Foreign trade
• In the next two lectures we will develop versions
of the IS-LM and AD-AS models for an open
economy.
• An open economy can have several meanings:
– Goods market: trades goods and services
– Financial market: allow the flow of investment capital
– Factor market: allows the free movement of
companies and people
• In this class we will focus on the first two:
openness in goods and financial markets.
How open is the Australian
economy?
120000
100000
80000
60000
40000
20000
0
19
4
19 9
5
19 2
5
19 5
5
19 8
6
19 1
6
19 4
6
19 7
7
19 0
7
19 3
7
19 6
7
19 9
8
19 2
8
19 5
8
19 8
9
19 1
94
Million A$
• You could measure
the size of imports or
exports (why not
both?) in the
Australian economy.
• But this would lead to
the same problems as
measuring GDP in
nominal terms.
Exports Imports
Importance of external trade
40
Ratio to GDP (percent)
35
Imports/GDP
30
25
20
15
10
Exports/GDP
5
0
1901
1911
1921
1931
1941
1951
1961
1971
1981
1991
2001
Globalization?
• Much is made of the “new” impact of
globalization in the world economy.
• But from the previous graph, the Australian
economy is as dependent (even less) on the rest
of the world as it was one century ago.
• “Globalization” must be referring to something
else instead- the free flow of people and ideas
across the world- rather than goods and
services.
Trade balance
• We define a term “net exports”, which is just
exports minus imports, X – M.
• If X>M, we say we are in a “trade surplus” and if
X<M, we say we are in a “trade deficit”.
• The trade deficit in Australia has grown large in
nominal terms in the last twenty years, but as a
percentage of GDP, it has stayed constant (or
even fallen).
• Later, we will explore what an Australian trade
deficit means.
Millions A$
0
-6
-4000
-9
-6000
-12000
-12
-8000
-15
-18
-10000
-21
-24
% of GDP
19
49
19
51
19
53
19
55
19
57
19
59
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
Australian trade deficit
4000
6
2000
3
0
-2000
-3
Nominal exchange rates
• When we talk of “exchange rates”, we have to be
cautious, as there are many types of “exchange rates”
that are used.
• The “nominal exchange rate” is the rate at which the
Australian dollar (A$) trades for other currencies- the
“price of the Australian dollar”.
• Example: If the Australian dollar trades for $0.80, we
mean that A$1 is worth US$0.80.
• Note that there will be as many nominal exchange rates
as there are other currencies.
• For Australia, the reference currencies are usually US$
and the Japanese Yen.
Price of the A$
1.60
US$ per A$
1.40
US$/A$
1.20
1.00
0.80
0.60
0.40
1960
1965
1970
1975
1980
1985
1990
1995
2000
Appreciation and depreciation
• When we talk of an “appreciation of the A$”, we
mean that the price of the A$ in terms of another
currency has increased, so the A$ was
appreciating in 1973.
• When we talk of a “depreciation of the A$”, we
mean that the price of the A$ in terms of
another currency has decreased, so the A$ has
generally depreciated against the US$ since the
mid 1970s.
• But these are nominal terms, and don’t signify
much in reality.
Real exchange rate
• We would like to have an exchange rate that got
rid of the effects of prices and concentrated on
“real” effects, just as we do with real GDP.
• We would like instead to talk simply in terms of
how Australian goods trade for American goods.
• Example: Harry Potter and the Half-Blood Prince
sells for US$17.99 at www.amazon.com, while at
www.dymocks.com.au it sells for A$29.95.
• What is the real exchange rate between Potter in
Australia and Potter in the US?
Real exchange rate
• We need to translate the prices into a common
currency, so we will use the Australian $. The
nominal exchange rate, E, is US$0.78/$A1.
• One US Potter goes for US$17.99, which is
US$17.99/E
US$17.99/(US$0.78/A$1) = A$23.06
• The real exchange rate is
A$29.95/A$23.06 = 1.30.
• But let’s say we want a real exchange rate for
the whole economy, not just for copies of Potter.
• We use the general
price levels (or GDP
deflators) in the two
countries. Let P be
the Australian price
level, and P* be the
US price level.
• Real exchange rate
e = P / (P*/E)
e = EP/P*
Australian goods in terms of US goods
Real exchange rate
1.60
Nominal
exchange rate,
1.40
1.20
1.00
0.80
0.60
Real exchange
rate, e
0.40
1960
1965
1970
1975
1980
1985
1990
1995
2000
Real exchange rate
• The real exchange rate then expresses how
average prices are moving in Australia with
respect to other countries, such as the US.
• The nominal exchange rate of the A$, E, fell
against the US$, but the real exchange rate did
not fall as much. Why?
• Answer: Average inflation in Australia was higher
than in the US, so P grew faster than P*
balancing out the drop in E.
Multilateral exchange rates
• The higher is e, the cheaper US goods are
compared to Australian goods.
• So far we have been considering only exchange
rates between Australia and the US, but
Australia trades with many countries. What if
the A$ falls against the US$, but rises against
the Japanese Yen?
• Multilateral exchange rates show the price of the
A$ compared to a weighted average of the
currencies of our trading partners, where the
weight of a currency depends on the percentage
of our trade it composes.
What determines E?
• The nominal exchange rate (say US$/A$) is
determined in a market for A$, where you have
both supply and demand for A$. E is the price in
this market.
• Who demands A$?
– Exporters who buy Australian goods to sell overseas.
– Foreign investors who buy Australian assets.
• Who supplies A$?
– Importers who want to buy overseas goods.
– Australian investors who buy foreign assets.
Market for A$
Exchange rate
(cost of 1 A$ in
terms of US$)
Supply of A$
•Domestic investors
•Importers
Demand for A$
•Foreign investors
•Exporters
Amount of A$
Market for A$
• The nominal exchange rate is then affected both
by changes in the goods market and also the
financial markets.
• But the volume of A$ traded on the world
financial markets was A$75 billion per day in
2001, while the volume of goods trade was
A$0.7 per day in 2001. Goods trade was only
1% of financial trading in the A$.
• In the short-term, the price of the A$ is
determined by changes in financial markets.
Financial market openness
• Openness in financial markets means that
investors are free to put their money where they
wish.
• Australian investors are free to invest overseas,
and foreign investors are free to invest in
Australia.
• In this case, investors will put their money where
they think it will earn the highest returns.
• In equilibrium that means that expected asset
returns must be the same in Australia as
overseas.
Domestic and foreign assets
• Return on A$1 invested in Australia for a year:
1+ it
• Return on A$1 invested in the US:
A$1 becomes US$Et
US$Et becomes US$(1+ it*)Et
US$(1+ it*)Et becomes US$(1+ it*)Et / Et+1e
• As you have to buy a US asset, earn the US
interest rate, i*, and then turn the US$ back into
A$ in a year.
Interest parity
• For returns on the two assets to be the same,
we will have:
1+ it = US$(1+ it*) Et / Et+1e
• Manipulating this and taking logs, it becomes the
condition:
it = it* - [(Et+1e - Et)/ Et]
• The domestic interest rate must be equal to the
foreign interest rate less the expected rate of
appreciation.
• Or it - it* = Expected appreciation of A$.
Interest parity
16.0
14.0
Australian interest rate
12.0
Per cent
• Another way of thinking
about this is to remember
that you earn money on
foreign assets either
because of foreign
interest rates or because
of exchange rate
movements.
• If I expect my currency to
depreciate, I will need a
high interest rate to keep
my money in the country.
10.0
8.0
6.0
U.S. interest rate
4.0
2.0
1971
1976
1981
1986
1991
1996
2001
Imports and exports
• We assume that Australian consumers will
consume more imports as their income rises and
as imports become cheaper (e rises):
IM = IM(Y, e)
(+ , +)
• We assume that foreign consumers will
consume more Australian exports as foreign
income rises and as exports become cheaper (e
falls):
X = X(Y*, e)
(+, -)
The new IS equation
• Exports are measured in Australian goods, but
imports are foreign goods, so we have to
translate into Australian good through the real
exchange rate, e, so net exports are:
NX = X(Y*, e) – IM(Y, e)/e
• This becomes a component of our AD, so
equilibrium in the goods market requires:
Y = C(Y-T) + I(Y, r) + G + NX
Y = C(Y-T) + I(Y, r) + G + X(Y*, e) – IM(Y, e)/e
The new IS equation
• We have a new IS curve which depends on Y
and r, and has G, T, Y* and e as parameters.
• An increase in Y* will shift the IS curve to the
right, as export demand rises, but what happens
when e rises?
• When e rises, perhaps because E rises, X falls
and IM rises, as Australian goods are now more
expensive. But what happens to IM/e- the value
of imports? It is ambiguous.
• Marshall-Lerner condition: A rise in e will lead to
a drop in NX.
The J curve
• Typically prices move much faster than
goods supply and demand- ie. firms order
goods in advance.
• In this case, X and IM will not move when
e falls. But that means that NX will initially
fall if e falls, even if the Marshall-Lerner
condition is satisfied. Eventually however
the X and IM will react and NX will rise.
• We saw this in the early 80s in Australia.
Real exchange rate (1995=100)
140
Real exchange
rate (scale at
left)
130
4
Trade deficit/GDP
(scale at right)
3
120
2
110
1
100
0
90
-1
1980
1985
1990
1995
2000
Ratio of trade deficit to GDP (percent)
Paul Keating’s J curve