Openness in Goods and Financial Markets

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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
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Openness in Goods Markets
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Openness in Goods Markets
Observations of U.S. Exports and Imports

• 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.

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Openness in Goods Markets
Measuring the Degree of Openness

• 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)

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Openness in Goods Markets
A Look Around the World

• Country Export Ratio () Country Export
  Ratio ()
• United States 12 Switzerland 40
• Japan 10 Austria 38
• Germany 23 Belgium 73
• United Kingdom 29 Luxembourg 91

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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
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Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Nominal Exchange Rates Two Views
For Example
April 11, 2004 Nominal exchange between U.S.
dollarand Euro
in terms of Euro 1 .827 EuroEuro in terms
of s 1 Euro 1.21
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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 Euro
(foreign)is the price of Euro in terms of E
1.21
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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

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Openness in Goods Markets
Nominal Exchange Rate, E (Price of Euro in terms
of dollars) Appreciation of the dollar Price of
dollars in Euro increases Equivalently Price
of Euro in dollars decreases
Equivalently Exchange rate decreases
E? Depreciation of the dollar Price of dollars
in Euro decreases Equivalently Price of
Euro in dollars increases Equivalently Excha
nge rate increases E?
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Nominal Exchange Rates

• The Nominal Exchange Rate Between the Dollar and
  the Pound, 1975-2000

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.
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Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Question
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From Nominal toReal Exchange Rates

• If the price of a Jaguar is 30,000, and a pound
  is worth 1.5 dollars, then the price of the
  Jaguar in dollars is 30,000 x 1.5 45,000.
• If a Cadillac is 40,000, then the relative price
  of a Jaguar in terms of Cadillacs is
  45,000/40,000 1.12
• To generalize this example to all of the goods in
  the economy, we use a price index for the
  economy, or the GDP deflator.

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Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Expanding the Real Exchange Rate Calculation to
the Entire EconomicSystem
NOTE Real exchange rates (?) are index numbers
and measure only relative change.
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Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
The Construction of the Real Exchange Rate
Price of Britishgoods in PoundP
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Openness in Goods Markets
Real Exchange Rate, ? (Price of British goods in
terms of U.S. goods) Real Appreciation Price of
U.S. goods in terms of British goods increases
Equivalently Price of British goods in terms
of U.S. goods decreases Equivalently Real
exchange rate decreases ? ? Real
Depreciation Price of U.S. goods in terms of
British goods decreases Equivalently Price
of British goods in terms of U.S. goods
increases Equivalently Real exchange rate
decreases ? ?
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From Nominal toReal Exchange Rates

• Real and Nominal Exchange Rates Between the
  United States and the United Kingdom, 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.
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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 countrys share of
  trade as the weight for that country

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From Bilateral toMultilateral Exchange Rates
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From Nominal toReal Exchange Rates

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

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.
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Openness in Goods Markets
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.

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Openness in Goods Markets
Openness in Financial Markets
The Relation Between Trade and Financial
FlowsThe U.S. Balance of Payments, 1998
Current Account Exports 931 Imports 1100 Trade
balance (deficit -) (1) -169 Investment income
received 242Investment income paid 265 Net
investment income (2) -23 Net transfers
received (3) -41Current 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
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Openness in Goods Markets
Openness in Financial Markets
The Balance of Payments
The Current Account (Above the Line)
All recorded payments to and from the rest of the
world
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Openness in Goods Markets
Openness in Financial Markets
The Balance of Payments (Continued)
The Current Account (Above the Line)
All recorded payments to and from the rest of the
world
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Openness in Goods Markets
Openness in Financial Markets
The Balance of Payments
The Capital Account
Statistical discrepancy Accounts for
differences in data sources.
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Openness in Goods Markets
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.

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Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
An Example Choose between U.S. and German 1 yr.
bonds

• US Bonds
• it U.S. nominal interest rate
• (1it) Return next year /purchase of U.S.
  bonds

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Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
(Continued)
An Example Choose between U.S. and British 1
yr. bonds

• German Bonds
• Et nominal exchange between the and GBP
• (1/Et) GBP/1
• it One year nominal interest rate on British
  Bonds (in GBP)
• (1/Et)(1it) Return/GBP invested

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Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
(Continued)
An Example Choose between U.S. and British 1
yr. bonds

• British Bonds
• Eet1 expected exchange rate next year
• (1/Et)(1it)Eet1 return/ invested

Note Interest rates and exchange rates influence
the choice between domestic and foreign assets.
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Openness in Goods Markets
Openness in Financial Markets
Expected Returns from Holding One-Year U.S. or
German Bonds
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Openness in Goods Markets
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 British bonds, they
must have the same return.
Or
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Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
(Continued)
A little reorganizing
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Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
Is the assumption that investors hold only assets
with thehighest expected return realistic?
Some other considerations-- Transaction
Costs-- Exchange Rate Risk
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Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
Adjusting the interest rate parity condition for
changes in thevalue of the domestic currency
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Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
(Continued)
An approximation
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Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
(Continued)
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Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
(Continued)
Its September 1993...

• Brazilian bonds pay a monthly interest of 36.9
• U.S. bonds pay a monthly interest of 0.2

Buy Brazilian?
What about currency (Cruziero) depreciation? July
1992 100,000 Cruzieros 1.01 August
1992 100,000 Cruzieros 0.75
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Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
(Continued)
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Interest Rates and Exchange Rates

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

U.S. and U.K. nominal interest rates have largely
moved together over the last 25 years.
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Openness in Goods Markets
Some Conclusions
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