Lecture 10

Openness in Goods and Financial Markets
Chapter 18: Openness in Goods and Financial Markets
Chapter 18
Q: How does openness modify the closed economy, IS-LM/AD-AS
model?
A: An open economy allows domestic residents to choose between
domestic and foreign goods and between domestic and foreign assets.
The first choice is governed by the relative price of foreign goods; the
second by relative returns on foreign assets.
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 6/e Olivier Blanchard
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Openness in Goods and Financial Markets
Openness has three distinct dimensions:

1. Openness in goods markets. Free trade restrictions
include tariffs and quotas.
2. Openness in financial markets - Capital controls
3. Openness in factor markets. The ability of firms to

choose where to locate production, and workers to
choose where to work, e.g. North American Free Trade
Agreement (NAFTA).
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18-1 Openness in Goods Markets

Exports and Imports
Figure 18 - 2
U.S. Exports and
Imports as Ratios of
GDP since 1960
Since 1960, exports and
imports have more than
doubled in relation to GDP.
The United States has
become a much more
open economy.
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Exports and Imports
The behavior of exports and imports in the United States

is characterized by:
The U.S. economy is becoming more open over
time, and trades more than twice as much (relative
to its GDP) with the rest of the world as it did just 50
years ago.
Although imports and exports have followed broadly
the same upward trend, since the early 1980s
imports have consistently exceeded exports.
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Exports and Imports

A good index of openness is the proportion of
aggregate output composed of tradable goodsor
goods that compete with foreign goods in either
domestic markets or foreign markets.
Estimates are that tradable goods represent around
60% of aggregate output in the United States today.
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Table 18-1 Ratios of Exports to GDP for Selected OECD

Countries, 2010
The main factors behind differences are geography and size:

- Distance from other markets.
- Size: The smaller the country, the more it must specialize in
producing and exporting only a few products and rely on
imports for other products.
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The Choice between Domestic Goods and Foreign Goods
In a closed economy, people face one decision:

Save, or buy(consume).
In an open economy, they have two decisions:

Save, or buy.
Buy domestic, or buy foreign.
(Central to the second decision is the real exchange rate,
which is not directly observable. We start by looking at
nominal exchange rate.)
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Nominal Exchange Rates
Nominal exchange rates (E) between two currencies

can be quoted in one of two ways:
As the price of the domestic currency in terms of
the foreign currency.
As the price of the foreign currency in terms of the
domestic currency.
Note: Either is fine. We adopt the first definition in this
book.
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Countries can operate under (chapter 21)

fixed-exchange-rate system: exchange rates were set at officially
determined level.
e.g. the Bretton Woods system, Hong Kong currency board, etc.
or flexible(floating)-exchange-rate system: exchange rates are
determined by conditions of supply and demand.
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Figure 18-3 The Nominal Exchange Rate between the Dollar and the
Pound since 1971
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Note the two main characteristics of the figure 18-3:

The trend increase in the exchange rate.
The large fluctuations in the exchange rate.

Note: nominal exchange rate (E) real exchange rate ()
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From Nominal to Real Exchange Rates
Example : Compare the price of hamburger:

Tokyo(foreign) vs. Kansas City(domestic)
E=80 /$ (yen per dollar)
P=$2/unit (in Kansas City)
P*=800/unit (in Tokyo)
A dollar is worth 80 yen, so the price of hamburger in yen in Kansas
City is $2*80/$=160
The price of hamburger in Tokyo is 800
Real exchange rate = 160/800=0.2
the number of foreign goods (Japanese Hamburgers) that can be
exchanged for one unit of domestic good (U.S. hamburgers).
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Figure 18 - 4
The Construction of the

Real Exchange Rate
1. P = price of U.S. goods in dollars

2. P* = price of British goods in pounds
EP

P
*
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Nominal vs. Real Exchange Rates

E how many units of a foreign currency can I get in exchange for
one unit of domestic currency?
Appreciation
Depreciation
how many units of a foreign goods can I get in exchange for
one unit of domestic good? (purchasing power of a currency)
Real appreciation
Real depreciation
Note: revaluation and devaluation are used when countries
operate under fixed exchange rate.
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Figure 18-5 Real and Nominal Exchange Rates between the United
States and the United Kingdom since 1971
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Note the two main characteristics of Figure 18-5:

The nominal and the real exchange rate can move in opposite
direction. (1970-1980)
EP

P*
Two things happened in the 1971s: (E,
P

P*
The large fluctuations in the nominal exchange rate also show

up in the real exchange rate.
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From Bilateral to Multilateral Exchange Rates
Table 18-2 The Country Composition of U.S. Exports and Imports,

2010
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Bilateral exchange rates are exchange rates
between two countries. Multilateral exchange rates
are exchange rates between several countries.
For example, to measure the average price of U.S.
goods relative to the average price of goods of U.S.
trading partners, we use the U.S. share of import and
export trade with each country as the weight for that
country, or the multilateral real U.S. exchange rate.
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Equivalent names for the relative price of foreign

goods vis--vis U.S. goods are:
The real multilateral U.S. exchange rate.
The U.S. trade-weighted real exchange rate.
The U.S. effective real exchange rate.
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Figure 18-6 The U.S. Multilateral Real Exchange Rate, since 1973
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Can Exports Exceed GDP?
GDP of Hong Kong in 2006

HK$ million
% of GDP
GDP (2005) Dollars
1,476,430
100%
Consumption
852,163
57.71%
Investment
307,506
20.83%
Government Spending 121,764
8.24%
Net Exports
195,202
13.22%
Exports
3,000,915
2x
Imports
2,805,713
1.9 x
-205
0%
Inventory
Source: Census and Statistics Dept. HKSAR
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18-2 Openness in Financial Markets
The purchase and sale of foreign assets implies buying or

selling foreign currencyforeign exchange.
Openness in financial markets allows:
Choose between domestic and foreign assets
Speculate on foreign interest rate versus domestic
interest rate
Countries to run trade surplus and deficits
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The Balance of Payments

The balance of payments account summarizes a countrys
transactions with the rest of the world.
Trade flows current account
Financial flows capital account
Basic Principles
Credit item (+): Funds flow into the country
e.g. exports of goods
Debit item (): Funds flow out of the country
e.g. imports of goods
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Table 18-3 The U.S. Balance of Payments, 2010, in Billions of

U.S. Dollars
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The Current Account
The transactions that record payments to and from the rest of the
world are called current account transactions.
Net exports of goods and services (NX)
Net income from abroad (NI)
Net unilateral transfers (NUT)
Current Account : CA = NX + NI + NUT
Positive current account balance current account surplus
Negative current account balance current account deficit
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The Current Account
Net exports of goods and services (NX)

Credit (+): Exports
Debit (-): Imports
Net unilateral transfers (NUT)

Credit (+): Country receives foreign aid
Debit (-): Country gives foreign aid
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The Current Account
Net income from abroad (NI)-net factor payment:

Credit (+):
Compensation received by residents working abroad
Domestic residents income on their foreign assets holdings
Debit (-):
Compensation paid to foreign residents working in the country
Payments to foreign owners of assets in the country
GNP Another measure of aggregate output:

GNP=GDP+NI
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GDP versus GNP
GDP measures value added domestically.

GNP measures the value added by domestic factors of
production.
When the economy is open, some of the income from domestic
production goes to foreigners; and domestic residents receive
some foreign income.
GNP is equal to GDP plus net income payments (NI) from the
rest of the world:
GNP = GDP + NI
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Focus: GDP versus GNP: The Example of

Kuwait
Table 1 GDP, GNP, and Net Income in Kuwait, 19891994
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The Capital Account

The capital account records trades in existing assets, either
real (for example, houses) or financial (for example, stocks and
bonds)
Capital Inflow
Credit (+) : Sale of U.S. assets to foreigners
Capital Outflow
Debit () : Purchase of foreign assets by U.S. residents
Capital account balance (KA) Net capital flows:
Positive: a capital account surplus.
Negative: a capital account deficit.
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The relationship between the current account and the capital account
Current account balance (CA) + capital and financial account
balance (KA) = 0
CA + KA = 0 by accounting; every transaction involves offsetting
effects
Note: The numbers for current and capital account transactions are
constructed using different sources; although they should give the
same answers, they typically do not. The difference between the
two is call the statistical discrepancy.
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Why the Current Account Balance and the Capital and Financial
Account Balance Sum to Zero: An Example
(Balance of Payments Data Refer to the United States)
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The Choice between Domestic and Foreign Assets

The decision whether to invest abroad or at home
depends not only on interest rate differences (i*-i), but
also on your expectation of what will happen to the
nominal exchange rate (Ee).
Figure 18 - 7
Expected Returns from
Holding One-Year U.S.
Bonds vs. One-Year U.K.
Bonds
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If both U.K. bonds and U.S. bonds are to be held, they
must have the same expected rate of return, so that the
following arbitrage relation must hold:
*
(1+i ) ( E )(1+i )
t
t 1
Rearranging the equation, we obtain the uncovered

interest parity relation, or interest parity condition:
(1+i ) (1+i )
*
t 1
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The assumption that financial investors will hold
only the bonds with the highest expected rate
of return is obviously too strong, for two
reasons:
It ignores transaction costs.
It ignores risk.
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Interest Rates and Exchange Rates

The relation between the domestic nominal interest rate,
the foreign nominal interest rate, and the expected rate
of depreciation of the domestic currency is stated as:
(1+i )
(1+i )=
[1+ ( E E ) / E )]
*
t 1
A good approximation of the equation above is given by:
E
E
i i
e
t 1
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E
E
i i
e
t 1
This is the relation you must remember: Arbitrage implies that the
domestic interest rate must be (approximately ) equal to the foreign
interest rate plus the expected depreciation rate of the domestic
currency.
, when
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Suppose i=2.0% in the U.S., i*=5.0% in the U.K., should you

hold U.K. bonds or U.S. bonds?
It depends whether you expect the pound to depreciate
vis--vis the dollar over the coming year.
If you expect the pound to depreciate by more then
3.0%, then investing in U.K. bonds is less attractive than
investing in U.S. bonds.
If you expect the pound to depreciate by less than 3.0%
or even to appreciate, then the reverse holds, and U.K.
bonds are more attractive than U.K. bonds.
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Figure 18 - 8
Three-Month Nominal
Interest Rates in the
United States and in
the United Kingdom
since 1970
U.S. and U.K. nominal interest
rates have largely moved
together over the past 40
years.
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18-3 Conclusions and a Look Ahead
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Lecture 10

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Openness in Goods and Financial Markets

Chapter 18: Openness in Goods and Financial Markets

Openness in Goods and Financial Markets

Chapter 18: Openness in Goods and Financial Markets

Openness has three distinct dimensions:

2. Openness in financial markets - Capital controls

3. Openness in factor markets. The ability of firms to

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

The behavior of exports and imports in the United States

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Exports and Imports

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Table 18-1 Ratios of Exports to GDP for Selected OECD

The main factors behind differences are geography and size:

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

In a closed economy, people face one decision:

In an open economy, they have two decisions:

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Nominal exchange rates (E) between two currencies

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Countries can operate under (chapter 21)

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Note the two main characteristics of the figure 18-3:

The large fluctuations in the exchange rate.

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Example : Compare the price of hamburger:

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

The Construction of the

1. P = price of U.S. goods in dollars

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Nominal vs. Real Exchange Rates

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Note the two main characteristics of Figure 18-5:

Two things happened in the 1971s: (E,

The large fluctuations in the nominal exchange rate also show

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Table 18-2 The Country Composition of U.S. Exports and Imports,

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

From Bilateral to Multilateral Exchange Rates

18-1 Openness in Goods Markets

Chapter 18: Openness in Goods and Financial Markets

Equivalent names for the relative price of foreign

18-1 Openness in Goods Markets