The Open Economy Terminology

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The Open EconomyTerminology
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Openness

• Three distinct dimensions
• Openness in goods markets trade.
• Openness in financial markets.
• Openness in factor marketsthe ability of firms
  to choose where to locate production, and workers
  to choose where to work.

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Openness in Goods Markets(U.S. exports and
imports)
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Exports and Imports
Ratios of Exports to GDP for Selected Countries, 2003 Ratios of Exports to GDP for Selected Countries, 2003 Ratios of Exports to GDP for Selected Countries, 2003 Ratios of Exports to GDP for Selected Countries, 2003 Ratios of Exports to GDP for Selected Countries, 2003 Ratios of Exports to GDP for Selected Countries, 2003
Country Export Ratio () Export Ratio () Country Export Ratio () Export Ratio ()
United States 10 Switzerland 42
Japan 12 Austria 51
Germany 36 Netherlands 62
United Kingdom 25 Belgium 79
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Exports and Imports

• An alternative index of openness is the
  proportion of aggregate output composed of
  tradable goodsgoods that compete with foreign
  goods in either domestic markets or foreign
  markets.
• Estimates are that tradable goods represent
  around 60 of aggregate output in the United
  States today.

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The Choice Between DomesticGoods and Foreign
Goods

• 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.

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Terminology for a Flexible Exchange Rate Regime

• The nominal exchange rate is the price of the
  domestic currency in terms of the foreign
  currency.
• An appreciation of the domestic currency is an
  increase in the price of the domestic currency in
  terms of the foreign currency.
• A depreciation of the domestic currency is a
  decrease in the price of the domestic currency in
  terms of the foreign currency.

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Terminology for a Fixed Exchange Rate Regime

• When countries operate under fixed exchange rates
  (maintain a constant exchange rate between them),
  two other terms used are
• Revaluations, rather than appreciations, which
  are increases in the exchange rate, and
• Devaluations, rather than depreciations, which
  are decreases in the exchange rate.

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Nominal Exchange Rates

• The Nominal Exchange Rate Between the Dollar, the
  Yen and the German Mark (Euro after 1999),
  1960-2004

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From Nominal toReal Exchange Rates

• The Construction of the Real Exchange Rate

P price of British goods in pounds E price
of pounds in terms of dollars P price of US
goods in dollars
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From Nominal toReal Exchange Rates

• An increase in the relative price of domestic
  goods in terms of foreign goods is called a real
  appreciation, which corresponds to an increase in
  the real exchange rate, ?.
• A decrease in the relative price of domestic
  goods in terms of foreign goods is called a real
  depreciation, which corresponds to a decrease in
  the real exchange rate, ?.

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From Nominal toReal Exchange Rates

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

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From Nominal toReal Exchange Rates

• The U.S. multilateral Effective Real Exchange
  Rate, 1973-2004

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The Big Mac Index (6/2006)
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Openness in Financial Markets

• The purchase and sale of foreign assets implies
  buying or selling foreign currencysometimes
  called foreign exchange.
• Openness in financial markets allows
• Financial investors to diversifyto hold both
  domestic and foreign assets.
• Allows countries to run trade surpluses and
  deficits.

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The Balance of Payments (BOP)

• The balance of payments account summarizes a
  countrys transactions with the rest of the world.

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The U.S. Balance of Payments - 2005
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The Choice BetweenDomestic and Foreign Assets

• The decision whether to invest abroad or at home
  depends on
• Interest rate differences.
• Expectation of what will happen to the nominal
  exchange rate.

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Expectations and Investment Decisions

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

This is the uncovered interest parity relation
(UIP)
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Interest Rates and Exchange Rates

• Arbitrage implies that the domestic interest rate
  must be (approximately) equal to the foreign
  interest rate plus the expected depreciation rate
  of the domestic currency.

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Interest Rates and Exchange Rates

• The assumption that financial investors will hold
  only the bonds with the highest expected rate of
  return is obviously too strong, for two reasons
• It ignores transaction costs.
• It ignores risk.
• It assumes no restrictions on the movements of
  capital across borders (open financial markets).

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Interest Rates and the Interest Parity Condition
Three-Month Nominal Interest Rates in the United
States and in the United Kingdom since 1970
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Conclusions

• The choice between identical domestic goods and
  foreign goods depends on the exchange rate.
• The choice between identical domestic and foreign
  assets depends on
• domestic interest rates
• foreign interest rates
• expected movement in the exchange rate