openness in goods and financial markets

The Goods Market in an Open Economy Slide #1Econ 302

Current Account

Exports 931

Imports 1100Trade balance (deficit = -) (1) -169

Investment income received 242Investment income paid 265

Net investment income (2) -23Net transfers received (3) -41

Current account balance (deficit = -) (1)+(2)+(3) -233

Capital AccountIncrease in foreign holdings of U.S. assets 542Increase in U.S. holdings of foreign assets 305Net increase in foreign holdings/net capital flow to the U.S. 237Statistical discrepancy 4

Openness in Goods and Financial MarketsOpenness in Goods and Financial Markets

Openness in Financial MarketsOpenness in Financial Markets

The Relation Between Trade and Financial FlowsThe U.S. Balance of Payments, 1998




The Balance of Payments

The Current Account (Above the Line)

All recorded payments to and from the rest of the world

1. Trade in Goods and Services* Exports: Payments from the rest of the world ($931 Billion)* Imports: Payments to the rest of the world ($1,100 Billion)

2. Investment Income* U.S. residents receive income on their holdings of foreign assets ($242 Billion)* Foreign residents receive income on their holdings of U.S. assets

($265 Billion)




The Balance of Payments (Continued)

The Current Account (Above the Line)

All recorded payments to and from the rest of the world

3. Foreign Aid (-$41 Billion)* Net transfers received The difference between foreign aid received and given

4. Current account balance (+,-)= 1+2+3= -$233 Billion (1998)





The Capital Account

1. Increase in foreign holdings of U.S. assets ($542 Billion)

2. Increase in U.S. holdings of foreign assets ($305 Billion)

3. Net capital flows = 1-2($542 Billion - $305 Billion = -237 Billion)

Statistical discrepancy: Accounts for differences in data sources.





• The Current Account Balance (+,-) = Capital Account Balance (+,-)

• A Current Account Deficit increases foreign holdings of U.S. assets and vice versa.




The Choice Between Domestic and Foreign Assets

• US Bonds

• it = U.S. nominal interest rate

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

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




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

U.S. bonds

German bonds

Year t Year t+1

$1 $(1+it)

tEDM

1)*1(

1t

t

iE

DM





If: Investors will hold only the asset with the highest rate ofreturn.

Then: To hold both U.S. and German bonds, they must havethe same return.

Or: ))(*1(1

1 1

t

e

t

t

tEi

Ei

U.S. BondReturn

German BondReturn

=




The Choice Between Domestic and Foreign Assets (Continued)

))(*1(1

1 1

t

et

tt Ei

Ei

U.S. BondReturn

German BondReturn

=

A little reorganizing:

t

te

tt E

Eii

1)*1(1

The Interest Parity Condition:





Is the assumption that investors hold only assets with thehighest expected return realistic?

Some other considerations:-- Transaction Costs-- Exchange Rate Risk

Observation:

The interest parity condition is a good approximation fordeveloped countries with open, well-organized financialmarkets.





Adjusting the interest rate parity condition for changes in thevalue of the domestic currency

t

te

tt E

Eii

1)*1(1

The Interest Parity Condition:

Or:

t

tte

tt EEE

ii1

1)*1(1

t

tte

E

EE 1= Expected rate of depreciation of the domestic currency


Openness in Goods in Financial MarketsOpenness in Goods in Financial Markets


The Choice Between Domestic and Foreign Assets (Continued)

An approximation:

t

tte

tt E

EEii

1

*



Some ConclusionsSome Conclusions

GoodsGoods

• Openness allows choice between domestic goods and foreign goods.

• Which goods are chosen depends primarily on the exchange rate.

Financial AssetsFinancial 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


The Goods Market in an Open EconomyThe Goods Market in an Open Economy

Expanding the Goods Market Model (Expanding the Goods Market Model (ISIS) to address these ) to address these questionsquestionsExpanding the Goods Market Model (Expanding the Goods Market Model (ISIS) to address these ) to address these questionsquestions

• Can a foreign expansion stimulate domestic economic growth?

• Should macroeconomic policies be coordinated betweencountries?


The The ISIS Relation in the Open Economy Relation in the Open Economy

The Open Economy Demand for Domestic Goods...The Open Economy Demand for Domestic Goods...The Open Economy Demand for Domestic Goods...The Open Economy Demand for Domestic Goods...

Z C + I + G - Q + XZ C + I + G - Q + X

Q: The value of imports in terms of domestic goods

X: Exports



The Determinants of the Demand for Domestic GoodsThe Determinants of the Demand for Domestic GoodsThe Determinants of the Demand for Domestic GoodsThe Determinants of the Demand for Domestic Goods

The Determinants of C, I, & GThe Determinants of C, I, & G

Domestic Demand: C + I + G = C(Y-T) + I(Y,r) + G ( + ) (+,-)

The Determinants of ImportsThe Determinants of Imports

Imports: Q = Q(Y, ) (+ , - )

The Determinants of ExportsThe Determinants of Exports

Exports: X = X(Y*, )(+ , +)



The Open Economy GraphicallyThe Open Economy GraphicallyThe Open Economy GraphicallyThe Open Economy Graphically

De

ma

nd

OutputD

em

an

dOutput

DD

Domestic demand(C + I + G)

DD

Observations

• Difference between DD & AA increases with income

• AA is flatter than DD

• AA has a positive slope

AA

Imports ( Q)


NXBC

Y

Y

Exports (X)

ZZ

De

ma

nd

Output

DD

AA


The Open Economy GraphicallyThe Open Economy GraphicallyThe Open Economy GraphicallyThe Open Economy Graphically

Y < YTB

Trade surplus

Y > YTB

Trade deficit

YTB

YTB

A

B

AB: Imports

BC: Net Exports (X – Q)

Demand for Domestic Goods

Including Exports (ZZ)

C

AC: Exports

0Ne

t e

xp

ort

s,

NX

Output, Y

Net Exports (NX) = X - Q



Equilibrium Output and the Trade BalanceEquilibrium Output and the Trade BalanceEquilibrium Output and the Trade BalanceEquilibrium Output and the Trade Balance

Goods Market Equilibrium: Y = Z

DomesticOutput

Demand forDomestic Goods

=

Y = C(Y-T) + I(Y,r) + G - Q(Y, ) + X(Y*, )


NX

YTB


Equilibrium Output and the Trade BalanceEquilibrium Output and the Trade BalanceEquilibrium Output and the Trade BalanceEquilibrium Output and the Trade Balance

De

ma

nd

, Z

Output

45°

ZZ

A

Y

Z

EquilibriumY = Z

C

B

Y

Trade deficit

0Ne

t e

xp

ort

s,

NX

Output, Y


De

ma

nd

, Z

Output

45°

ZZ

A

Initial equilibrium

Y

ZZ´ (G > 0)

G > 0


Increases in Demand, Domestic or ForeignIncreases in Demand, Domestic or ForeignIncreases in Demand, Domestic or ForeignIncreases in Demand, Domestic or Foreign

Increases in Domestic Demand

• Assume G is increased to increase domestic demand & Y

NX

0Ne

t e

xp

ort

s,

NX

Output, Y

YYTB

Initial equilibriumY = YTB

C

B

A´

NewEquilibrium

( Y > G)

Trade deficitBC@Y’

Y´




The Impact of Increasing G in an Open EconomyThe Impact of Increasing G in an Open Economy

Some Observations

• A trade deficit is created

• The multiplier is smaller

Question: How are the trade deficit and the smaller multiplierrelated?




The Impact of Increasing G in an Open EconomyThe Impact of Increasing G in an Open Economy

Observation:

The more open an economy, the smaller the impactof a change in domestic demand on output.

Example:

Belgium: Ratio of imports to GDP is 70%. Therefore, 70%of an increase in domestic demand will go forimports.

U.S.: Import ratio = 13%Even in the U.S. domestic policy is reduced bythe open economy.


45°

De

ma

nd

, Z

Output

ZZ

A

Y

DD

ZZ´

X

NX´

X

NX

0

Ne

t e

xp

ort

s,

NX

Output, Y

YYTB



Increases in Foreign DemandIncreases in Foreign Demand

Y´

A´

Y´

NX

Domestic demand

NX

Demand for domestic goods

D

C

A: Initial equilibrium &

balanced trade

Y*: Increases & X

A´: New equilibrium




Increases in Foreign DemandIncreases in Foreign Demand

A Summary

• Increase in Y* increases demand for domestic goods,exports grow and equilibrium Y increases.

• The increase in Y increases imports. The increase inimports is less than the growth in exports.




Two Observations:Two Observations:

Increase in domestic demand leads to an increase inY and a trade deficit.

1.

Increase in foreign demand leads to an increase inY and a trade surplus.

2.



Depreciation, the Trade Balance, and OutputDepreciation, the Trade Balance, and OutputDepreciation, the Trade Balance, and OutputDepreciation, the Trade Balance, and Output

The Depreciation of a Currency ($)The Depreciation of a Currency ($)

Real Exchange Rate: E: Nominal exchange rateP*: Foreign price levelP: Domestic price level

Recall:

P

EP*

Assuming ConstantPrices:

The depreciation of a currency ($) will makethat country’s goods cheaper in other countries and vice versa.




Depreciation and the Trade Balance: The Marshall-LernerConditionDepreciation and the Trade Balance: The Marshall-LernerCondition

Net Exports: NX X - QNX = X(Y*, ) - Q(Y, )

Depreciation (increase in ) affects the trade balance in three ways:

1. X increases

2. Q decreases

3. Q increases

The Marshall-Lerner Condition: For depreciation to improve thetrade balance--the increase in X and decrease in Q is greater

than the increase in Q.




The Effects of a DepreciationThe Effects of a Depreciation

Tracing a Depreciation Through the Economy

1. Shift demand, both foreign and domestic toward domestic goods

2. Net exports increase (Marshall-Lerner)

3. Equilibrium Y increases

4. Trade balance improves



Combining Exchange Rate and Fiscal PoliciesCombining Exchange Rate and Fiscal Policies

Objective: Reduce the trade deficit without changing YPolicy: Balance depreciation and fiscal constraint


ZZ´A´

Y´

NX

Depreciation shiftsZZ to ZZ´ & Y to Y´

Reduction in G shifts ZZ´ to ZZ & Y G

NX´

NX B

Depreciation shiftsNX to NX´ & balanced trade

45°

De

ma

nd

, Z

Output

ZZ

A

Y

NX

0

Ne

t e

xp

ort

s,

NX

Output, Y

Y

Initial equilibrium C



Combining Exchange Rate and Fiscal PoliciesCombining Exchange Rate and Fiscal Policies


Exchange Rate and Fiscal Policy Combinations

Initial Conditions Trade Surplus Trade Deficit

Low output ? G G?

High output G? ? G



Looking at Dynamics: The J-CurveLooking at Dynamics: The J-CurveLooking at Dynamics: The J-CurveLooking at Dynamics: The J-Curve

Depreciation

0

Ne

t e

xp

ort

s,

NX

Time

CA

B

0

_

+



The Real Exchange Rate and the Ratio of Net Exports to The Real Exchange Rate and the Ratio of Net Exports to GDP: U.S., 1980-1990GDP: U.S., 1980-1990The Real Exchange Rate and the Ratio of Net Exports to The Real Exchange Rate and the Ratio of Net Exports to GDP: U.S., 1980-1990GDP: U.S., 1980-1990



Looking at Dynamics - The J-CurveLooking at Dynamics - The J-CurveLooking at Dynamics - The J-CurveLooking at Dynamics - The J-Curve

The U.S. - 1980-1990The U.S. - 1980-1990

1. Movements real exchange rates were reflected in parallelmovements in net exports.

2. There were substantial lags in the response of the trade balanceto changes in the real exchange rate. The J-Curve at work.



Saving, Investment, and Trade DeficitsSaving, Investment, and Trade DeficitsSaving, Investment, and Trade DeficitsSaving, Investment, and Trade Deficits

Subtract C + T from both sides:

S = I + G - T - Q + X

And using NX X - Q

Recall:Recall: Y = C + I + G - Q + X and S = Y - C + T

NX = S + (T - G) - I

TradeBalance

Saving Investment= -



Saving, Investment, and Trade DeficitsSaving, Investment, and Trade DeficitsSaving, Investment, and Trade DeficitsSaving, Investment, and Trade Deficits

Observations:

NX = S + (T-G) - INX = S + (T-G) - I

• Trade surplus: Excess of saving over investment

• Trade deficit: Excess of investment over saving

• An increase in investment must be reflected either in an increase in private or public saving or in a deterioration of the trade balance.

• An increase in the budget deficit must be reflected in an increase in private saving, decrease in investment, or a deterioration of the trade balance.

• A country with a high saving rate, public and private, must have a high investment rate or a large trade surplus.




Games that Countries PlayGames that Countries Play

A Scenario...

There is a group of countries that are trading partners.

• The countries are in a recession

• The countries have balanced trade

Questions:

Why would any one country be reluctant to expand domesticdemand?

What would be the impact on the trade balance if all countriesincreased domestic demand together?




Games that Countries PlayGames that Countries Play

Coordination: As global commerce expands, the motivation forcoordination increases. For example, the G7 meetings.

The Evidence: There is very little limited macro-coordination.

Barriers toCoordination:

• Not all countries experience the same economic conditions.

• Budget and trade balances may differ.

• Countries have an incentive to promise and then not deliver on the promise.


Equilibrium in the Goods Market (Equilibrium in the Goods Market (ISIS))Equilibrium in the Goods Market (Equilibrium in the Goods Market (ISIS))

Output - Demand for Domestic GoodsOutput - Demand for Domestic Goods

Y = C(Y-T) + I(Y,r) + G - Q(Y, ) + X(Y*, ) ( + ) (+,-) (+, -) (+ , +)

Output, the Interest Rate, and the Output, the Interest Rate, and the Exchange RateExchange Rate

Net Exports = X - Q NX(Y,Y*, ) X(Y*, ) - Q(Y,G)

Y = C(Y-T) + I(Y,r) + G + NX(Y,Y*, )

Observation: Equilibrium Y & Demand depend on the…real interest rate (r)real exchange rate ()

r I Demand Multiplier Y Demand for Domestic Goods Demand Y


Equilibrium in the Goods Market (Equilibrium in the Goods Market (ISIS))Equilibrium in the Goods Market (Equilibrium in the Goods Market (ISIS))

Some AssumptionsSome Assumptions


Y = C(Y-T) + I(Y,i) + G + NX(Y,Y*, E) ( + ) (+,-) (- , + , + )

• The domestic price level is given (e = O & r = i)

• The foreign price level is given ( & E move together) P*/P = I & = E

New Equilibrium StatementNew Equilibrium Statement


Equilibrium in the Financial MarketsEquilibrium in the Financial MarketsEquilibrium in the Financial MarketsEquilibrium in the Financial Markets

Money vs. BondsMoney vs. Bonds


Money: Equilibrium in the money market in an open economy

Supply of money = Demand for money

P

M= YL(i)





Domestic Bonds vs. Foreign Bonds Equilibrium in domestic bonds and foreign bonds

Interest parity relation:

t

tttt E

EEii

1*

*

Domestici =

Foreigni +

ExpectedDepreciation





Domestic Bonds vs. Foreign Bonds (Continued) Equilibrium in domestic bonds and foreign bonds

Assume:ee EE itdenotegivenis

Then:*1

*ii

EEii

e

t

Solving for E:*1 ii

EE

e



Domestic Bonds vs. Foreign BondsDomestic Bonds vs. Foreign Bonds


Interpreting: *1 ii

EE

e

i Exchange Rate (appreciation of domestic currency)

i* Exchange Rate (depreciation of domestic currency)





An example: The adjustment of exchange markets to an increasein U.S. interest rates above German rates

• Initially: i = i* & E=Ee

• U.S. monetary contraction increases i, if E is constantU.S. bonds become more attractive i > i*

• To buy U.S. bonds, Germans must sell German bonds forDM, then sell DM for $s and the $ appreciates.

To maintain equilibrium:

• the $ appreciation until the expected future depreciationcompensates for the increase in i





A numeric example:

Assume: U.S. i & Di* = 4%

• Then U.S. i increases to 10%

• The $ will appreciate 6%

• At a 6% appreciation, holding U.S. or German bonds yields 10% in $s

In terms ofE

EEii

e *

10% = 4% + 6%


Putting Goods and Financial Markets TogetherPutting Goods and Financial Markets TogetherPutting Goods and Financial Markets TogetherPutting Goods and Financial Markets Together


The goods market equilibrium depends, in part, on i & E

Output: Y = C(Y-T) + I(Y,i) + G + NX(Y,Y*,E)

The money market determines i

Interest Rate: )(iYLP

M

The interest parity condition implies i & E are negatively related.

Exchange Rate: *1 ii

EE

e


Equilibrium in Financial MarketsEquilibrium in Financial Markets

The Relation Between the Interest Rate and the Exchange Rate Implied by Interest Parity

A lower domestic interest A lower domestic interest rate leads to a higher rate leads to a higher exchange rate—to a exchange rate—to a depreciation of the depreciation of the domestic currency. A domestic currency. A higher domestic interest higher domestic interest rate leads to a lower rate leads to a lower exchange rate—to an exchange rate—to an appreciation of the appreciation of the domestic currency.domestic currency.




The goods market equilibrium depends, in part, on i & E (Continued)

The Open-Economy IS-LM Model

*1

*,,),()(:ISii

EYYNXGiYITYCY

e




Consider:

*1

*,,),()(:ISii

EYYNXGiYITYCY

e

If i increases:

• Direct Effect: I Y

• Indirect Effect: Domestic Currency Appreciates NX Y

In an open economy is the multiplier larger or smaller?In an open economy is the multiplier larger or smaller?


Fiscal PolicyFiscal Policy


G Demand Y Money Demand i makes domesticbonds more attractive domestic currency appreciates the higher i and appreciation reduce demand for domestic goods and offsets some of the effects of G on Y.

The Effects of Policy in an Open EconomyThe Effects of Policy in an Open EconomyThe Effects of Policy in an Open EconomyThe Effects of Policy in an Open Economy

A Summary:


Putting Goods andPutting Goods andFinancial Markets TogetherFinancial Markets Together

The IS-LM Model in the Open EconomyAn increase in the interest An increase in the interest rate reduces output both rate reduces output both directly and indirectly directly and indirectly (through the exchange (through the exchange rate). The IS curve is rate). The IS curve is downward sloping. Given downward sloping. Given the real money stock, an the real money stock, an increase in income increase in income increases the interest increases the interest rate: The LM curve is rate: The LM curve is upward sloping.upward sloping.


The Effects of PolicyThe Effects of Policyin an Open Economyin an Open Economy

The Effects of an Increase in Government SpendingAn increase in An increase in government spending government spending leads to an increase in leads to an increase in output, an increase in output, an increase in the interest rate, and the interest rate, and an appreciation.an appreciation.

20-4

The increase in The increase in government spending government spending affects neither the affects neither the LMLM curve nor the interest-curve nor the interest-parity curve.parity curve.


The Effects of Monetary PolicyThe Effects of Monetary Policyin an Open Economyin an Open Economy

The Effects of a Monetary ContractionA monetary contraction A monetary contraction leads to a decrease in leads to a decrease in output, an increase in output, an increase in the interest rate, and the interest rate, and an appreciation.an appreciation.

The decrease in the The decrease in the money supply affects money supply affects neither the neither the ISIS curve curve nor the interest-parity nor the interest-parity curve.curve.


Fiscal PolicyFiscal Policy


• G: G

• C: Increase in Y C

• I: Ambiguous: Y I & i I

• NX: Decrease: Appreciation & Y NX

The Effects of Policy in an Open EconomyThe Effects of Policy in an Open EconomyThe Effects of Policy in an Open EconomyThe Effects of Policy in an Open Economy

Can we tell what happens to the various components of demand(C, I, G, NX) from the increase in G?



Pegs, Crawling Pegs, Bans, the EMS, & the EuroPegs, Crawling Pegs, Bans, the EMS, & the EuroPegs, Crawling Pegs, Bans, the EMS, & the EuroPegs, Crawling Pegs, Bans, the EMS, & the Euro

Fixed Exchange RatesFixed Exchange RatesFixed Exchange RatesFixed Exchange Rates

Exchange rate policies vary from country to country.

• Flexible exchange rates: The U.S. and Japan

• Fixed exchange rates:

• Pegs: Setting the exchange rate to the dollar or some other currencies. Adjust by evaluation and devaluation.

• Crawling Peg: Setting an exchange rate target.

• EMS: European Monetary System: Maintain bilateral exchange rates or band around a central parity.



Pegging the Exchange Rate and Monetary ControlPegging the Exchange Rate and Monetary ControlPegging the Exchange Rate and Monetary ControlPegging the Exchange Rate and Monetary Control


Assume: A country pegs its exchange at E

Given the interest parity condition:t

tte

tt E

EEii

1

*

And: , thenEEt ttt iE

EEii **

Recall the LM Relation: now i=i* or)(iYLP

M *)(iYL

P

M

Therefore, to maintain , the money supply must be adjustedto keep i at i*.

E


Fiscal Policy UnderFiscal Policy UnderFixed Exchange RatesFixed Exchange Rates

The Effects of a Fiscal Expansion Under Fixed Exchange Rates

Under flexible Under flexible exchange rates, a exchange rates, a fiscal expansion fiscal expansion increases output, from increases output, from YYAA to Y to YBB. Under fixed . Under fixed

exchange rates, output exchange rates, output increases from Yincreases from YAA to to

YYCC..

The central bank must accommodate the resulting increase in the The central bank must accommodate the resulting increase in the demand for money.demand for money.


Good or Bad Idea?Good or Bad Idea?Good or Bad Idea?Good or Bad Idea?



With fixed exchange rates, a country… Gives up a powerful tool for correcting trade imbalances and

changing the level of economic activity. Gives up control of its interest rate. Must accommodate its fiscal policy with monetary policy.

Are there any benefits to fixed exchange rates? This requires a look into the medium-run.

openness in goods and financial markets

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