Openness in Goods and Financial Markets

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Openness in Goods and Financial Markets
Openness in Financial Markets
The Relation Between Trade and Financial
FlowsThe U.S. Balance of Payments, 1998
Current Account Exports 931 Imports 1100 Trade
balance (deficit -) (1) -169 Investment income
received 242Investment income paid 265 Net
investment income (2) -23 Net transfers
received (3) -41Current account balance
(deficit -) (1)(2)(3) -233 Capital
AccountIncrease in foreign holdings of U.S.
assets 542Increase in U.S. holdings of foreign
assets 305Net increase in foreign holdings/net
capital flow to the U.S. 237Statistical
discrepancy 4
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Openness in Goods and Financial 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
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Openness in Goods and Financial 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
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Openness in Goods and Financial Markets
Openness in Financial Markets
The Balance of Payments
The Capital Account
Statistical discrepancy Accounts for
differences in data sources.
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Openness in Goods and Financial 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.

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Openness in Goods and Financial 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
• (1it) Return next year /purchase of U.S.
  bonds

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Openness in Goods and Financial Markets
Openness in Financial Markets
Expected Returns from Holding One-Year U.S. or
German Bonds
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Openness in Goods and Financial 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 German bonds, they
must have the same return.
Or
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Openness in Goods and Financial Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
(Continued)
A little reorganizing
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Openness in Goods and Financial Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
Is the assumption that investors hold only assets
with thehighest expected return realistic?
Some other considerations-- Transaction
Costs-- Exchange Rate Risk
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Openness in Goods and Financial Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
Adjusting the interest rate parity condition for
changes in thevalue of the domestic currency
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Openness in Goods in Financial Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
(Continued)
An approximation
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Openness in Goods and Financial 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

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The Goods Market in an Open Economy
Expanding the Goods Market Model (IS) to address
these questions

• Can a foreign expansion stimulate domestic
  economic growth?
• Should macroeconomic policies be coordinated
  between countries?

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The IS Relation in the Open Economy
The Open Economy Demand for Domestic Goods...
Z ? C I G - ?Q X
? Q The value of imports in terms of domestic
goods X Exports
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The IS Relation in the Open Economy
The Determinants of the Demand for Domestic Goods
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The IS Relation in the Open Economy
The Open Economy Graphically
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The IS Relation in the Open Economy
The Open Economy Graphically
Demand for Domestic Goods Including Exports (ZZ)
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The IS Relation in the Open Economy
Equilibrium Output and the Trade Balance
Goods Market Equilibrium Y Z
Y C(Y-T) I(Y,r) G - ? Q(Y, ?) X(Y, ?)
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The IS Relation in the Open Economy
Equilibrium Output and the Trade Balance
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The IS Relation in the Open Economy
Increases in Demand, Domestic or Foreign
Increases in Domestic Demand

• Assume G is increased to increase domestic
  demand Y

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The IS Relation in the Open Economy
Increases in Demand, Domestic or Foreign
The Impact of Increasing G in an Open Economy
Some Observations

• A trade deficit is created
• The multiplier is smaller

Question How are the trade deficit and the
smaller multiplier related?
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The IS Relation in the Open Economy
Increases in Demand, Domestic or Foreign
The Impact of Increasing G in an Open Economy
Observation
The more open an economy, the smaller the
impactof a change in domestic demand on output.
Example
Belgium Ratio of imports to GDP is 70.
Therefore, 70 of an increase in domestic demand
will go for imports. U.S. Import ratio
13 Even in the U.S. domestic policy is reduced
by the open economy.
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The IS Relation in the Open Economy
Increases in Demand, Domestic or Foreign
Increases in Foreign Demand
A New equilibrium
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The IS Relation in the Open Economy
Increases in Demand, Domestic or Foreign
Increases in Foreign Demand
A Summary

• Increase in Y increases demand for domestic
  goods, exports grow and equilibrium Y increases.
• The increase in Y increases imports. The
  increase in imports is less than the growth in
  exports.

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The IS Relation in the Open Economy
Increases in Demand, Domestic or Foreign
Two Observations
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The IS Relation in the Open Economy
Depreciation, the Trade Balance, and Output
The Depreciation of a Currency ()
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The IS Relation in the Open Economy
Depreciation, the Trade Balance, and Output
Depreciation and the Trade Balance The
Marshall-LernerCondition
Net Exports NX ? X - ? Q NX X(Y, ?) - ?
Q(Y, ?)
Depreciation (increase in ?) affects the trade
balance in three ways
The Marshall-Lerner Condition For depreciation
to improve thetrade balance--the increase in X
and decrease in Q is greaterthan the increase in
? Q.
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The IS Relation in the Open Economy
Depreciation, the Trade Balance, and Output
The Effects of a Depreciation
Tracing a Depreciation Through the Economy
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The IS Relation in the Open Economy
Depreciation, the Trade Balance, and Output
Combining Exchange Rate and Fiscal Policies
Objective Reduce the trade deficit without
changing YPolicy Balance depreciation and
fiscal constraint
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The IS Relation in the Open Economy
Depreciation, the Trade Balance, and Output
Combining Exchange Rate and Fiscal Policies
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The IS Relation in the Open Economy
Looking at Dynamics The J-Curve
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The IS Relation in the Open Economy
The Real Exchange Rate and the Ratio of Net
Exports to GDP U.S., 1980-1990
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The IS Relation in the Open Economy
Looking at Dynamics - The J-Curve
The U.S. - 1980-1990
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The IS Relation in the Open Economy
Saving, Investment, and Trade Deficits
Subtract C T from both sides S I G - T -
? Q X
And using NX ? X - ? Q
NX S (T - G) - I
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The IS Relation in the Open Economy
Saving, Investment, and Trade Deficits
NX S (T-G) - I
Observations

• Trade surplus Excess of saving over investment
• Trade deficit Excess of investment over saving
• An increase in investment must be reflected
  either in an increase in private or public
  saving or in a deterioration of the trade
  balance.
• An increase in the budget deficit must be
  reflected in an increase in private saving,
  decrease in investment, or a deterioration of
  the trade balance.
• A country with a high saving rate, public and
  private, must have a high investment rate or a
  large trade surplus.

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The IS Relation in the Open Economy
Increases in Demand, Domestic or Foreign
Games that Countries Play
A Scenario...

• There is a group of countries that are trading
  partners.
• The countries are in a recession
• The countries have balanced trade

Questions
Why would any one country be reluctant to expand
domesticdemand? What would be the impact on the
trade balance if all countriesincreased domestic
demand together?
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The IS Relation in the Open Economy
Increases in Demand, Domestic or Foreign
Games that Countries Play
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Output, the Interest Rate, and the Exchange Rate
Equilibrium in the Goods Market (IS)
Output - Demand for Domestic Goods
Y C(Y-T) I(Y,r) G - ?Q(Y, ?) X(Y, ?)
( ) (,-) (, -)
( , )
Net Exports X - ? Q NX(Y,Y, ?) ?
X(Y, ?) - ? Q(Y,G)
Y C(Y-T) I(Y,r) G NX(Y,Y, ?)
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Output, the Interest Rate, and the Exchange Rate
Equilibrium in the Goods Market (IS)
Some Assumptions

• The domestic price level is given (?e O r
  i)
• The foreign price level is given (? E move
  together) P/P I ? E

New Equilibrium Statement
Y C(Y-T) I(Y,i) G NX(Y,Y, E) (
) (,-) (- , , )
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Output, the Interest Rate, and the Exchange Rate
Equilibrium in the Financial Markets
Money vs. Bonds
Money Equilibrium in the money market in an
open economy
Supply of money Demand for money
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Output, the Interest Rate, and the Exchange Rate
Equilibrium in the Financial Markets
Money vs. Bonds
Domestic Bonds vs. Foreign Bonds Equilibrium
in domestic bonds and foreign bonds
Interest parity relation
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Output, the Interest Rate, and the Exchange Rate
Equilibrium in the Financial Markets
Money vs. Bonds
Domestic Bonds vs. Foreign Bonds (Continued)
Equilibrium in domestic bonds and foreign bonds
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Output, the Interest Rate, and the Exchange Rate
Equilibrium in the Financial Markets
Domestic Bonds vs. Foreign Bonds
?i ??Exchange Rate (appreciation of domestic
currency) ?i?? Exchange Rate (depreciation of
domestic currency)
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Output, the Interest Rate, and the Exchange Rate
Equilibrium in the Financial Markets
Domestic Bonds vs. Foreign Bonds
An example The adjustment of exchange markets
to an increase in U.S. interest rates above
German rates

• Initially i i EEe

• U.S. monetary contraction increases i, if E is
  constant U.S. bonds become more attractive i gt
  i
• To buy U.S. bonds, Germans must sell German
  bonds for DM, then sell DM for s and the
  appreciates.

To maintain equilibrium

• ? the appreciation until the expected future
  depreciation compensates for the increase in i

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Output, the Interest Rate, and the Exchange Rate
Equilibrium in the Financial Markets
Domestic Bonds vs. Foreign Bonds
A numeric example
Assume U.S. i Di 4

• Then U.S. i increases to 10
• The will appreciate 6
• At a 6 appreciation, holding U.S. or German
  bonds yields 10 in s

10 4 6
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Output, the Interest Rate, and the Exchange Rate
Putting Goods and Financial Markets Together
The goods market equilibrium depends, in part, on
i E
Output Y C(Y-T) I(Y,i) G NX(Y,Y,E)
The money market determines i
The interest parity condition implies i E are
negatively related.
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Equilibrium in Financial Markets

• The Relation Between the Interest Rate and the
  Exchange Rate Implied by Interest Parity

A lower domestic interest rate leads to a higher
exchange rateto a depreciation of the domestic
currency. A higher domestic interest rate leads
to a lower exchange rateto an appreciation of
the domestic currency.
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Output, the Interest Rate, and the Exchange Rate
Putting Goods and Financial Markets Together
The goods market equilibrium depends, in part, on
i E (Continued)
The Open-Economy IS-LM Model
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Output, the Interest Rate, and the Exchange Rate
Putting Goods and Financial Markets Together

• If i increases
• Direct Effect ?I ? ?Y
• Indirect Effect Domestic Currency
  Appreciates? NX? ? ?Y

In an open economy is the multiplier larger or
smaller?
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Output, the Interest Rate, and the Exchange Rate
The Effects of Policy in an Open Economy
Fiscal Policy
A Summary
?G? ?Demand ? Y ? ?Money Demand ? ?i makes
domesticbonds more attractive ? domestic
currency appreciates ? the higher i and
appreciation reduce demand for domestic goods
and offsets some of the effects of ?G on Y.
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Putting Goods andFinancial Markets Together

• The IS-LM Model in the Open Economy

An increase in the interest rate reduces output
both directly and indirectly (through the
exchange rate). The IS curve is downward
sloping. Given the real money stock, an increase
in income increases the interest rate The LM
curve is upward sloping.
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The Effects of Policyin an Open Economy
20-4

• The Effects of an Increase in Government Spending

An increase in government spending leads to an
increase in output, an increase in the interest
rate, and an appreciation.
The increase in government spending affects
neither the LM curve nor the interest-parity
curve.
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The Effects of Monetary Policyin an Open Economy

• The Effects of a Monetary Contraction

A monetary contraction leads to a decrease in
output, an increase in the interest rate, and an
appreciation.
The decrease in the money supply affects neither
the IS curve nor the interest-parity curve.
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Output, the Interest Rate, and the Exchange Rate
The Effects of Policy in an Open Economy
Fiscal Policy
Can we tell what happens to the various
components of demand(C, I, G, NX) from the
increase in G?

• G G?
• C Increase in ?Y ? ?C
• I Ambiguous ?Y ? ? I ?i ? ?I
• NX Decrease Appreciation ? Y ? ?NX

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Output, the Interest Rate, and the Exchange Rate
Fixed Exchange Rates
Pegs, Crawling Pegs, Bans, the EMS, the Euro
Exchange rate policies vary from country to
country.

• Flexible exchange rates The U.S. and Japan
• Fixed exchange rates
• Pegs Setting the exchange rate to the dollar
  or some other currencies. Adjust by evaluation
  and devaluation.
• Crawling Peg Setting an exchange rate target.
• EMS European Monetary System Maintain
  bilateral exchange rates or band around a
  central parity.

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Output, the Interest Rate, and the Exchange Rate
Fixed Exchange Rates
Pegging the Exchange Rate and Monetary Control
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Fiscal Policy UnderFixed Exchange Rates

• The Effects of a Fiscal Expansion Under Fixed
  Exchange Rates

Under flexible exchange rates, a fiscal expansion
increases output, from YA to YB. Under fixed
exchange rates, output increases from YA to YC.
The central bank must accommodate the resulting
increase in the demand for money.
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Output, the Interest Rate, and the Exchange Rate
Fixed Exchange Rates
Good or Bad Idea?

• With fixed exchange rates, a country
• Gives up a powerful tool for correcting trade
  imbalances and changing the level of economic
  activity.
• Gives up control of its interest rate.
• Must accommodate its fiscal policy with monetary
  policy.
• Are there any benefits to fixed exchange rates?
  This requires a look into the medium-run.