of return, so that the following arbitrage relation must hold:so that the following arbitrage relation must hold:

1 11

i iE

Et t

et

t

( )*

11

1 1

i

Ei Et

t

tet( )( )*

Rearranging the equation, we obtain the Rearranging the equation, we obtain the uncovered uncovered interest parity relationinterest parity relation, or , or interest parity conditioninterest parity condition::


Interest Rates and Exchange Interest Rates and Exchange RatesRates

The relation between the domestic nominal The relation between the domestic nominal interest rate, the foreign nominal interest rate, interest rate, the foreign nominal interest rate, and the expected rate of depreciation of the and the expected rate of depreciation of the domestic currency is stated as:domestic currency is stated as:

1 1 11

i i

E E

Et t

et t

t

( )*

A good approximation of the equation above is given A good approximation of the equation above is given by:by:

t

tet

tt E

EEii

1*



This is the relation you must remember: This is the relation you must remember: Arbitrage implies that the domestic interest Arbitrage implies that the domestic interest rate must be (approximately ) equal to the rate must be (approximately ) equal to the foreign interest rate plus the expected foreign interest rate plus the expected depreciation rate of the domestic currency.depreciation rate of the domestic currency.

If , then If , then E Eet t 1 i it t *

t

tet

tt E

EEii

1*



One-Year Nominal Interest One-Year Nominal Interest Rates in the United States Rates in the United States and in the United Kingdom, and in the United Kingdom, 1975-20001975-2000

U.S. and U.K. nominal interest rates have largely moved together over the last 25 years.


Conclusions andConclusions anda Look Aheada Look Ahead

18-3

The choice between domestic goods and The choice between domestic goods and foreign goods depends primarily on the real foreign goods depends primarily on the real exchange rate.exchange rate.

The choice between domestic assets and The choice between domestic assets and foreign assets depends primarily on their foreign assets depends primarily on their relative rates of return, which depend on relative rates of return, which depend on domestic interest rates and foreign interest domestic interest rates and foreign interest rates, and on the expected depreciation of rates, and on the expected depreciation of the domestic currency.the domestic currency.

c h a p t e r prepared by: fernando quijano and yvonn quijano and modified by gabriel martinez the...

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