Chapter 18: Openness in Goods and Financial Markets

1
Chapter 18 Openness in Goods and Financial
Markets

• 18-1 Openness in Goods Markets
• 18-2 Openness in Financial Markets
• 18-3 Conclusions and a Look Ahead

2
18-1 Openness in Goods Markets

• The Choice between Domestic and Foreign Goods
• Nominal Exchange Rates
• Real Exchange Rates

3
The Choice between Domestic and Foreign Goods

• Small countries tend to trade more
• They cant produce everything they need
  efficiently
• Geographically isolated countries tend to trade
  less
• Transportation costs discourage trade
• Countries generally trade the most with their
  neighbors
• Africa and South America are exceptions to this
  rule

4
Nominal Exchange Rates

• This is the price of a foreign currency in terms
  of the domestic currency, E
• 1 unit of the foreign currency costs an American
  how much?
• The media frequently reverses this ratio for
  convenience purposes
• For example. they typically will quote our
  exchange rate with Japan as 100, rather than .01

5
Digression 1 Exchange Rate Systems

• Exchange rates are determined by a system that a
  government chooses, and hopefully is able to
  maintain
• Fixed the rate of exchange between the currency
  and something else of value (like another
  currency or an asset like gold) is held constant
  at some value (ideally forever)
• Flexible the rate changes every time any two
  parties negotiate a trade of one currency for
  another
• Some governments are uncomfortable allowing truly
  flexible exchange rates, so if they interfere a
  lot in the process their exchange rates may be
  referred to as floating

6
Digression 2 Terminology for Changes in Exchange
Rates

• Fixed exchange rates are not supposed to change,
  but governments often have to any way.
• Almost always, this is a reduction in the
  purchasing power of their currency overseas, and
  is known as a devaluation
• Flexible exchange rates change all the time
• Appreciation means your currency buys more
  overseas
• Depreciation means it buys less overseas

7
Real Exchange Rates

• Prices for identical goods may also differ
  between countries
• Suppose a good costs P in a foreign country
  (denominated in their currency) and P here (in )
• If you bought the good in the foreign country,
  you would first have to convert your dollar into
  E units of foreign currency
• So, EP is the price you pay in
• The real exchange rate is then e EP/P

8
18-2 Openness in Financial Markets

• The Balance of Payments
• The Choice between Domestic and Foreign Assets

9
The Balance of Payments

• This is a summary of a countries international
  transactions. It is divided into two parts
• The current account captures all goods, services,
  and income related trade
• The capital account captures all asset exchanges
• There is always a positive statistical
  discrepancy in the balance of payments, since
• Exports are not hidden, and are counted in full
• Imports are often hidden, and not counted in full

10
The Choice between Domestic and Foreign Assets

• Rates of return also differ between countries
• The comparison is similar to calculating a real
  exchange rate, but we also have to include
  expectations of future exchange rates
• The problem is that in practice you dont know
  what that exchange rate will be in the future
  when you make the decision

11
The Choice between Domestic and Foreign Assets
Contd.

• Domestically
• You invest 1
• You get back (1i) after 1 period
• Alternatively
• You take your 1, and convert it into 1/Et units
  of foreign currency
• You invest it there and get back (1i)/Et after
  1 period
• You convert it back to Et1(1i)/Et dollars
• Ideally, these should be equivalent, so that
• (1i) Et1(1i)/Et, which is called
  (uncovered) interest parity

12
18-3 Conclusions and a Look Ahead

• Goods trade is determined by real exchange rates
• Asset trade is determined by changes in interest
  rate parity