Open Economy Macroeconomics
The Final Frontier
Closed Economy
Macroeconomics
• Y = C + I + G (Goods Market)
• S = I + (G-T) (Asset Market)
• There is only one medium of exchange ($)
Open Economy Macroeconomics
• NX = Exports – Imports
– NX < 0 : Trade Deficit
– NX > 0 : Trade Surplus
• Y = C + I + G + NX
• S = I + (G-T) + NX
Output/Income in the Open
Economy
• Trade Deficits imply NX< 0
• Therefore, Y- (C + I + G) = NX < 0
• Countries that run trade deficits are
consuming more that they earn
Savings in the Open Economy
• Again, a trade deficit implies NX<0
• Therefore, S – (I – (G-T)) = NX < 0
– A country with a trade deficit is borrowing
from the rest of the world
– That is, foreign countries are acquiring
domestic assets
Balance of Payments Accounting
• Anything that we buy or sell to the rest of
the world must be paid for.
– The current account (CA) tracks the flow of
goods and services between the US and the rest
of the world
– The capital & financial account tracks the
payments for those goods & services (KFA)
– CA + KFA = 0
The Current Account
• Any transaction that represents a flow of funds out of the
US is represented by debit (-). Transactions that represent
a flow of money into the US are represented by a credit(+)
The Current Account
• Any transaction that represents a flow of funds out of the
US is represented by debit (-). Transactions that represent
a flow of money into the US are represented by a credit(+)
– Net Exports of Goods and Services
Exports (+)
Imports (-)
– Net Income From Abroad (NFP)
Income Earned by US nationals abroad (+)
Income earned by foreign nationals in the US (-)
– Net Unilateral Transfers
Payments from foreign countries (+)
Payments to foreign Countries (-)
The US Current Account (in
Billions of $s)
• Net Exports of Goods & Services
– Services: $52
– Goods: -$652
-$600
• Net Factor Payments: -$12
• Net Unilateral Transfers: -$72
Current Account Balance: -$684
The Capital & Financial Account
• Again, any transaction that represents funds
flowing into (out of) the US are credits (debits) in
the KFA
The Capital & Financial Account
• Again, any transaction that represents funds
flowing into (out of) the US are credits (debits) in
the KFA
– Financial assets
Foreign acquisition of US assets (+)
US acquisition of foreign assets (-)
– Official Reserve Assets
Foreign acquisition of US reserve assets (+)
US acquisition of foreign reserve assets (-)
The US Capital & Financial
Account (in billions of $s)
• Private Assets
– Foreign acquisition of US assets: $1,060
– US acquisition of foreign assets: -$472
$588
• Official Reserve Assets
– Foreign acquisition of US ORA: $22
– US acquisition of foreign ORA: $2
$24
• US KFA account balance: $612
• Note: CA (-$684) + KFA ($612) = -$72 (statistical discrepancy)
Example
• Suppose that you purchase a case of French wine
for $1500 (for simplicity, assume that you pay
with cash)
Balance of Payments Accounts
Current Account
Exports
Goods:
Services:
Imports
Goods: -$1500
Services:
Net Factor Income:
Net Unilateral Transfers:
Capital & Financial Account
Financial assets:
Foreign acquisition of US
assets:
US acquisition of foreign
assets
Official Reserve Assets
Foreign acquisition of US
ORA:
US acquisition of foreign
ORA:
Example
• Suppose that you purchase a case of French wine
for $1500 (for simplicity, assume that you pay
with cash)
– Case #1: The French wine distributor uses the $1500 to
purchase a computer from Dell
Balance of Payments Accounts
Current Account
Exports
Goods: $1500
Services:
Imports
Goods: -$1500
Services:
Net Factor Income:
Net Unilateral Transfers:
Capital & Financial Account
Financial assets:
Foreign acquisition of US
assets:
US acquisition of foreign
assets
Official Reserve Assets
Foreign acquisition of US
ORA:
US acquisition of foreign
ORA:
Example
• Suppose that you purchase a case of French wine
for $1500 (for simplicity, assume that you pay
with cash)
– Case #1: The French wine distributor uses the $1500 to
purchase a computer from Dell
– Case #2: The French wine distributor uses the $1500 to
buy a US T-Bill.
Balance of Payments Accounts
Current Account
Exports
Goods:
Services:
Imports
Goods: -$1500
Services:
Net Factor Income:
Net Unilateral Transfers:
Capital & Financial Account
Financial assets:
Foreign acquisition of US
assets: $1500
US acquisition of foreign
assets:
Official Reserve Assets
Foreign acquisition of US
ORA:
US acquisition of foreign
ORA:
Example
• Suppose that you purchase a case of French wine
for $1500 (for simplicity, assume that you pay
with cash)
– Case #1: The French wine distributor uses the $1500 to
purchase a computer from Dell
– Case #2: The French wine distributor uses the $1500 to
buy a US T-Bill.
– Case #3: The French wine distributor uses the $1500 to
buy Euros from the Federal Reserve
Balance of Payments Accounts
Current Account
Exports
Goods:
Services:
Imports
Goods: -$1500
Services:
Net Factor Income:
Net Unilateral Transfers:
Capital & Financial Account
Financial assets:
Foreign acquisition of US
assets:
US acquisition of foreign
assets:
Official Reserve Assets
Foreign acquisition of US
ORA: $1500
US acquisition of foreign
ORA:
Payments to Iraq
• In 2003, The US government approved an $87 billion aid
package to Iraq. How will this be reflected in the BOP
accounts?
Balance of Payments Accounts
Current Account
Exports
Goods:
Services:
Imports
Goods:
Services:
Net Factor Income:
Net Unilateral Transfers: -$87B
Capital & Financial Account
Financial assets:
Foreign acquisition of US
assets:
US acquisition of foreign
assets:
Official Reserve Assets
Foreign acquisition of US
ORA:
US acquisition of foreign
ORA:
Payments to Iraq
• In 2003, the US government approved an $87 billion aid
package to Iraq. How will this be reflected in the BOP
accounts?
– The $87 billion payment is represented by a debit under
unilateral transfers
– Most of that money was used to pay US soldiers and
US reconstruction companies (around $70B)
Balance of Payments Accounts
Current Account
Exports
Goods:
Services:
Imports
Goods:
Services:
Net Factor Income: $70B
Net Unilateral Transfers: -$87B
Capital & Financial Account
Financial assets:
Foreign acquisition of US
assets:
US acquisition of foreign
assets:
Official Reserve Assets
Foreign acquisition of US
ORA:
US acquisition of foreign
ORA:
Payments to Iraq
• The US government just approved an $87 billion aid
package to Iraq. How will this be reflected in the BOP
accounts?
– The $87 billion payment is represented by a debit under
unilateral transfers
– Most of that money is being used to pay US soldiers
and US reconstruction companies (around $70B)
– The rest will be used to buy US goods or US assets
(either by Iraq or by other countries)
Balance of Payments Accounts
Current Account
Exports
Goods: $5B
Services: $7B
Imports
Goods:
Services:
Net Factor Income: $70B
Net Unilateral Transfers: -$87B
Capital & Financial Account
Financial assets:
Foreign acquisition of US
assets: $5B
US acquisition of foreign
assets:
Official Reserve Assets
Foreign acquisition of US
ORA:
US acquisition of foreign
ORA:
Payments to Iraq
• The US government just approved an $87 billion aid
package to Iraq. How will this be reflected in the BOP
accounts?
– The $87 billion payment is represented by a debit under
unilateral transfers
– Most of that money is being used to pay US soldiers
and US reconstruction companies (around $70B)
– The rest will be used to buy US goods or US assets
(either by Iraq or by other countries)
• How would the BOPs change if this $87B was a loan
rather than aid?
Balance of Payments Accounts
Current Account
Exports
Goods: $5B
Services: $7B
Imports
Goods:
Services:
Net Factor Income: $70B
Net Unilateral Transfers:
Capital & Financial Account
Financial assets:
Foreign acquisition of US
assets: $5B
US acquisition of foreign
assets: -$87B
Official Reserve Assets
Foreign acquisition of US
ORA:
US acquisition of foreign
ORA:
The Balance of Payments
• There are two possible definitions for the
balance of payments:
– Current Account + Net foreign acquisition of
US assets
-$684 + $588 = -$96
– Net acquisition of Foreign Official Reserve
Assets: $24
• The difference is the statistical discrepancy
Trade Deficits vs. Balance of
Payments Deficits
• The US currently has a growing trade deficit.
– There more demand for foreign currencies (to buy
foreign goods) that demand for US dollars (to buy US
goods). Does this mean that the dollar should
depreciate?
-20
-40
-60
-80
-100
-120
-140
-160
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
US Balance of Payments
20
0
Current Account
-50
-100
-150
-200
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
US Balance of Payments
250
200
150
100
50
0
Current Account
FKA
-50
-100
-150
-200
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
US Balance of Payments
200
150
100
50
0
BOP
ORA
US Trade Weighted Exchange
Rate Index
140
130
120
110
100
90
80
70
60
50
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
ECU/$
Exchange Rates
• The nominal exchange rate reflects the relative value of
one currency in terms of another.
• BE CAREFUL!!!! WATCH THE UNITS!!!!
Exchange Rates
• The nominal exchange rate reflects the relative value of
one currency in terms of another.
• BE CAREFUL!!!! WATCH THE UNITS!!!!
• If the exchange rate (e) is defined as the dollar price of a
unit of foreign currency
for example, 1 Euro = $1.33
– An increase (decrease) in e represents a dollar depreciation
(appreciation)
Exchange Rates
• The nominal exchange rate reflects the relative value of
one currency in terms of another.
• BE CAREFUL!!!! WATCH THE UNITS!!!!
• If the exchange rate (e) is defined as the foreign currency
price of a dollar
for example, $1 = E .75
– An increase (decrease) in e represents a dollar appreciation
(depreciation)
The Dollar vs. The Euro
1.2
1.15
1.1
1.05
1
0.95
0.9
0.85
0.8
0.75
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
$/Euro
Cross Rates
• Note that most currency prices are related to the dollar.
For example, the British pound sells for $1.93/GBP
• We can use any two dollar exchange rates to find the
“cross rates” (non-dollar exchange rates)
Cross Rates
• Note that most currency prices are related to the dollar.
For example, the British pound sells for $1.93/GBP
• We can use any two dollar exchange rates to find the
“cross rates” (non-dollar exchange rates)
• For example, if the exchange rate for Japanese yen is
Y109.62/$, then the price of a GBN in Yen is
E = 102(Y/$) * 1.93 ($/GBP)
= 196.86(Y/GBP)
Adding Net Exports to Capital
Markets
• Without access to world capital
markets, a country’s private
saving is the sole source of
funds. Therefore, the domestic
interest rate must adjust to
insure that S = I + (G-T)
• In this example, the domestic
interest rate is equal to 10% and
S = I +(G-T) = 300
• What will happen if we expose
this country to trade?
20
16
12
8
4
0
0
100
200
300
400
500
Adding Net Exports to Capital
Markets
• Suppose that the prevailing
world (real) interest rate is 6%
20
16
12
8
4
0
0
100
200
300
400
500
Adding Net Exports to Capital
Markets
• Suppose that the prevailing
world interest rate is 6%
• At 6%,
– S = $100
– I + (G-T) = $500
– NX = $100 - $500 = -$400
20
16
12
8
4
0
0
100
200
300
400
500
Adding Net Exports to Capital
Markets
• Suppose that the prevailing
world interest rate is 14%
20
16
12
8
4
0
0
100
200
300
400
500
Adding Net Exports to Capital
Markets
• Suppose that the prevailing
world interest rate is 14%
– S = $500
– I + (G-T) = $100
– NX = $500 - $100 = $400
20
16
12
8
4
0
0
100
200
300
400
500
Where does the world interest
rate come from?
20
16
12
8
4
0
00
50
0
00
40
0
00
30
00
20
0
00
10
0
0
0
• Aggregate world savings is the
sum of private savings across
countries
• Aggregate Private Investment
and Government Deficits are
also summed over all countries
• By definition, NX summed over
all countries must equal zero.
Therefore, at the world
equilibrium interest rate,
S = I + (G-T)
• In this example, r = 11%
Example: An increase in
productivity
20
16
12
8
4
0
00
50
0
00
40
0
00
30
00
20
0
00
10
0
0
0
• Suppose that trade is initially
balanced. A rise in productivity
increases investment demand
Example: An increase in
productivity
24
20
16
12
8
4
0
00
50
0
00
40
0
00
30
00
20
0
00
10
0
0
0
• Suppose that trade is initially
balanced. A rise in productivity
increases investment demand
• In a closed economy, interest
rates would rise
Example: An increase in
productivity
24
20
16
12
8
4
0
00
50
0
00
40
0
00
30
00
20
0
00
10
0
0
0
• Suppose that trade is initially
balanced. A rise in productivity
increases investment demand
• In a closed economy, interest
rates would rise
• In an open economy, the trade
deficit would increase. In the
case, the deficit increases from
zero to -$15,000
• Do interest rates rise at all?
World Capital Markets
• A country’s ability to influence world interest rates
depends on its size relative to the world economy (recall,
global interest rates are determined such that global capital
markets clear)
• The US makes up roughly 35% of the global economy.
Therefore, the US can significantly influence global
interest rates (as can Japan, EU, and China)
• The rest of the world has little influence unless it acts as a
unified group (Latin American Financial Crisis, Asian
Crisis)
Exchange Rates and Price Levels
• The Law of One Price (LOOP)
states that the same product
should cost the same in every
location
• For example, suppose that the
price of a television is $200 in
the US and E190 in Europe.
The current exchange rate is
$1.17/E
• What should happen here?
P* = E190 (E Price in Europe)
eP* = ($1.17/E)(E190)
= $222.30
Exchange Rates and Price Levels
• The Law of One Price (LOOP)
states that the same product
should cost the same in every
location
• For example, suppose that the
price of a television is $200 in
the US and E190 in Europe.
The current exchange rate is
$1.17/E
• What should happen here?
• A profit can be made by buying
TVs in the US and selling them
in Europe.
P* = E190 (E Price in Europe)
eP* = ($1.17/E)(E190)
= $222.30
Exchange Rates and Price Levels
• The Law of One Price (LOOP)
states that the same product
should cost the same in every
location
• LOOP states that in
equilibrium, no such profits can
occur. Therefore, P = eP*
• If the price of a TV is $200 in
the US and E190 in Europe, the
implied exchange rate is
$1.05/E
Exchange Rates and Price Levels
• The Law of One Price (LOOP)
states that the same product
should cost the same in every
location
• LOOP states that in
equilibrium, no such profits can
occur. Therefore, P = eP*
• If the price of a TV is $200 in
the US and E190 in Europe, the
implied exchange rate is
$1.05/E
P = $200
P* = E190
P = eP*
e = P/P* = $200/E190
= $1.05/E
Purchasing Power Parity
• Purchasing power parity (PPP) is simply LOOP applied to general
price indices
P = eP*
Purchasing Power Parity
• Purchasing power parity (PPP) is simply LOOP applied to general
price indices
P = eP*
• A more useful form of PPP is
%Change in e = Inflation – Inflation*
Purchasing Power Parity
• Purchasing power parity (PPP) is simply LOOP applied to general
price indices
P = eP*
• A more useful form of PPP is
%Change in e = Inflation – Inflation*
• For example, if the US inflation rate (annual) is 4% while the annual
European inflation rate is 2%, the the dollar should depreciate by 2%
over the year.
PPP and the “Fundamentals”
• Again, recall that PPP gives the following formula for the
nominal exchange rate:
e = P/P*
PPP and the “Fundamentals”
• Again, recall that PPP gives the following formula for the
nominal exchange rate:
e = P/P*
• Further, the quantity theory give the price level as a
function of money and output
P = MV/Y
PPP and the “Fundamentals”
• Again, recall that PPP gives the following formula for the
nominal exchange rate:
e = P/P*
• Further, the quantity theory give the price level as a
function of money and output
P = MV/Y
• Combining the two,
e = (V/V*)(M/M*)(Y*/Y)
• V,M,and Y are exchange rate “fundamentals”
PPP and the Real Exchange Rate
• While the nominal exchange rate is defined as the
dollar price of foreign currency, the real exchange
rate is defined as the price of foreign goods in
terms of domestic goods
q = eP*/P
PPP and the Real Exchange Rate
• While the nominal exchange rate is defined as the
dollar price of foreign currency, the real exchange
rate is defined as the price of foreign goods in
terms of domestic goods
q = eP*/P
• PPP implies that the real exchange is always
constant (actually, its equal to 1)
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Nominal/Real Exchange Rates
300
250
200
150
Yen/$
100
50
0
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Nominal/Real Exchange Rates
350
300
250
200
150
Yen/$
Real
100
50
0
The Hamburger Standard and
LOOP
• The Economist regularly calculates the
LOOP predicted exchange rates using a
McDonalds Big Mac as the commodity
e = P/P*
• This has become known as “the hamburger
standard”
Explaining Deviations from PPP
• Transportation costs, tariffs, taxes, etc.
interfere with LOOP
• Non-Traded goods
• Price indices are constructed differently
• Fixed prices in the short run
Interest Rate Parity
• Interest rate parity is the asset
equivalent of PPP. It states that
all assets should be expected to
earn the same return
• For example, suppose that the
interest rate in the US is 5%, the
interest rate in Europe is 7%,,
the current exchange rate is
$1.15/E and the anticipated
exchange rate in a year is
$1.10/E
Interest Rate Parity
• Interest rate parity is the asset
equivalent of PPP. It states that
all assets should be expected to
earn the same return
• For example, suppose that the
interest rate in the US is 5%, the
interest rate in Europe is 7%,,
the current exchange rate is
$1.15/E and the anticipated
exchange rate in a year is
$1.10/E
• Each $1 invested in the US will
be worth $1.05 in a year. How
about each $ invested in
Europe?
Interest Rate Parity
• Interest rate parity is the asset
equivalent of PPP. It states that
all assets should be expected to
earn the same return
• For example, suppose that the
interest rate in the US is 5%, the
interest rate in Europe is 7%,,
the current exchange rate is
$1.15/E and the anticipated
exchange rate in a year is
$1.10/E
• Each $1 invested in the US will
be worth $1.05 in a year. How
about each $1 invested in
Europe?
• $1 = (1/1.15) = .87E
.87E(1.07) = .93E
.93E ($1.10/E) = $1.02
Interest Rate Parity
• Interest rate parity is the asset
equivalent of PPP. It states that
all assets should be expected to
earn the same return
• For example, suppose that the
interest rate in the US is 5%, the
interest rate in Europe is 7%,,
the current exchange rate is
$1.15/E and the anticipated
exchange rate in a year is
$1.10/E
• Each $1 invested in the US will
be worth $1.05 in a year. How
about each $1 invested in
Europe?
• $1 = (1/1.15) = .87E
.87E(1.07) = .93E
.93E ($1.10/E) = $1.02
• Even with the higher return in
Europe, the 5% appreciation of
the dollar makes the US asset a
better investment. Therefore,
funds will flow to the US.
Interest Rate Parity
• Interest parity states that exchange rates
should be expected to adjust such that assets
pay equal returns across countries
(1+i) = (1+i*)(e’/e)
Interest Rate Parity
• Interest parity states that exchange rates should be
expected to adjust such that assets pay equal returns across
countries
(1+i) = (1+i*)(e’/e)
• A more useful form is
i – i* = % change in e
• For example, if the interest rate in the US is 5% and the
interest rate in Japan is 2%, the dollar should depreciate by
3% against the Yen
Interest Rate Parity
• Interest parity states that exchange rates should be
expected to adjust such that assets pay equal returns across
countries
(1+i) = (1+i*)(e’/e)
• A more useful form is
i – i* = % change in e
• For example, if the interest rate in the US is 5% and the
interest rate in Japan is 2%, the dollar should depreciate by
3% against the Yen
• Interest rate parity fails just as badly as PPP.
Interest Rate Parity & PPP
• Recall that PPP gives the following:
% change in e = Inflation – Inflation*
Interest Rate Parity & PPP
• Recall that PPP gives the following:
% change in e = Inflation – Inflation*
• Interest Parity gives the following:
i – i* = % change in e
Interest Rate Parity & PPP
• Recall that PPP gives the following:
% change in e = Inflation – Inflation*
• Interest Parity gives the following:
i – i* = % change in e
• Combining them gives us
i – i* = Inflation – Inflation*
Interest Rate Parity & PPP
• Recall that PPP gives the following:
% change in e = Inflation – Inflation*
• Interest Parity gives the following:
i – i* = % change in e
• Combining them gives us
i – i* = Inflation – Inflation*
i – Inflation = i* - Inflation*
Interest Rate Parity & PPP
• Recall that PPP gives the following:
% change in e = Inflation – Inflation*
• Interest Parity gives the following:
i – i* = % change in e
• Combining them gives us
i – i* = Inflation – Inflation*
i – Inflation = i* - Inflation*
r = r*