openness in goods and financial markets

Openness in Goods and

Financial Markets

Chapter 18

© 2013 Pearson Education, Inc. All rights reserved. 18-2

Figure 18-1 Growth in Advancedand Emerging Economies since 2005


18-1 Openness in Goods MarketsFigure 18-2 U.S. Exports and Imports as Ratios of GDP since 1960


18-1 Openness in Goods MarketsTable 18-1 Ratios of Exports to GDP for Selected OECD Countries, 2010


18-1 Openness in Goods MarketsFigure 18-3 The Nominal Exchange Rate between the Dollar and the Pound since 1971


18-1 Openness in Goods Markets

• Choose between domestic goods and foreign goods

• The decision depends on the price of the domestic good relative to the foreign good, the real exchange rate.

• Nominal exchange rate (E) is the relative price of currencies.

• The price of domestic currency in terms of foreign currency. If E is 0.5, 1 dollar is worth 0.5 pounds.



• E changes every day. These changes are called nominal appreciations or depreciations.

• Appreciation (depreciation) of domestic currency is the increase (decrease) in the price of domestic currency in terms of foreign currency.

• The terms devaluation and evaluation are used when countries operate under the fixed exchange rate regime.



• Multiplying price of US goods (P) by the exchange rate (E, the the price of dollars in terms of pounds) gives the the price of US goods in terms of pounds.

• Divide EP by P*(the price of British goods) to find the real exchange rate, the price of US goods in terms of British goods.


18-1 Openness in Goods MarketsFigure 18-4 The Construction of the Real Exchange Rate


18-1 Openness in Goods MarketsFigure 18-5 Real and Nominal Exchange Rates between the United States and the United Kingdom since 1971


From Bileteral to Multileteral Exchange Rates

• Multileteral exchange rate is a weighted average of the real exchange rate against all other countries.

• The weight on a given country reflects two factors:

1.the degree to which the country trades with the domestic country.

2.the degree to which the country competes with the domestic country in international markets.


18-1 Openness in Goods MarketsTable 18-2 The Country Composition of U.S. Exports and Imports, 2010


18-1 Openness in Goods MarketsFigure 18-6 The U.S. Multilateral Real Exchange Rate, since 1973


18-2 Openness in Financial MarketsTable 18-3 The U.S. Balance of Payments, 2010, in Billions of U.S. Dollars


18-2 Openness in Financial Markets

• The Balance of Payments keep track of a country’s transactions with the ROW, including both trade flows and financial flows.

• The table has two parts seperated by a line. Transactions are referred to as being above the line or below the line.



• The Current Account: The transactions above the line record payments to and from the ROW (current account transactions).

• Exports and imports• Investment income: Domestic residents

receive interest income on their holdings of foreign assets and foreigners receive interest income on their holdings of domestic assets.

• The countries give and receive foreign aid.



• The Financial Account: The transactions below the line are financial account transactions.

• Foreign holdings of US assets > US holdings of foreign assets: positive net capital flows: financial account surplus

• Statistical Discrepancy


18-2 Openness in Financial MarketsFigure 18-7 Expected Returns from Holding One-Year U.S. Bonds vs. One-Year U.K. Bonds



• The financial investors only care about the expected rate of return and therefore want to hold the asset with the highest expected rate of return. In that case, because of arbitrage, equation (18.2) must hold. Equation 18.2 is called interest parity condition.

• Arbitrage: The proposition that expected rates of return on two financial assets must be equal.



• Equation (18.3) gives us a relation between domestic interest rate, foreign interest rate, and the expected rate of appreciation of the domestic currency.

• A good approximation to equation (18.3) is given by equation (18.4).

• Equation (18.4) implies that the domestic interest rate must be equal to the foreign interest rate minus the the expected rate of appreciation of the domestic currency.


An application• One-year US bonds versus one-year UK bonds. The

one-year nominal interest rate is 2% in the US, and it is 5% in the UK. Should you hold UK bonds or US bonds?

• Answer depends whether you expect the pond to depraciate vis-a-vis dollar over the coming year by more or less than the difference between the US interest rate and the UK interest rate, 3% in this case.

• If you expect the pound to depreciate by more than 3%, then invest in US bonds.

• If you expect the pound to depreciate by less than 3%, then invest in UK bonds.


18-2 Openness in Financial MarketsFigure 18-8 Three-Month Nominal Interest Rates in the United States and in the United Kingdom since 1970

openness in goods and financial markets

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