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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.