OPENNESS IN GOODS AND FINANCIAL MARKETS ‘We have assumed so far that the economy did not interact with the rest of the world. It is time to relax this assumption. Nearly all economies in the world are open and are very much affected by what happens in the rest of the world. Openness cavers three distinct notions: (I) Openness in goods markets: the opportunity for consumers and firms to choose between domestic and foreign goods. In no coun- try Is this choice completely free of restrictions: Even the countries ‘most committed to free trade have tariffs and quotas on at least some foreign goods. (Tariffs are taxes on imported goods; quotas are re- strictions on the quantities of goods that can be imported} At the same time, in most countries average tariffs are low and getting lower. To use an analogy that the United States has used in its trade dealings with Japan, the playing field—between domestic and foreign goods—in most countries is not fully level, but itis typically not very steep either: (2) Openness in financial markets: the opportunity for financial in- vestors to choose between domestic and foreign financial assets. Until recently even some of the richest countries, such as France and Italy, had capital controls, tight restrictions on the foreign assets their domestic 205 Pmresidents could hold as well as on the domestic assets foreigners could hold, These restrictions are rapidly disappearing. As a result, world finan- cial markets are becoming more and mere closely integrated. @) Openness in factor markets: the opportunity for firms to | ‘choose where to locate production, and for workers to choose where i to work and whether or not to migrate. Here again trends are clear | Firms are thinking harder about where to locate their new plants. | Multinational companies operate plants in many countries and move their operations around the world to take advantage of low costs Much of the debate about the North American Free Trade Agree- ment (NAFTA) signed in 1993 by the United States, Canada, and Mexico centered on its implications for the relocation of US. firms to Mexico. And immigration from low-wage countries to higher-wage countries is a hot political issue in countries ranging from Germany to the United States. This and the next three chapters focus on the implications of || ‘openness in both goods and financial markets. We shall leave aside for ‘the moment the implications of openness in factor markets, This is be- | cause, to deal with those, we need to look at the supply side of the | economy in more detail than we have done so far. For the moment, we | shall keep our assumption—our last major oversimplifying assump- \ | tion—that firms are willing to supply whatever is demanded at the ex- | isting price level. lI 11-1. OPENNESS IN GOODS MARKETS jgure 11-1 plots the evolution of U.S, exports and imports as ratios of GDP since 1929. “US. exports” meuns exports from the United States: “U.S. imports” means imports the United States. What is striking is how these ratios have increased ‘over time, Exports and imports. which were equal to 5% of GDP as recently asthe 1960s. now stand above 10% of GDP. This means that the United States trades sub- stantially more with the rest of the world than it did just 30 years ago. "A closer look at Figure 11-1 reveals two other interesting features as well, The | first is the sharp deetine in both exports and imports between 1929 and 1936, This | celine was due in large part to the now infamous Smvot-Hawley Act of 1930. In 8 ! misguided attempt to help the US. economy recover from the Great Depression | Smoot-Hawley sharply increased tariffs in order to inerease the demand for domes sults were retaliation by other countries (in the form of higher tar «ia sharp decrease in world trade, Mr. Smoot and Mr. Havley. tic goods, Th 1 iffs on US. goods) 206 OPENNESSBE 3 $6 é Exports 3 ° 1929 189519411967 195319591965 1971-1977 19831989 Year FIGURE 11-1 US. Exports and Imports as Ratios of GDP, 1929-1994 US. exports and imports, which were equal to 5% of GDP as recently as the 1960s, now stand above 10% of GDP. Sew: National Income and Product Accoun, the two authors of the bill, had a fleeting new moment of fame during a TV debate on NAFTA in 1993, when U.S. Vice-President Albert Gore presented their framed Picture to H. Ross Perot as a way of reminding Americans of the dangers of oppos- ing free trade The second is that while imports and exports have followed broadly the same trend, they have also diverged for long periods of time. generating sustained trade surpluses or trade deficits. (Reeall from Chapter 3 that the trade balance is equal to the difference between exports and imports. A positive trade balance isa trade sur lus; 2 negative trade balance is a trade deficit.) Two episodes stand out: the large trade surpluses in the late 1940s and the large trade deficits in the 1980s, The sur- Pluses ofthe late 1940s were due to the post-World War II reconstruction effort in Enrope. leading to large exports from the United States to Europe. The eause of the ‘id 1980s trade deficits —which have decreased but not disappeared in the 1990s— 2s mostly the U.S. fiscal-monetary policy mix. We examine these deficits in Chap: ter 13, Given the volume of discussion about how trade is transforming the United States. a volume of trade (measured by the ratio of exports or imports to GDP) of ‘tound 10% of GDP may weil strike you as surprisingly small, However. the vol- ‘me of trade is not necessarily a good index of openness. Many sectors can be ex- Posed to foreign competition without the effects of this competition showing up in OPENSHSS IN GOODS AND FINANCIAL MARKETS 207sectors that a bette of goods in eith domestic or for increased imports: By being competitive and keeping their prices low enough. these retain their domestic market share and keep imports out. This st index of openness than export or import ratios may be the proportion, ¢ oUIput composed of tradable goods—goods that compete with for Is sn markets, Estimates are that this number jg around 50 10 600% in the United States today It remains true that, with exports around 10% of GDP. the United States has ‘one of the smallest ratios of exports to GDP amo Jes ratios for a number of OECD countries. The table shows that. with ratios around 10%, the United States and Japan are at the low end of the rang ree European countries. such as Germany and the United Table Nl g export ratios. The he rich countries of the world of Kingdom, have ratios that are two or three times larger. And the evidence from the smaller Europe: countries is even more striking, Switzerland, 10 71% in Belgium. to 89% in Luxembourg! (Luxembourg's 89) port ratios range from 36% in ts ratio of exports to GDP raises an odd possibility. Could a country have exports larger than its GDP and thus export ratio greater than 1? The answer is yes, and is de- veloped in the Focus box entitled “Can Exports Exceed GDP?") Do these numbers indicate that the United Sta say. the United Kingdom or Luxembourg geography and size. Distance from other markets expla low Japanese ratio, Also, the smaller the country. the more it few products and thus have both high imports and hig about 5% of U.S. GDP, and Luxembourg’ GDP is less tha has more trade barriers than, n factors behind these differ 4 good part ofthe to specialize in only a h exports: Belgium’ GDP is 03% of US. GDP Itis io, The m: clear that neither Belgium nor Luxembourg can afford to produce the range of goods produced, say, by the United States. Can a country have exports larger than its GDP. and thus an export ratio greater than 1? ‘At frst, the answer would seem to be that coun tries cannot export more than they produce, so that the export ratio must be less than 1-But cis answer is incorrect. The trick is to realize that exports and im- ports may be exports and imports of intermediate goods. ‘An example wil help here. Take a country that im- ports intermediate goods for $1 billion. Suppose that it transforms chem into final goods using only labor Say that total wages are equal to $200 milion and there are no profits. The value of final goods is thus ‘equal to $1,200 milion. Assume that $1 billion worth ‘of final goods is exported and the rest is consumed in the country. Exports and imports are therefore both equal to OPENNESS $1 bilion, What is GDP in this economy? Remember that GDP is value added in the economy (see Chapter is thus equal to $200 milion, so thatthe rato of ‘exports to GDP is equal tS. ‘So, exports can exceed GDP This is indeod the ‘ase for many small counties organized around a har bor and import-expore activities, where exports and imports are indeed equal to many times GDP. This even the case for small countries where manufacturing plays an important role. Singapore is such a couney. Ia 1994, is rato of exports to GDP was 140 percent. In che cexe we shall ypically think of exports and imports as exports and imports of final goods. But his is just for simplicity. Remember that exports and im pores, as they are measured, refer to exports and it ports of all goods and services, from raw materials © intermediate products co final goodsEXPORT RATIO EXPORT RATIO. ©. COUNTRY 3) “Thenumber for Lvembour i for 1992, sear hiemavonl Fancast, IME December 1995 How does openness in goods markets force us to rethink the way we look at equilibrium in the goods market? When thinking about consumers’ decisions in the ‘goods market, we have thus far focused on their decision to save or to consume. But when goods markets are open, domestic consumers face a second major decision: whether to buy domestic goods or to buy foreign goods. Other domestic buyers— firms, the government—and foreign buyers also face this decision. If they decide to buy more domestic goods. the demand for domestic goods increases, and so does domestic output. If they decide to buy more foreign goods. then itis foreign output that increases. Central to consumers” and firms’ decisions is the price of foreign goods in terms of domestic goods. We call this relative price the real exchange rate, The real exchange rate is not directly observable, and you will not find it by fipping throu the pages of newspapers. What you will find there are nominal exchange rates, the relative prices of currencies. Let’s start by looking at these. then see how we can use them to construct real exchange rates. NOMINAL EXCHANGE Rat Nominal exchange rates between currencies are quoted in two ways: (1) the number of units of forcign currency you can get for one unit of domestic currency. or (2) the number of units of domestic currency you can get for one unit of foreign currency InDecember 1995. for example, the nominal exchange rate between the dollar an the German currency. the deutsche mark (DM), was quoted as either 1:13 DM for | dollar or, equivalently 0.70 dollar for | DM. In this book. | shall define the nominal exchange rate as the umber of units of domestic currency you cun get for one nit of foreign currency. or equivalently. as the Price of foreign currency in terins of domestic currenc’, an 1 shall denote it by FF example, when looking at the exchange rate between Germany and the United States fom the viewpoint of the United States (so that the dollar is the domestic currency). E Will denote the number of dollars one can get for | DM—thus. as of December 1995, 70, {shall write it for short as the $/DM (dollars per DM) exchange rate.! To convert dollars int» DM. simply divide by £: To eonvert DM into dollars, multiply by E. s "Awami he coms lena enchnse rate st pre foi cure tn dene cu renege genera ete evocation the US. i of the Ata. ne ier Side stereos fe ear rin defn ne nae pr fom caren toms fc cares tn ella erp he Cine Kin, OPENNESS IN GOODS AND FISANCIAE MARKETS 209FIGURE 11-2 ‘The Nominal Exchange Rate, Appreciation, and Depreciation: United i States and Germany (from the Viewpoint of the United States) Exchange rates between foreign currencies and the dollar change every day, indeed every minute during the day, These changes are called nominal appreciations or nominal depreciations—appreciations or depreciations for short. An apprecia. tion of the domestic currency is an increase in the price of the domestic curreney in ney. Given our definition of the exchange rate as the price of the foreign currency in terms of domestic currency. an appreciation corresponds to decrease in the exchange rate, £ ‘This is more intuitive than it first seems: Consider the dollar and the DM gain from the viewpoint of the United States). An appreciation of the dollar (also called a dollar appreciation) means that the dollar's value goes up in terms of the DM. Equivalently, the DM is worth fewer dollars. which is the same as saying that the exchange rate has decreased. Similarly, a depreciation of the dollar (or a doltar depreciation) means that the dollar is going down in terms of the DM, and thus cor. responds to an inerease in E2 ‘That an appreciation corresponds to a decrease in the exchange rate.andade- "| preciation to an increase, wil almost surely be confusing to you at first—it confuses, any professional economists—but it wil eventually become second nature as your understanding of open-economy macroeconomics deepens. Until then, you may find it useful to consult Figure 11-2, which summarizes the terminology. With these preliminaries out of the way. Figure 11-3 plots the dollar/DM ex- change rate since 1970, It has two important features: 1. The wend increase in the exchange rate, the trend depreciation of the dollar vis- auvis the DM over the last 25 years. A DM was worth slightly more than 25, cents in 1970, Inthe last quarter of 1994—the last observation in the figure—it Price of DM in dollars equivalently: ‘Number of dollars per DM (SDM) ‘Nominal exchange rate (E) Appreciation of the dollar: Price of DM in dollars decreases Value of dollar increases equivalently Number of dollars per DM decreases i EL 5 Depreciation of the dollar: Price of DM in dollars increases Value of dollar decreases equivalently. Number of dollars per DM increases Et Taw may have enconatcred we ether words for changes exchange rates: “revaluations” and “dev tons These tens are aed when countries operate under fixed exchange rates—a sistem in which 2 Cinmore conics muanuain a fine exchange rate benseen ter eurrencics Under sch a system, decreases line cachange re, which ave by defution infrequent evens. are called revaluation rather than appt eudninay Dnreanes in the euchonge rate ave called devaluation (ther than depreciations). We discus Jed exchange rates in dealt Chaper 13.I E (nominal exchange rate) otters per DM 040 038 020 025, 1994 1986 1988 1990 1992 1994 Hy toro 1972 1874 1976 1978 1900 1962 i Year 4 1 FIGURE 11-3 1 {The DollarlDM Nominal Exchange Rate, 1970-1994 { + Ratarp dollar appreciacion in the first hal ofthe 1980s was fllowed by an equally sharP | dollar depreciation in the second half of the 1980s. Sear OECD Main Eanes nda cents, And, as we saw earlier, by December 1995 the dollar had ‘ated and the DM was worth 70 cents, nearly three times its ‘was worth 65 further depr value in 1970, 2. The large fluctuations in the exchange rate, In the space of five years in the carly 1080s, the value of the DM dropped from 37 cents to only 30 cents. Put Tate of dollar appreciation trom the beginning of was 12% a year, This appreciation was then fully un reginning of 1985 to the end of dollar in terms of the DM ia warth elose to 600 cents. i another way. the avel 1980 to the end of 19 done during the next three years: From the bs 1987, the average yearly rate of depreciation of the ‘was 20 percent, By the end of 1987, the DM was Fisure 11-3 tells us only about swings in the relative price of the wo curren: cies, However, to German tourists thinking of visiting the Liited States, the que ot only how many dollars they ean get for | DM. but aso how many gonds yea buy, Itdaes them litte good (o get more dollars per DM if the dollar wads in the United States have increased proportionately. In the same firm thinking of exporting to Germany needs 10 know aot only the DM of German products with which it to the construc: way. the U nominal exchange rate but also the price Will have to compete. This takes us closer to where we want 10 tion of reat excha rales, Ones wns is Goobs AND FINANCIAL Marien 21 —REAL EXCHANGE RATES How do we construct the real exchange rate between the United States and Ger. many Suppose that Germany produced only one 200% is one of those completely counterfaetual "Suppos come more realistic below). and that the United 000d, say Cadillac Sevilles. ‘Consiructing the real exchange rate. the price of German goods in terms of 4 US. goods, would be straightforward: The price of a Mercedes in Gefmany is 100.000 DM. The first step would be to convert this price in DM to a price indollars, j |h DM is worth 0.70 dolar so the price of a Mercedes in dollars i 100.000 «0.70 Srotooo. The second stop would he to compute the ratio of the price of the Mer- aedes in dollars to the price of the Caclillac in dotars. The price of Cadillac inthe United States is $41,000, Thus the price of a Mercedes in terms of Cadillacs—that ie the real exchange rate between the United States and Germany—would be $70,0001841,000 = 1.71 ‘But Germany and the United States produce more than Mercedes and Cadi. acs. and we want to construct a real exchange rate that reflects the relative price of athe aoods produced in Germany in terms of all the goods produced in the United Stoes, The computation in the preceding paragraph gives us a hint about how to proceed, Rather than use the DM price of a Mercedes and the dollar price of @ Eradillac, we must use a DM price index for all goods produced in Germany and a Solar price index for all goods produced in the United States. This is exactly what the GDP deflaiors we introduced in Chapter 2 do: They are by definition price in dloxes forthe set of final goods and services produced in an economy. “Thus, let P be the GDP deflator for the United States, P* be the GDP deflator for Germany (as a rule, T shall denote foreign variables by a star). and E be the Nominal exchange rate between the dollar and the DM. Figure 11-4 shows the steps ih the conetruction of the real exchange rate. The price of German goods in DM & Pe. Maitipying it by the exchange rate. E, gives us the price of German goods ie Gola, EP", The price of U.S. goods in dollars is P The real exchange rate, the price of German goods in terms of U.S. goods, which we shal calle (the Greek ow ercase epsilon). is thus given by Mercedes SL-class cars (this statements, but we shall be- es also produced only one EPS Fe au) FIGURE 11-4 The Construction of the | Prise of Germa Price of German Real exchange Real Exchange Rate goods in DM: goods in dlrs rate: - — P Price of US. —~—, goods in dollars 212 OPENNESNote that unlike the price of Mercedes in terms of Cadillacs, the real exchange rate is an index number and thus does not have a natural level. This is because the GDP deflators used in the construction of the real exchange rate are indexes and thus have no natural level: as we saw in Chapter 2. they are equal to I in whatever year is chosen as the base year. But while the level of the real exchange rate is arbi- iran. its movements are not. They tell us whether foreign goods are becoming rela- tively more or less expensive than domestic goods. ‘An increase in the relative price of domestic goods in terms of forcign goods is, called a real appreciation; a decrease is called a real depreciation. The word real, as, opposed to nominal, indicates that we are now referring to changes in the relative price of goods rather than in the relative price of currencies. Given our definition of the real exchange rate as the price of foreign goods in terms of domestic goods, real appreciation corresponds to a decrease in the real exchange rate, e. Similarly a real depreciation corresponds to an increase in ¢. These relations are summarized in Figure 11-5, which corresponds to Figure 11-2, but this time for the real exchange nate Figure 11-6 on page 214 plots the evolution of the real exchange rate between the United States and Germany from 1970 to 1994, For convenience, it also repro- duces the evolution of the nominal exchange rate from Figure 11-3. The GDP defla- tors have been chosen to be equal (0 | in 1987, so that in that year the nominal and real exchange rates are equal by construction, Figure 11-6 has two major features: (1) The real depreciation since 1970 has been smaller than the nominal deprecia- tion, While the DM has increased in value by 3.6% a year on average with respect to the dollar. the price of German goods in terms of U.S. goods has increased by only 2.1% a year on average. To understand where the difference comes from, note that by definition the real exchange rate is equal to the nominal exchange rate (E) times the ratio of the German price level to the U'S. price level. P*/P. Since 1970, inflation in Germany has been lower than in the United States by 1.5% a year on average, so that the German price level has increased more slowly than the U.S. price level: P*/P has decreased. Thus, while the nominal exchange rate has increased by 3.6% a year on average. the price ratio has decreased by 1.5% a year on average, leading to an in- ‘ease in the real exchange rate of only 2.1% a year. Real exchange rate (€): Price of German goods in terms of U.S. goods Real appreciation: Price of German goods in USS, goods are relatively terms of US, goods decreases: more expensive el Real depreciation Price of German goods in US. goods are relatively terms of US. goods increases less expensive et FIGURE 11-5 The Real Exchange Rate, Real Appreciation, and Real Depreciation: United States and Ger- many (from the View. point of the United States) OPENNESS IN GOODS AND FINANCIAL MARKETS 213,070 | 06s e (teal exchange rate) 060 Dollars per DM E (cominal ‘exchange rate) | ' oo | | 0% | 025, 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 y FIGURE 11-6 Real and Nominal Exchange Rates between the United States and Germany, \ 1970-1994 | Except fora difference in trend, the nominal andthe real exchange rates have moved very much together since 1970. Sources OECD Man Econ Indctr Board of Governor ofthe Federal Reserve System, To make this explanation more intuitive, think of German tourists who last 4 visited the United States in 1970. In preparing for tei rip this time, they wil find | that a DM buys more dollars (the nominal depreciation of the dollar) but thatthe =} | cost of things in the United States has increased significantly more than in Germany 4 7 (due to the differential in inflation). Thus the trip is cheaper now than it was in 1970, 1 but by less than the large nominal dollar depreciation might suggest. (2) The large swings in the nominal exchange rate during the 1980s that we saw in Figure 11-3 also show up in the real exchange rate. This is not very surprising. Asin- Wig ation rates are not very different in Germany and the United States, the move- i] ‘ments in the price ratio P*/P are slow. Thus, from year to year. or even over a few 7 years, movements in the real exchange rate € are driven mostly by movements in the nominal exchange rate £. From the beginning of 1980 to the end of 1984, the av- erage rate of appreciation was 15% per year. This is higher than the yearly rate of =, nominal appreciation over the same period. The reasons that not ony was the da lar appreciating vis-i-vis the mark. but U.S. inflation was also higher than German inflation. Like the nominal appreciation, this real appreciation was fully undone it the following three years. From the beginning of 1985 to the end of 1987, the avet- age rate of real depreciation was 21% per yearWe have one last step to take, We have so far concentrated on the nominal and real exchange rates between the United States and Germany. But the United Siates trades with many countries besides Germany. Table 11-2 gives the geographic composition of U.S. trade for both exports and imports. The numbers refer only to merchandise trade, exports and imports of goods; they do not include exports and and tourism, for whieh this decomposi imports of services. such as travel serv tion is not available ‘Canada and Western Europe account for 40 to 46% (depending on whether one looks at imports or exports) of U.S. merchandise trade. But trade with Japan and the rest of Asia accounts for a steadily inereasing proportion of U.S. merchandi trade. Interestingly. trade is much more imbalanced with Japan and the rest of Asi than with Canada and Western Europe. In 1994 the dollar volume of U.S. exports of goods to Japan was equal to less than half of the dollar volume of U.S. imports of goods from Japan, This merchandise trade deficit with Japan has become a major source of tension between the two countries. We shall return to it in Chapter 14. How do we go from bilateral real exchange rates, such as the real exchange rate between the United States and Germany ("bi” in bilateral means two. thus re- ferring to the exchange rate between a pair of countries). to multilateral real ex change rates? The answer is straightforward. If we want to measure the average price of U.S. goods relative to those of all of its trading partners. we should use as weights the U.S. share of trade with each country. Using export shares we can con- siruct an “export” real exchange rate, and using import shares we cin construct an “import” real exchange rate. Because economists usually do not want to keep track. of two different exchange rates, they typically use an exchange rate that takes an av- erage of export and import shares. This is the variable we shall think of when talk- ing about the real multilateral U.S. exchange rate, or simply the U.S. real exchange tale. Other names are the U S. trade-weighted real exchange rate, or the U.S. effec- tive real exchange rate. TABLE 11-2 THE COUNTRY COMPOSITION OF U.S. MERCHANDISE TRADE, 1994 EXPORTS TO IMPORTS FROM ntries. $ Billions ions. = Percent us BI 20 Europe NS 133 20 a ny 18 st 50 7 3 157 B 7 rT 5 m4 8 7 502 669 109 ‘Noting pan C:Organstion of Petroleum Exporting Counties. Source: Survey of Caren Beans, March 1995.62 LOPENSUSS IN GOODS. AND FINANCIAL MARKETS 21526 Figure 11-7 shows the evolution of this multilateral real exchange rat, the ay. erage price of foreign goods relative to U.S. goods, from 1960 to 1994. Like the bi. lateral real exchange rates we saw earlier, itis an index number. Thus its level ig arbitrarysitis chosen here to equal 1 in 1987. Figure 11-7 shows that in the 1980s, the movement in the multilateral ex. change rate parallels to the movement in the German-U‘S. real exchange rate we saw in Figure 11-6: Foreign goods were substantially less expensive compared 9 USS. goods in the mid-1980s than they were either atthe beginning or the end of the decade. In other words, there was a large real appreciation of U.S. goods in the early 1980s, followed by an almost equally large real depreciation. This large swing, which, as we have seen, has its origins in the movement of the nominal exchange iking that it has been given many names, from the “dollar cycle” to the more graphic “dance of the dollar.” It is tempting to think of it as one of the causes of the large U.S. trade deficits that also characterized much of the 1980s. Part of our task in the coming chapters will be to understand where this swing came from and what effects these movements in the real exchange rate had on the trade deficit and ‘on economic activity. rate, is so st 128 17 1.08 1.9) 099 080 Index (1987: oat o7e 063 1970 1972 1974 1976 1978 1900 1982 984 1995 1988 1990 1992 1994 Voor FIGURE 11-7 ‘The U.S. Effective Real Exchange Rate, 1970-1994 ‘The large real appreciation in the first haf of the 1980s was followed by an equally large real depreciation in the second half of the 1980s. These large swings in the 1980s are sometimes called the “dance of the dolla” Source: Board of Govermersof he Feder Reserve System. | a 4 anata ce secant ici aS eastiblactassiaRe ie asst11-2 OPENNESS IN FINANCIAL MARKETS Openness in financial markets allows financial investors to hold both domestic and foreign assets. thus to diversify their portfolios, and to speculate on movements in foreign versus domestic interest rates. exchange rates, and so on. And diversify and speculate they do, Given that buying or selling foreign assets implies. as part of the operation, buying or selling foreign currency (sometimes ealled exchange). the size of transactions in forcign-exchange markets gives a sense of the importance of international financial transactions, In 1994 the daily volume of foreign-exchange transactions in the world was $1 trillion, of which 80%—about $800 billion—in- volved dollars on one side of the transaction ‘To get a sense of the magnitude of these numbers, recall from Chapter 3 that the annual average of U.S. exports and imports is roughly $800 billion. This number {sfor the whole year and thus corresponds to about $2 billion a day. Thus if the only dollar transactions in foreign-exchange markets were, on one side, by U.S. exporters selling their foreign currency earnings. and on the other by U.S. importers buying the foreign currency they need to buy foreign goods. the volume of transactions would be equal to $2 billion a day, or about 0.25% of the actual volume of transactions in- volving dollars in foreign exchange markets. Mast of the transactions are thus associ- ated not with trade, but with purchases and sales of financial assets. The volume of transactions in foreign exchange markets isnot only high but also rapidly increasing. ‘The volume of foreign-exchange transactions in New York is now more than 12 limes what it was in 1980. Again this activity reflects mostly an increase in financial transactions rather than an inercase in trade over the last 15 years For a country as a whole. openness in financial markets has another important implication. It allows the country to run trade surpluses and trade deficits. Recall that a country running a trade deficit is buying more from the rest of the world than itis selling to rest of the world. Thus. it must borrow the difference. It does so by making it attractive for foreign financial investors to increase their holdings of do- inestc assets in effect to lend to the country. Let now look atthe relation between trade and financial lows more closely THE BALANCE OF PAYMENTS, A country’s transactions with the rest of the world are summarized by a set of ac- counts called the balance of payments. Table 11-3 on the next page presents the US. balance of payments for 1994. Note that the table has two parts separated by a line. For this reason. transactions are referred to either a ictions above the line oF transactions below the line. The current account. Lets first look at the transactions above the fine. all of hich record payments to and from the rest of the world. These are called enrrent Account transactions. ‘The first two lines record exports and imports of goods and services. Exports lead to payments from the rest of the world. imports to payments (o the rest of the OPENNESS IN GOODS AND FINANCIAL MARKETS 207TABLE 113 i THE U.S. BALANCE OF PAYMENTS, 1994 CURRENT ACCOUNT. Exporss 3 Imports ‘Trade balance (deficit =+) (1) ue Investment income received ‘ Investment income paid é : 'Ner investment Income Q) I ‘Net transfers recelved (3)... : ‘Current account balance (deficie=-)(1) + @2)'+ @) Anerease in foreign holdings of US. assets Increase in.US. holdings of foreign assets ° | [Net increate in foreign holdings! i net eapeal flows to the US, Stastieal discrepancy ‘Stace Srey of Corent Baines, March 199556 All umbers in blions of dollars | world. In 1994. imports exceeded exports, leading to a U.S. trade deficit of $106 bil | lion, (Note that the numbers for exports and imports are different from those in Hi | Table 11-2: this is because the numbers here include both goods and services.) | Exports and impor are not the only sources of payments to and from the restot the world U.S. residents receive investment income on their holdings of foreign aces, | and foreign residents receive investment income on their holdings of US. assets. In i 1994, investment income received from the rest of the world was $134 billion and in- He vestment income paid to foreigners was $150 billion, fora net balance of -816 billion, ' Finally. countries give and receive foreign aid; the net value of these payments \ | is recorded as net transfers received. These amounted in 1994 10 ~$34 billion. This \ negative amount reflects the fact that the United States has traditionally been a net donor of foreign aid. Adding all payments to and from the rest of the world, net payments were thus equal to ~$106 ~ $16 ~ $34 = ~$156 billion. This total isthe current account bal- dance. In 1994, the United States ran a current account deficit of $156 billion, about 23% of its GDP | ‘The capital account. The U.S. current account deficit in 1994 implied that the | United States had 10 borrow $156 billion from the rest of the world—or. equiva: i Tently. that net foreign holdings of U.S. assets had to increase by $156 billion. The numbers below the line describe the way this result was achieved. Transactions i below the line are called capital account transactions. The inerease in U.S. holdings of forcign assets in 1994 was $125 billion. But at the same time. the inerease in foreign holdings of U.S. assets in 1994 was $314 bil lion, Thus. the net increase in U.S, foreign indebtedness. which is also called nel | capital flows to the United States. was $314 ~ $125 = $189 billion. Shouldn't net capital flows be equal to the current account deficit? The at swer is: Conceptually yes. but they do not in practice. The numbers for current and 218 OPENNESSapital account transactions come from different sources: while they should give the ame tats ouched on briefly in Chapter ve have used so far) and GNP. another measure the Global Macro box entitled “GDP versus GNP: The Example of Ku nswers, they typi cal discrepaney, was equal to $33 billion.* (a sec as Audie ene ie ‘Should value added in an open economy be defined as, the value added domestically (chat is, within the coun- try) or as the value added by domestically owned fac~ tors of production? These wo need not be the same: Some domestic output may be produced by capital ‘owned by foreigners, while some foreign output may bbe produced by capical owned by US. residents. ‘The answer is that either definition is fine, and economists use both. Gross domestic product (GDP), the measure we have used so far, corre- sponds to value added domestically. Gross national product (GNP) corresponds to the value added by domestically owned factors of production, GNP is thus equal to GDP plus net factor payments from the rest of the world. While GDP is now the measure ‘most commonly mentioned, GNP was widely used ‘until afew years ago, and you will stil often encounter it in newspapers and academic publications. For most countries, the difference between GNP and GDP is typically small, because factor payments to and from the rest of the world roughly cancel. For the United States in 1994, for example, GDP was $6,736 billion compared to $6,727 biion for GNP. But chere are a few exceptions. One is Kuwait. When oil was discovered in Kuwait, Kuwait's govern- ‘ment decided that a portion of oll revenues would be saved and invested abroad rather than spent, so as to provide future Kuwaiti generations with investment in- come when oil revenues came to an end. As a result, ly do not. In 1994, the difference between the two, the Now that We have looked at the current account, we can return to an issue we 2 the difference between GDP (the measure of output igeregrate output. This is done in Kuwait accumulated large foreign assets and thus now ‘receives substantial investment income from the rest of the world, Table I gives GDR GNP, and net factor payments for Kuwait. Note how much larger GNP is compared to GDP throughout the period. But note also how net factor payments have decreased since 1989. This is because ‘Kuwaie has had co pay its alles for part of the cost of the Gulf War and to pay for reconstruction after the ‘war As a result, Kuwait’ foreign assets and factor pay- ments have steadily decreased, GDP, GNP, AND NET FACTOR PAYMENTS IN KUWAIT, 1988-1994 YEAR GDP GNP NET FACTOR é PAYMENTS. - 1308 S773_7765 2 1989 74395822419 1990: 5307. 7503 2196 1991 3130 4674 54 19725518" 7008 191 993.7136 sea 49 994" 714 “a7? 1088 Scarce: International ancl Static, HE, May 1995 ‘Aloumbersia llns of Kawa dae = $33 0399) {rotkerwnivacal problem: Ie clear tha the sum ofthe current aconnt defies fall sont old Be alto enw One countre' deft should show pasa cups forthe other counties taken whole, sr the ease If we put the plished erent acount eit of al dhe cours the wort ‘ould appear date world is rnmon tear large current "sy spetutte that she explanation se nreconded tae withthe etsurement ise explanaion OPENS IN GooDs AND fic. Some ccomomst jo tans. Moat others ete dt is ANCIAL MARKETS 219THE CHOICE BETWEEN DOMESTIC AND FOREIGN ASSETS Openness in final markets implies that financial investors face the choice of holding domestic versus foreign assets It might appear that we have to think about at least nvo new decisions, the choice of holding domestic versus foreign money, and the choice of holding domes. tic versus foreign interest-paying assets. But remember why people hold money: engage in transactions For somebody who lives in the United States, whose tne factions are thus mostly or fully in doliars, there is litte point in holding foreign cur. reney: It cannot be used for transactions. and if the goal is to hold foreign assets, =! holding foreign currency is clearly less desirable than holding foreign bonds, which i pay interest.” Thus. the only new choice we have to think about is that between do. (3 | mestic and foreign interest-paying assets. Let's think of them for the time being as) domestic and foreign one-year bonds. Consider. for example. the choice between U.S. and German one-year bonds, . Suppose that you decide to hold U.S. bonds. Let i, be the one-year U.S. nominal in. terest rate in year &. Then. as Figure 11-8 shows. for every dollar you put in US, bonds, you will et (1 + ,) dollars next year. \j Suppose you decide instead to hold German bonds. To buy German bonds, you must first buy DM. Let E, be the nominal exchange rate between the dollar and | the DM. Thus for every dollar you get (1/E,) DM. Let denote the one-year nomi- nal interest rate on German bonds (in DM). When next year comes. you will have (Q/E)( +7) DM, You will then have to convert your DM back into dollars. If you expect the nominal exchange rate next year to be £7... you can expect to have (VE)(1 +7)E%,, dollars next year for every dollar you invested. This set of stepsis °; i represented in the second part of Figure 11-8. 3 j We shall look at this expression in more detail soon, But note already its basi | implication. In assessing the attractiveness of German bonds, you cannot look just | at the German and U.S. interest rates; you must also assess what you think will hap- | pen to the dollar/DM exchange rate between this year and next. ' Let's now make the same assumption we made in Chapter 9 when discussing | the choice between short- and long-term bonds. or between bonds and stocks. Let | assume that you and other financial investors want to hold only the asset with the | highest rate of return, In that case. if both German and U.S. bonds are to be held, | | they must have the same expected rate of return, so thatthe following arbitrage re- lation must hole: | sie (E}o sme (11a) FFhere are nwa quaiifcuions o this ratement Fr, freiges involved i egal activites often hold dot lars. because these cam be exchanged easly ed canst be waced. Aso. tines of vers high inflation, Pe ple sometimes swich to the use of foreign currency often the don even for some domest® transactions Thais knoe asthe dlltiation ofan econ: anl we shal retro tin Chapter 21. Re ont eximas y researchers ot the Fed sagged tar perhaps more than half of the US. currenes sock 8 eld abroad. We shel fore tis aspect of real here 220Year Year r+ US. bonds ee ed | German bonds st sGE)0 inet pM) ——> DM Gein Remember "Divide by £ to convert dollars to DM. *Multiply by E to convert DM to dollars Equation (11.2) is called the uncovered interest parity retation, or simply the inter- est parity condition. ‘The assumption that financial investors will hold only the bonds with the high- est expected rate of return is obviously t00 strong, for two reasons. First it ignores iransaction costs: Going in and out of German bonds requires three separate trans- actions, each with a transaction cost. Second, it ignores risk: The exchange rate a year from now is uncertain; thus. holding German bonds is more risky. for a U.S. in- vestor, than holding US. bonds. But as a characterization of capital movements among the major world financial markets (New York, Frankfurt, London, and Tokyo). itis not far off. Small changes in interest rates and rumors of impending ap- precation or depreciation can lead to movements of billions of dollars within min- 5 ules. For the rich countries of the world, the arbitrage assumption in equation (11.2) js a good approximation of reality. Other countries whose capital markets are i+ smaller and less developed. or that have various forms of capital controls, have more leeway in choosing their domestic interest rate than is implied by equation (11.2). To get a better sense of what arbitrage implies. rewrite equation (11.2) as Lagecsin(le 3) |. This gives a relation between the domestic nominal interest rate, the foreign nom F nalinterest rate, and the expected rate of depreciation. Remember that an increase in Eis a depreciation. so that (E%,; - E,\F, is the expected rate of depreciation of = the domestic currency. (If the domestic currency is expected to appreciate. them this & term is negative.) As long as interest rates or the expected rate of dept F Rot too large—say, below 20% a year—a good approximation to this equation is «ay f fe Dieting deeper. The wond uncoweced #10 diingnsh trom anunher relawon called the covered interest [patna a comn deve mo flows ace The freon ld [Wetter eer Bo hn ea i ep [ed agrec il te BA fosters eur aed aa precrinel rcesied he orward exchang 4p fe The a ferro these ace hhc he redize td e e e fe Th covered nv py cotton ee aia comin 1 eft om Propoton 3m Appi? FIGURE | Expected Returns from Holding One-Year U.S. or German Bonds OPENNESS IN GOODS AND FINANCIAL MARKETS 21and German one-year nomi | tively (these were the wi German bonds is mor : German bonds despite the Prine atin pleted Put yourself back in September 1993. (I choose this date because the very high interest rate in Brazil a the time makes the point | want to make very dramati- cally) Brazllan bonds are paying a monthly interest rate of 36.9 percent. This seems very attractive com- pared to an annual rate of 3% on US. bonds. Shouldn't you buy Brazilian bonds? “The discussion in the text tells you that, to decide, you need one more crucial element, the expected rate ‘of appreciation of the dollar vis-d-vis the cruzeiro (the ame of the Braziian currency at the time; the cur- rency is now called che real). You need this informa- i tion because (as Figure I-8 makes clear) the return in | dollars from investing in Braziian bonds for a month is. What rate of cruzeiro depreciation should you ex- pect over the coming month? Assume that the rate of | 22 OPENNESS, This isthe relation you must remember: Arbitr rate must be (approximately) equal to the foreign interest rate plus the expected de. preciaion rave of the domestic currency: 4 Let’ apply this equation to U.S. versus German bonds. Suppose that the Us, interest rates are eq ues of these two interest rates in December 1995). Should you hold German or U.S. bonds? It depends whether you expect the dollar to de. preciate vis-a-vis the DM by more or less than 5.8% ~ 3.9 year. If you expect the dollar to depreciate by more than 1.9%. then despite the fast that the interest rate is lower in Gen active than investing in H bonds. you will get fewer DM a year from now, but DM will also be worth more in terms of dollars a year from now. maki investing in U.S. bonds. However, if you expect the dollar to depreciate by ven 10 appreciate. the reverse holds and U.S. bonds are more al- a depreciation of the doll 1.9% over the coming year. and this is why financial investors are willing to hold lower interest rate. (Another example is provided in the Global Macro box entitled “Should You Buy Bi implies that she domestic interes, to 5.8% and 3.9%. respec. 3 1% over the coming yy than the United States. investing in, S. bonds. By holding German investing in German bonds more attrac. tells us that financial markets must be ex- with respect to the DM of about ian Bonds?*) depreciation next month wil be equal to the rat oi Geprecition fart mont. You know that 10000 truzeiros, worth $1.01 atthe end of July 1993, were The expected rate of return in dollars from hold Brazilian bonds is thus only (017 ~ 1) = 1.7% month, not the 36.9% per month that looked so at tractive. Note that 1.7% per month is stil much/ higher than the monthly rate of return on US) bonds. But think of the risk and che transactiot costs—all the elements we ignored when we wrote the arbiragecondtion, When dese are cakan i account, you may well decide to keep your funds out of Brazil.The arbitrage relation between interest rates and exchange rates in equation (11.4) will play a central role in the following chapters. It suggests that unless partie {pants in financial and foreign exchange markets expect large depreciations or ap preciations, domestic and foreign interest rate are likely to move very much together. Take the extreme case of two countries that commit to maintaining their bilateral exchange rate at a fixed value. If markets have faith in this commitment, they will expect the exchange rate to remain constant, and the expected deprecia- tion will be equal to zero. In that case. the arbitrage condition implies that interest rates in the two countries will have to move together exactly. Most of the time, as we shall sce. governments do not make such absolute commitments to maintain the ex- change rate, but they often do try to avoid large movements in the rate. This in turn puts sharp limits on how much they can allow their interest rate to deviate from in- terest rates elsewhere in the world, How much do nominal interest rates actually move together between major countries? Figure 11-9 plots one-year nominal interest rates in the United States and Getmany for each year since 1970, The impression is indeed one of closely re- lated but not identical movements, Interest rates were high (by historical standards) in both countries in the mid-1970s, low in the late 1970s, and very high in the early 1980s, They have been generally decreasing since then in both countries. At the |< US. nominal intrest rato 180 2s too 15 50 ‘German nominal intorast rata 28 1970 1972 1974 1976 1978 1980 1982 1984 1985 1988 1990 1952 1904 Year IGURE 11-9 aS ‘and German One-Year Nominal Interest Rates, 1970-1995 {US.and German nominal interest rates have largely moved together over the last — rely ox £25 - Mo Eeanome Innes OPESNESS IN GOODS AND {ANCIAL MARKETS Fraysame time, differences between the two are sometimes large. In 1984, the Germay 34 interest rate was nearly 5 percentage points below the U.S. interest rate. In 1999, by a the German ineron rate wa nearly 6 percentage points above the US" terest rate, Onl since 1994 have the two rates converged again. Inthe Coming chap. ters we shall return to why these differences emerged and what their implication, 11-3 CONCLUSIONS AND A LOOK : AHEAD We have now set the stage for the open economy. Openness in goods markets a jows fora choige between domestic and foreign goods. This choice depends primar. ily on the real exchange rae, the relative price of foreign goods in terms of domeste if sods, Openness in financial markets allows for tin assets This choice depends primarily on ther refative rate of return, which de. pends in turn on domestic and foreig interest rates, and on the expected rate of Aepreviation ofthe domestic currency Inthe next chapter we look atthe implications of openness in goods markers,“ Chapter 13 then brings in openness in financial markets. In Chapter 14 we reinro- | “luce the role of expectations and thus put together the two major extensions ofthe cof domestic goods in t 8 of forcign goods. It corr 224 OPENNESS return in terms of domestic currency on domestic and \ 1S-LM model we have seen so far. the role of expectations and the openness ofthe i} economy, a : i hi Openness in goods markets allows people and firms to sponds toa decrease in the real exchange rate. A real de- he chanel between domestic and forcien goods. Openness in preciation is a decrease in the relative price of domestic) hi financial markets allows financial investors to hold do- goods. It corresponds to an inerease in the real exchange A mestic of foreign financial assets. a i! “The nominal exchange rate isthe price of one unit of jal real exchange rate. or real exchange Vay foreign currency in terms of domestic currency. Thus, n weighted average of bilateral realex: 24! Hy | from the viewpoint of the United States. the nominal ex- change rates, with weights equal to trade shares. i. | ‘change rate between the United States and Germany is The balance of payments records a country’s transac: the number of dollars per DM. tions with the rest of the world, The eurrent account bal- II “A nominal appreciation (or appreciation. for short) is ance is equal to the sum of the trade balance, net I an incense relative price the domestic currency investment income, and net transfers received from the | in terms of foreign currencies, Given the definition of the rest of the world, The capital account balance is equal 10 te) exchange rate. it corresponds toa decrease in the ex- capital flows from the res ofthe world, minus capital i Change rate, A nominal depreciation (or depreciation, for flows to the rest of the world ae ' Short) is decrease in the relative price of the domestic The current account and the capital account are mir> | currency in terms of forcign currencies: it corresponds to ror images of each other. A current account deficits f+ | ‘an inerease in the exchange rate nanced by net capital flows from the rest of the world, ] The real exchange rate ts the relative price of foreign thus by a capital account surplus. Similarly, a current goods in terms of domestic goods. tis equal to te nomi- account surphs corresponds to a capital account ral exchange rate times the Toreign price level divided by deficit the domestic price level Uncovered interest party, or interest parity for short. “A real appreciation isan increase in the relative price an arbitrage condition stating thatthe expected rates of ff