Openness in Goods and Financial Markets
Openness in Financial Markets
The Relation Between Trade and Financial Flows
The U.S. Balance of Payments, 1998
Current Account
Exports
931
Imports
Trade balance (deficit = -) (1)
Investment income received
Investment income paid
Net investment income (2)
Net transfers received (3)
Current account balance (deficit = -) (1)+(2)+(3)
Capital Account
Increase in foreign holdings of U.S. assets
Increase in U.S. holdings of foreign assets
Net increase in foreign holdings/net capital flow to the U.S.
Statistical discrepancy
Econ 302
1100
-169
242
265
-23
-41
-233
542
305
The Goods Market in an Open Economy
237
4
Slide #1
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
1. Trade in Goods and Services
* Exports: Payments from the rest of the world ($931 Billion)
* Imports: Payments to the rest of the world ($1,100 Billion)
2. Investment Income
* U.S. residents receive income on their holdings of foreign assets
($242 Billion)
* Foreign residents receive income on their holdings of U.S. assets
($265 Billion)
Econ 302
The Goods Market in an Open Economy
Slide #2
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
3. Foreign Aid (-$41 Billion)
* Net transfers received
The difference between foreign aid received and given
4. Current account balance (+,-)= 1+2+3= -$233 Billion (1998)
Econ 302
The Goods Market in an Open Economy
Slide #3
Openness in Goods and Financial Markets
Openness in Financial Markets
The Balance of Payments
The Capital Account
1. Increase in foreign holdings of U.S. assets ($542 Billion)
2. Increase in U.S. holdings of foreign assets ($305 Billion)
3. Net capital flows = 1-2
($542 Billion - $305 Billion = -237 Billion)
Statistical discrepancy: Accounts for differences in data sources.
Econ 302
The Goods Market in an Open Economy
Slide #4
Openness in Goods and Financial Markets
Openness in Financial Markets
The Balance of Payments
• The Current Account Balance (+,-) = Capital Account Balance (+,-)
• A Current Account Deficit increases foreign holdings of U.S.
assets and vice versa.
Econ 302
The Goods Market in an Open Economy
Slide #5
Openness in Goods and Financial Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets
An Example: Choose between U.S. and German 1 yr. bonds
• US Bonds
• it = U.S. nominal interest rate
• (1+it) = Return next year /$purchase of U.S. bonds
Econ 302
The Goods Market in an Open Economy
Slide #6
Openness in Goods and Financial Markets
Openness in Financial Markets
Expected Returns from Holding One-Year U.S. or German Bonds
Year t+1
Year t
U.S. bonds
German bonds
Econ 302
$1
 1
DM 
 Et
$(1+it)



 1
DM 
 Et
The Goods Market in an Open Economy

(1  i * t )

Slide #7
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:
1
e
1  it   (1  i *t )( E t 1 )
 Et 
U.S. Bond =
Return
Econ 302
German Bond
Return
The Goods Market in an Open Economy
Slide #8
Openness in Goods and Financial Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets (Continued)
 1
1  it  
 Et
U.S. Bond
Return
=

(1  i *t )(E et 1)

German Bond
Return
A little reorganizing:
The Interest Parity Condition:
Econ 302
E et 1
1  it  (1  i *t )
Et
The Goods Market in an Open Economy
Slide #9
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 the
highest expected return realistic?
Some other considerations:
-- Transaction Costs
-- Exchange Rate Risk
Observation:
The interest parity condition is a good approximation for
developed countries with open, well-organized financial
markets.
Econ 302
The Goods Market in an Open Economy
Slide #10
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 the
value of the domestic currency
E et 1
The Interest Parity Condition: 1  i t  (1  i *t )
Et
 E e t 1  Et 

Or: 1  i t  (1  i *t )1 
Et


E
Econ 302
e
 Et
Et
t 1
= Expected rate of depreciation of the domestic
currency
The Goods Market in an Open Economy
Slide #11
Openness in Goods in Financial Markets
Openness in Financial Markets
The Choice Between Domestic and Foreign Assets (Continued)
An approximation:
i t  i *t 
Econ 302
E
e
t 1
 Et
Et
The Goods Market in an Open Economy
Slide #12
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
Econ 302
The Goods Market in an Open Economy
Slide #13
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?
Econ 302
The Goods Market in an Open Economy
Slide #14
The IS Relation in the Open Economy
The Open Economy Demand for Domestic Goods...
Z  C + I + G - Q + X
Econ 302
 Q:
The value of imports in terms of domestic goods
X:
Exports
The Goods Market in an Open Economy
Slide #15
The IS Relation in the Open Economy
The Determinants of the Demand for Domestic Goods
The Determinants of C, I, & G
Domestic Demand: C + I + G = C(Y-T) + I(Y,r) + G
(+)
(+,-)
The Determinants of Imports
Imports: Q = Q(Y, )
(+ , - )
The Determinants of Exports
Exports: X = X(Y*, )
(+ , +)
Econ 302
The Goods Market in an Open Economy
Slide #16
The IS Relation in the Open Economy
The Open Economy Graphically
DD
Domestic demand
(C + I + G)
AA
Demand
Demand
DD
Imports ( Q)
Output
Output
Observations
• Difference between DD & AA increases with income
• AA is flatter than DD
• AA has a positive slope
Econ 302
The Goods Market in an Open Economy
Slide #17
The IS Relation in the Open Economy
The Open Economy Graphically
Demand for Domestic Goods
Net Exports (NX) = X -
Including Exports (ZZ)
Q
DD
Net exports, NX
Demand
ZZ
AA
C
Exports (X)
B
BC: Net Exports (X –
A
AC: Exports
Y < YTB
Trade surplus
0
Y
Q)
NX
BC
AB: Imports
Y
Econ 302
YTB
YTB
Output
The Goods Market in an Open Economy
Y > YTB
Trade deficit
Output, Y
Slide #18
The IS Relation in the Open Economy
Equilibrium Output and the Trade Balance
Goods Market Equilibrium:
Y
=
Domestic
Output
=
Z
Demand for
Domestic Goods
Y = C(Y-T) + I(Y,r) + G -  Q(Y, ) + X(Y*, )
Econ 302
The Goods Market in an Open Economy
Slide #19
The IS Relation in the Open Economy
ZZ
A
Z
Net exports, NX
Demand, Z
Equilibrium Output and the Trade Balance
Trade deficit
B
0
Y
YTB
Equilibrium
Y=Z
C
NX
45°
Y
Econ 302
Output
The Goods Market in an Open Economy
Output, Y
Slide #20
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
Demand, Z
A´
ZZ
G>0
A
New
Equilibrium
( Y >  G)
Net exports, NX
ZZ´ (G > 0)
Initial equilibrium
Y = YTB
Trade deficit
BC@Y’
B
0
Y
YTB
C
NX
Initial
equilibrium
45°
Y
Econ 302
Y´
Output
The Goods Market in an Open Economy
Output, Y
Slide #21
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?
Econ 302
The Goods Market in an Open Economy
Slide #22
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 impact
of 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.:
Econ 302
Import ratio = 13%
Even in the U.S. domestic policy is reduced by
the open economy.
The Goods Market in an Open Economy
Slide #23
The IS Relation in the Open Economy
Increases in Demand, Domestic or Foreign
Increases in Foreign Demand
A: Initial equilibrium &
balanced trade
Y*: Increases &  X
DD
 NX
A´: New equilibrium
ZZ
C
X
ZZ´
X
A
Demand for domestic
goods
Domestic demand
D
45°
Y
Econ 302
Y´
Net exports, NX
Demand, Z
A´
0
Output
The Goods Market in an Open Economy
 NX
YTB
Y
Y´
NX´
NX
Output, Y
Slide #24
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.
Econ 302
The Goods Market in an Open Economy
Slide #25
The IS Relation in the Open Economy
Increases in Demand, Domestic or Foreign
Two Observations:
Econ 302
1.
Increase in domestic demand leads to an increase in
Y and a trade deficit.
2.
Increase in foreign demand leads to an increase in
Y and a trade surplus.
The Goods Market in an Open Economy
Slide #26
The IS Relation in the Open Economy
Depreciation, the Trade Balance, and Output
The Depreciation of a Currency ($)
Recall:
EP *

P
Real Exchange Rate: E: Nominal exchange rate
P*: Foreign price level
P: Domestic price level
Assuming Constant
Prices:
Econ 302
The depreciation of a currency ($) will make
that country’s goods cheaper in other
countries and vice versa.
The Goods Market in an Open Economy
Slide #27
The IS Relation in the Open Economy
Depreciation, the Trade Balance, and Output
Depreciation and the Trade Balance: The Marshall-Lerner
Condition
Net Exports:
NX  X -  Q
NX = X(Y*, ) -  Q(Y, )
Depreciation (increase in ) affects the trade balance in three ways:
1. X increases
3.  Q increases
2. Q decreases
The Marshall-Lerner Condition: For depreciation to improve the
trade balance--the increase in X and decrease in Q is greater
than the increase in  Q.
Econ 302
The Goods Market in an Open Economy
Slide #28
The IS Relation in the Open Economy
Depreciation, the Trade Balance, and Output
The Effects of a Depreciation
Tracing a Depreciation Through the Economy
1. Shift demand, both foreign and domestic toward domestic goods
2. Net exports increase (Marshall-Lerner)
3. Equilibrium Y increases
4. Trade balance improves
Econ 302
The Goods Market in an Open Economy
Slide #29
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 Y
Policy:
Balance depreciation and fiscal constraint
Depreciation shifts
ZZ to ZZ´ & Y to Y´
NX
ZZ´
A´
G
NX
A
Initial
equilibrium
45°
Y
Econ 302
ZZ
Net exports, NX
Demand, Z
Reduction in G shifts
ZZ´ to ZZ & Y
Depreciation shifts
NX to NX´ &
balanced trade
Y´
B
0
Output
The Goods Market in an Open Economy
Y
NX´
C
NX
Output, Y
Slide #30
The IS Relation in the Open Economy
Depreciation, the Trade Balance, and Output
Combining Exchange Rate and Fiscal Policies
Exchange Rate and Fiscal Policy Combinations
Initial Conditions
Trade Surplus
Trade Deficit
Low output
? G
  G?
High output
  G?
? G
Econ 302
The Goods Market in an Open Economy
Slide #31
The IS Relation in the Open Economy
Looking at Dynamics: The J-Curve
+
Net exports, NX
Depreciation
Time
0
0
A
C
B
_
Econ 302
The Goods Market in an Open Economy
Slide #32
The IS Relation in the Open Economy
The Real Exchange Rate and the Ratio of Net Exports to
GDP: U.S., 1980-1990
Econ 302
The Goods Market in an Open Economy
Slide #33
The IS Relation in the Open Economy
Looking at Dynamics - The J-Curve
The U.S. - 1980-1990
1. Movements real exchange rates were reflected in parallel
movements in net exports.
2. There were substantial lags in the response of the trade balance
to changes in the real exchange rate. The J-Curve at work.
Econ 302
The Goods Market in an Open Economy
Slide #34
The IS Relation in the Open Economy
Saving, Investment, and Trade Deficits
Recall:
Y = C + I + G -  Q + X and S = Y - C + T
Subtract C + T from both sides:
S=I+G-T-Q+X
And using NX  X -  Q
NX
Trade
Balance
Econ 302
= S + (T - G) - I
=
Saving
-
Investment
The Goods Market in an Open Economy
Slide #35
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.
Econ 302
The Goods Market in an Open Economy
Slide #36
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 domestic
demand?
What would be the impact on the trade balance if all countries
increased domestic demand together?
Econ 302
The Goods Market in an Open Economy
Slide #37
The IS Relation in the Open Economy
Increases in Demand, Domestic or Foreign
Games that Countries Play
Coordination:
As global commerce expands, the motivation for
coordination increases. For example, the G7
meetings.
The Evidence:
There is very little limited macro-coordination.
Barriers to
Coordination:
• Not all countries experience the same economic
conditions.
• Budget and trade balances may differ.
• Countries have an incentive to promise and then
not deliver on the promise.
Econ 302
The Goods Market in an Open Economy
Slide #38
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*, )
Observation: Equilibrium Y & Demand depend on the…
real interest rate (r)
real exchange rate ()
r  I  Demand  Multiplier  Y
    Demand for Domestic Goods Demand Y
Econ 302
The Goods Market in an Open Economy
Slide #39
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)
( + ) (+,-)
(- , + , + )
Econ 302
The Goods Market in an Open Economy
Slide #40
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
Econ 302
Supply of money
=
M
P
=
Demand for money
YL(i)
The Goods Market in an Open Economy
Slide #41
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:
i t  i *t
Domestic
i
Econ 302
=
E *t 1 Et

Et
Foreign
i
+
The Goods Market in an Open Economy
Expected
Depreciation
Slide #42
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
Assume:
E e is given   denote it E e
E E
it  i * 
1 i  i *
e
Then:
Solving for E:
Econ 302
Ee
E
1 i  i *
The Goods Market in an Open Economy
Slide #43
Output, the Interest Rate, and the
Exchange Rate
Equilibrium in the Financial Markets
Domestic Bonds vs. Foreign Bonds
e
Interpreting:
E
E
1 i  i *
i Exchange Rate (appreciation of domestic currency)
i* Exchange Rate (depreciation of domestic currency)
Econ 302
The Goods Market in an Open Economy
Slide #44
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*
& E=Ee
• U.S. monetary contraction increases i, if E is constant
U.S. bonds become more attractive i > 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
Econ 302
The Goods Market in an Open Economy
Slide #45
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
e
E E
In terms of i  i * 
E
10% = 4% + 6%
Econ 302
The Goods Market in an Open Economy
Slide #46
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
Interest Rate:
M
 YL(i )
P
The interest parity condition implies i & E are negatively
related.
Ee
Exchange Rate: E 
1 i  i *
Econ 302
The Goods Market in an Open Economy
Slide #47
Equilibrium in Financial Markets
The Relation
Between the Interest
Rate and the
A
lower domestic
Exchange
Rateinterest
rate
leadsby
to a
higher
Implied
Interest
exchange
Parity rate—to a
depreciation of the
domestic currency. A
higher domestic interest
rate leads to a lower
exchange rate—to an
appreciation of the
domestic currency.
Econ 302
The Goods Market in an Open Economy
Slide #48
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

Ee 

IS : Y  C (Y  T )  I (Y , i )  G  NX Y ,Y *,
1 i  i * 

Econ 302
The Goods Market in an Open Economy
Slide #49
Output, the Interest Rate, and the
Exchange Rate
Putting Goods and Financial Markets Together
Consider:

Ee 

IS : Y  C (Y  T )  I (Y , i )  G  NX Y ,Y *,
1 i  i * 

If i increases:
• Direct Effect: I  Y
• Indirect Effect: Domestic Currency Appreciates
NX  Y
In an open economy is the multiplier larger or smaller?
Econ 302
The Goods Market in an Open Economy
Slide #50
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 domestic
bonds 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.
Econ 302
The Goods Market in an Open Economy
Slide #51
Putting Goods and
Financial 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.
Econ 302
The Goods Market in an Open Economy
Slide #52
20-4
The Effects of Policy
in an Open Economy
The Effects of an
Increase in
Government
An increase in
government spending
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 interestparity curve.
Econ 302
The Goods Market in an Open Economy
Slide #53
The Effects of Monetary Policy
in an Open Economy
The Effects of a
Monetary
A monetary contraction
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.
Econ 302
The Goods Market in an Open Economy
Slide #54
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
Econ 302
The Goods Market in an Open Economy
Slide #55
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.
Econ 302
The Goods Market in an Open Economy
Slide #56
Output, the Interest Rate, and the
Exchange Rate
Fixed Exchange Rates
Pegging the Exchange Rate and Monetary Control
Assume: A country pegs its exchange at
E
E e t 1  Et
Given the interest parity condition: i t  i *t 
Et
E E
 i *t
And: Et  E , then i t  i * t 
E
M
M
 YL(i ) now i=i* or
 YL(i *)
Recall the LM Relation:
P
P
Therefore, to maintain
to keep i at i*.
Econ 302
E
, the money supply must be adjusted
The Goods Market in an Open Economy
Slide #57
Fiscal Policy Under
Fixed Exchange Rates
The Effects of a
Fiscal Expansion
Under
Fixed
Under flexible
exchange
rates,
a
Exchange
Rates
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.
Econ 302
The Goods Market in an Open Economy
Slide #58
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.
Econ 302
The Goods Market in an Open Economy
Slide #59