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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
Econ 302
Openness in Goods and Financial Markets
Slide #1
Openness in Goods Markets
Econ 302
Openness in Goods and Financial Markets
Slide #2
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.
Econ 302
Openness in Goods and Financial Markets
Slide #3
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%)
Econ 302
Openness in Goods and Financial Markets
Slide #4
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
Econ 302
Openness in Goods and Financial Markets
Slide #5
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
Econ 302
Openness in Goods and Financial Markets
Slide #6
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Nominal Exchange Rates: Two Views
1.
The price of domestic currency in terms of foreign
currency.
2.
The price of foreign currency in terms of domestic
currency.
For Example:
April 11, 2004: Nominal exchange between U.S. dollar
and Euro
$ in terms of Euro:
Euro in terms of $s:
Econ 302
$1 = .827 Euro
1 Euro = $1.21
Openness in Goods and Financial Markets
Slide #7
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
Econ 302
Openness in Goods and Financial Markets
Slide #8
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Measuring Changes in the Nominal Exchange Rate (E)
Econ 302
•
Appreciation of domestic currency corresponds to
a decrease in E
•
Depreciation of domestic currency corresponds to
an increase in E
Openness in Goods and Financial Markets
Slide #9
Openness in Goods Markets
The Nominal Exchange Rate, Appreciation, and
Depreciation: EMU and the United States*
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:
Exchange rate increases: E
Econ 302
Openness in Goods and Financial Markets
*From the point of view of the
United States
Slide #10
Nominal Exchange Rates
The Nominal
Exchange Rate
Between the Dollar
While
the Pound,
dollar has
and the
strongly
appreciated
1975-2000
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.
Econ 302
Openness in Goods and Financial Markets
Slide #11
Econ 302
Openness in Goods and Financial Markets
Slide #12
Econ 302
Openness in Goods and Financial Markets
Slide #13
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Question:
Does a decrease in E of U.S. $s for DMs necessarily
mean U.S. citizens can buy more British goods with
their dollars?
Hint: What is the inflation rate in Germany?
Econ 302
Openness in Goods and Financial Markets
Slide #14
From Nominal to
Real 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.
Econ 302
Openness in Goods and Financial Markets
Slide #15
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Expanding the Real Exchange Rate Calculation to the Entire Economic
System
If:
P = U.S. GDP Deflator
P* = British GDP Deflator
E = Pound-dollar nominal exchange rate
Then:
Price of British goods in $s = EP*
Real exchange rate () = EP*
P
NOTE:
Real exchange rates () are index numbers and measure
only relative change.
Econ 302
Openness in Goods and Financial Markets
Slide #16
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
The Construction of the Real Exchange Rate
Price of British
goods in Pound
P*
Price of British
goods in dollars
EP*
Price of U.S.
goods in dollars
P
Econ 302
Openness in Goods and Financial Markets
Real exchange
rate
 = EP*
P
Slide #17
Openness in Goods Markets
The Real Exchange Rate and Real
Appreciation and Real Depreciation*
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:  
Econ 302
Openness in Goods and Financial Markets
*From the point of viewpoint of the
United States
Slide #18
From Nominal to
Real Exchange Rates
Real and Nominal
Exchange Rates
Between the
United States and
Except
for the
the United
difference
trend
Kingdom,in1975reflecting higher
2000
average inflation in the
United Kingdom than
in the United States,
the nominal and the
real exchange rates
have moved largely
together since 1975.
Econ 302
Openness in Goods and Financial Markets
Slide #19
Openness in Goods Markets
The Choice Between Domestic and Foreign Goods
Real Multilateral Exchange Rates
Econ 302
•
The real exchange rate when considering many countries
•
Calculate by using each country’s share of trade as the
weight for that country
Openness in Goods and Financial Markets
Slide #20
From Bilateral to
Multilateral Exchange Rates
The Country Composition of U.S. Merchandise Trade,
2000
Exports to
Countries
$ Billions
Imports from
Percent
$ Billions
Percent
Canada
179
23
232
19
Western
Europe
178
23
243
20
Japan
64
8
146
12
Mexico
86
11
136
11
Asia*
130
17
340
28
OPEC
20
3
42
3
Others
116
15
83
7
Total
773
100
1222
100
Econ *302
Not
including Japan. Openness in Goods and Financial Markets
Slide #21
From Nominal to
Real 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.”
Econ 302
Openness in Goods and Financial Markets
Slide #22
Openness in Goods Markets
Openness in Financial Markets
Foreign Exchange:
Econ 302
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.
Openness in Goods and Financial Markets
Slide #23
Openness in Goods Markets
Openness in Financial Markets
The Relation Between Trade and Financial Flows
The U.S. Balance of Payments, 1998
Current Account
Exports
931
Imports
Trade balance (deficit = -) (1)
Investment income received
Investment income paid
Net investment income (2)
Net transfers received (3)
Current account balance (deficit = -) (1)+(2)+(3)
Capital Account
Increase in foreign holdings of U.S. assets
Increase in U.S. holdings of foreign assets
Net increase in foreign holdings/net capital flow to the U.S.
Statistical discrepancy
Econ 302
1100
-169
242
265
-23
-41
-233
542
305
Openness in Goods and Financial Markets
237
4
Slide #24
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
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)
Econ 302
Openness in Goods and Financial Markets
Slide #25
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
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)
Econ 302
Openness in Goods and Financial Markets
Slide #26
Openness in Goods Markets
Openness in Financial Markets
The Balance of Payments
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 - $305 Billion = -237 Billion)
Statistical discrepancy: Accounts for differences in data sources.
Econ 302
Openness in Goods and Financial Markets
Slide #27
Openness in Goods Markets
Openness in Financial Markets
The Balance of Payments
• The Current Account Balance (+,-) = Capital Account Balance (+,-)
• A Current Account Deficit increases foreign holdings of U.S.
assets and vice versa.
Econ 302
Openness in Goods and Financial Markets
Slide #28
Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
An Example: Choose between U.S. and German 1 yr. bonds
• US Bonds
• it = U.S. nominal interest rate
• (1+it) = Return next year /$purchase of U.S. bonds
Econ 302
Openness in Goods and Financial Markets
Slide #29
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/$1
• i*t = One year nominal interest rate on British Bonds
(in GBP)
•(1/Et)(1+i*t) = Return/GBP invested
Econ 302
Openness in Goods and Financial Markets
Slide #30
Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets (Continued)
An Example: Choose between U.S. and British 1 yr. bonds
• British Bonds
• Eet+1 = expected exchange rate next year
•(1/Et)(1+i*t)Eet+1 = return/$ invested
Note:
Econ 302
Interest rates and exchange rates influence the choice
between domestic and foreign assets.
Openness in Goods and Financial Markets
Slide #31
Openness in Goods Markets
Openness in Financial Markets
Expected Returns from Holding One-Year U.S. or German Bonds
Year t+1
Year t
U.S. bonds
German bonds
Econ 302
$1
1
GBP
 Et
$(1+it)



1
GBP
 Et
Openness in Goods and Financial Markets

(1  i *t )

Slide #32
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:
1
e
1  it   (1  i *t )( E t 1 )
 Et 
U.S. Bond =
Return
Econ 302
British Bond
Return
Openness in Goods and Financial Markets
Slide #33
Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets (Continued)
 1
1  it  
 Et
U.S. Bond
Return
=

(1  i *t )(E et 1)

British Bond
Return
A little reorganizing:
The Interest Parity Condition:
Econ 302
E et 1
1  it  (1  i *t )
Et
Openness in Goods and Financial Markets
Slide #34
Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
Is the assumption that investors hold only assets with the
highest expected return realistic?
Some other considerations:
-- Transaction Costs
-- Exchange Rate Risk
Observation:
The interest parity condition is a good approximation for
developed countries with open, well-organized financial
markets.
Econ 302
Openness in Goods and Financial Markets
Slide #35
Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
Adjusting the interest rate parity condition for changes in the
value of the domestic currency
E et 1
The Interest Parity Condition: 1  i t  (1  i *t )
Et
 E et 1  Et 

Or: 1  i t  (1  i *t )1 
Et


E
Econ 302
e
 Et
Et
t 1
= Expected rate of depreciation of the domestic
currency
Openness in Goods and Financial Markets
Slide #36
Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets (Continued)
An approximation:
i t  i *t 
Econ 302
E
e
t 1
 Et
Et
Openness in Goods and Financial Markets
Slide #37
Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets (Continued)
Remember!
OR:
Econ 302
Arbitrage implies: The domestic interest rate must
be (approximately) equal to the foreign interest
rate plus the expected depreciated rate of the
domestic currency.
i t  i *t 
E
e
t 1
 Et
Et
Openness in Goods and Financial Markets
Slide #38
Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets (Continued)
It’s 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:
August 1992:
Econ 302
100,000 Cruzieros = $1.01
100,000 Cruzieros = $0.75
Openness in Goods and Financial Markets
Slide #39
Openness in Goods Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets (Continued)
E e t 1
 0.75 
(1  i *t )
 (1.369)
  1.016  1  ...
Et
 1.01 
1.6% per month Brazil Vs. 0.2% per month U.S.
U.S. vs. Brazil?
Econ 302
Do not forget: Risk
Transaction Costs
Openness in Goods and Financial Markets
Slide #40
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.
Econ 302
Openness in Goods and Financial Markets
Slide #41
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
Econ 302
Openness in Goods and Financial Markets
Slide #42