Download Lecture 22

Macroeconomics in an Open Economy
Part I:
Trade Flows, Foreign Exchange
How Economies are Connected
• Goods flow between nations
USA sends corn to China
China sends flat screen TVs to the USA
Services flow between nations
USA processes European transactions, via Mastercard
India fields questions on IPAD usage, via call centers
Financial Assets flow between nations
China’s central bank bought billions of U.S. treasuries
U.S. Companies invest $billions building factories in China
USA Buys Chinese made flat screen TVs
China buys U.S government T-Bonds
• U.S. citizens, yearly, buy $475b worth of Chinese goods.
China collects 475 billion DOLLARS
• What do the Chinese with the 475 billion DOLLARS?
Chinese citizens buy $115 billion worth of U.S. goods
• China still has 360 billion Dollars to spend!
China accepts $360 billion IOUs from USA:
China receives $360 billion of U.S. assets:
China, via their central bank, buys U.S. t-bonds
Chinese elites buy U.S. stocks
Chinese elites buy Arizona real estate
The USA runs a trade deficit, therefore they must
run a capital account surplus. LET’S SIMPLIFY:
• USA, in Sept. bought $40b MORE, goods and services,
than we sold to ROW.
• Therefore ROW buys $40 billion MORE of USA assets
than the ROW sells to the USA
• USA invests in factories in China (buy factory asset)
• USA buys European Stock (buy equity asset)
• ROW buys USA treasuries (buy government asset)
• ROW buys shares of USA companies (buy equity asset)
• ROW buys USA houses in Florida (buy tangible asset)
• ROW purchases of USA assets must be $40 billion higher
than USA purchases of ROW assets
Because the U.S. has consistently had a deficit, in its goods ands
service account, it has seen the size of its
NET DEBTOR POSITION grow.
What is also clear? The U.S. owns a very large sum of ROW
Assets. The ‘net’ of our net debtor status is small relative to
gross cross national asset ownership
USA Net debtor position
akin to U.S. government debt
• The US runs a budget deficit.
• Each yearly deficit contributes to an increase in the size of
government debt.
• The USA runs a current account deficit (CAD).
• Each yearly CAD contributes to an increase in the size of
the USA international investment position.
• The USA NET DEBTOR STATUS, is a measure of the
mismatch between USA ownership of foreign assets vs
ROW ownership of USA assets
•
U.S. Net Debtor Status:
the story is the surge in gross flows
The world is much more “inter-owned”
proportionate
U.S. net debtor status ($ trillions)
U.S. net debtor status (share of GDP)
U.S. owned foreign assets ($ trillions)
U.S. owned foreign assets (share of GDP)
Foreign owned U.S. assets ($ trillions)
Foreign owned U.S. assets (share of GDP)
2000
-1.3
-0.10
2014
-8.1
-0.43
6.2
0.49
25.1
1.36
2.9
-7.6
-0.61
-33.4
-1.80
2.9
change:
3.3
Moreover, despite the U.S. ‘net debtor’ status, it collects
more on its assets, than more than it pays on its liabilities.
• Income received in U.S. investments abroad:
$783 billion in 2015
• Income paid on foreign owned U.S. investments:
$600.5 billion in 2015
USA collects $783 billion on $25 trillion (3.1%)
USA pays $600 billion on $33 trillion (1.8%)
Why does USA do have a much better
return on assets (ROA)????
What assets does the U.S. own around the world
What are the biggest holdings, by foreigners, of
U.S,. Assets?
USA owns factories around the world
Foreigners own U.S. treasury bonds and notes
Factories yield more than treasuries.
(Think Baa vs T-notes)
The USA exports and imports as a share of GDP
China’s trade with the USA:
an explosive rise in exports to the USA
Billions of Dollars
1999
2008
2014
Exports to China
13
71
124
Imports from China
82
340
457
balance
-69
-269
-333
China, from 8% to 20% of USA imports
Share of total
1999
2008
2014
Exports to China
2%
5%
7%
Imports from China
8%
16%
20%
The USA trade deficit as a share of GDP
The USA REAL trade deficit as a share of GDP
(NOTE THE DETERIORATION OVER THE LAST FOUR QUARTERS)
Foreign exchange rates
When a firm or consumer wants to buy something—a good, a
service, a financial asset—from a foreigner, that foreigner will
often want to be paid in their own currency.
The rate at which one country’s currency can be traded for
another’s is known as the nominal exchange rate.
Example: If one U.S. dollar can purchase 100 Japanese yen, then
the exchange rate is ¥100 = $1; or alternatively, ¥1 = $0.01.
Economists also calculate the real exchange rate, which corrects
the nominal exchange rate for differences in prices of goods and
services between countries.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
16 of 39
Exchange Rates: volatile relative prices of
currencies:
Q4:2006
Euro
Yen
(Euro area)
(Japan)
1.32$/€
120Y/$
Renminbi
(China)
7.8R/$
Ruble
(Russia)
26.3RB/$
Q4:2012
1.32$/€
85Y/$
6.3R/$
30.3RB/$
Q4:2016
1.07$/€
109Y/$
6.9R/$
64.8RB/$
Exchange Rates PROFOUNDLY affect investors:
Look at an investor in Brazil’s stock market:
(prize of Brazilian stocks in Brazilian reals)
Now look at Brazilian stock market, if we
evaluate the U.S. dollar value of Brazilian Stocks
How would the currency swings affect the
returns of a U.S. investor?
Brazilian Stock Market
(Index level)
(brazilian reals) percent
(thousands)
change
12/30/2005
12/30/2010
12/30/2015
33.4
69.3
47.4
107%
-32%
Brazilian Stock Market
(Index level)
(U.S. dollars)
percent
(thousands)
change
14.4
41.7
12.5
reals
per
dollar
2.33
190%
-70%
1.66
3.80
We can think about exchange rates using supply
and demand curves:
Supply and Demand, Foreign Exchange Markets:
(Two sides of the same coin)
yen per
dollar
160
140
120
100
80
dollar
per yen
0.0063
0.0071
0.0083
0.0100
0.0125
dollars
traded
(dollar
demand)
2
4
6
8
10
yen
traded
(yen
supply)
320
560
720
800
800
The demand curve for dollar vs yen EQUALS
The supply curve for yen vs dollars:
Shifts in demand and effects on the
exchange rate
• 1. Changes in demand for U.S. goods and changes in
demand for foreign goods change demand for the dollar.
• 2.Changes in desire to buy U.S. financial assets and
changes in desire to buy foreign assets change the
demand for the U.S. dollar.
• 3. Changes in expectations of currency traders about the
likely direction of the dollar changes the demand for U.S.
dollars
We can see how a USA boom would affect the
dollar/yen market—and the yen/dollar market
(Effect #1: strong demand for goods)
• Strong USA consumer lifts USA demand for all goods. This
includes demand for Japanese goods.
• Increased demand for Japanese goods leads to increased
demand for Japanese Yen
(USA needs more Japanese yen to buy more Japanese goods)
First effect from goods demand:
supply of $ UP and demand for Yen UP
yen/$ price falls, qty. of $ traded rises (graph 1)
$/yen price rises, qty. of Yen traded rises (graph 2)
A boom in U.S. also affects interest rates and
this affects both the dollar/yen market—and the
yen/dollar market
(Effect #2: strong demand for U.S. bonds)
• Strong USA economy lifts USA interest rates. This
increases Japanese demand for U.S. assets.
• Increased demand for USA assets leads to increased
demand for U.S. dollar
(Japanese need more dollars to buy more USA bonds)
Second effect from investment demand
Demand for $ UP and supply of Yen UP
yen/$ price rises, qty. of $ traded rises (graph 1)
$/yen price falls, qty. of Yen traded rises (graph 2)
Exchange rate movements, we can see,
will be driven by changing demand for
foreign goods and for foreign assets.
• The U.S. has run a trade deficit for 40 years.
• That means for 40 years, the USA has been buying ROW
currencies and handing out dollars, in order to pay for
ROW goods purchases in excess of the goods foreigners
bought from the USA.
What might the U.S. dollar have done if currencies were
driven ONLY by supply/demand of global trade of goods
and services?
Currency movements, however, reflect supply/demand for
tradable goods and for assets. Healthy appetite for U.S. assets,
1995-2015, more than made up for the trade deficit and the dollar
rose.
The Dollar Index: Up from 90 to 124
The Real Dollar Index: Up from 100 to 115
Real Exchange Rates
the Same concept as real interest rates
•
•
•
•
Recall Bert and Ernie
Bert lent Ernie $1,000, asking for $1,050 one year later.
Bert was demanding he be paid 5%, so i = 5%
Bert wanted to buy the bike for $1,000 and helmet for $50
• But inflation, π, was 10% over the next year.
• The bike cost $1,100. Bert could not buy the bike.
• Fisher equation:
i=r+π
• Bert earned -5% in real or PURCHASING POWER TERMS
REAL EXCHANGE RATES SEEK OUT CHANGES
IN PURCHASING POWER
REAL EXCHANGE RATE
(Nominal exchange rate)
=
x(
𝑫𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝑷𝒓𝒊𝒄𝒆 𝑳𝒆𝒗𝒆𝒍
)
𝑭𝒐𝒓𝒆𝒊𝒈𝒏 𝑷𝒓𝒊𝒄𝒆 𝑳𝒆𝒗𝒆𝒍
If our goal is to evaluate the change in the U.S.
dollar’s relative power to purchase goods in Europe,
we need to know
TWO things:
1. what did the $ do, relative to the euro
2. what did prices in USA do, relative to Europe
A 20% rise for the $ versus the €
5% Price increase in USA
2% Price increase in Germany
The Mercedes: much cheaper than Cadillac
percent
change
€/$
Cadillac, ($ price)
Mercedes (€/CAR)
Mercedes ($/CAR)
1.25
4,000
3,200
4,000
1.0
4,200
3,264
3,264
20%
5%
2%
-18%
We can calculate the real exchange rate for USA.
We need the nominal exchange rate, USA vs. ROW
USA price index, ROW price index:
USA Price ROW Price
Index Index
1995 153
2015 238
56%
2.2%
138
255
85%
3.1%
1.11
0.93
30%
0.9%
USA Price Index is 11% Higher than ROW Price Index
USA Price index is 7% Lower than ROW Price Index
USA Prices rose by 18% less than ROW Prices
Avg. annual ROW inflation: 0.9 percentage points faster
Real Exchange Rate up 12%
Nominal Up 33%
Rising prices ROW vs USA tempers increased
PURCHASING POWER of climbing US dollar
Real
exchange
rate
1995
2015
100
112
12%
Equals
Equals
Equals
nominal
exchange
rate
90
120
33%
times
domestic price level/
foreign price level
X
X
153/138
238/255
Free markets in currencies, not always the rule
When thinking about ‘Open Economies’
we must return to thinking about monetary
policy:
• What do central banks do?
• They usually buy and sell treasury bills.
• Why? We said, from a closed economy perspective, to
drive one of two targets:
They can use the quantity equation and target money:
MV = PY
They can think of a loanable funds model and target interest
rates:
ff = π + 0.5 X(π – π*) + (U* - U) +2
Or, central banks can use monetary
policy to target their exchange rate:
How did the renminbi stay steady vs the dollar as
the U.S. deficit with China soared?
• China pegged their currency:
• We bought TVs
• The Chinese central bank bought T bonds
Cumulative purchases? Over 15 years,
China bought nearly $4 trillion of U.S. bonds
Suddenly 2015’s Summer: They began selling!
A central bank can print money, increase supply,
and drive its currency lower.