978-0133780581 Chapter 17 Lecture Note

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Chapter 17. Openness in Goods

and Financial Markets

I. MOTIVATING QUESTION

How does openness modify the closed economy IS-LM model?

An open economy allows domestic residents to choose between domestic and foreign goods and between

domestic and foreign assets. The first choice is governed by the relative price of foreign goods; the

second by relative returns on foreign assets.

II. WHY THE ANSWER MATTERS

For countries other than the United States, open economy considerations have long had substantial effects

on economic performance. In the United States, open economy issues are becoming increasingly

important. This chapter describes the basic determinants of the trade balance and describes the

implications of arbitrage between domestic and foreign bonds. Chapter 18 integrates the trade balance

discussion into the closed economy goods market model (the Keynesian cross). Chapter 19 integrates the

asset market discussion into the closed economy model of the money market, and develops an open

economy IS-LM model. Chapter 20 considers a medium run-model of an open economy with a fixed

exchange rate, explores exchange rate crises and the behavior of flexible exchange rates, and discusses

the choice of exchange rate regime.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS

1. Tools and Concepts

i. The nominal exchange rate is the foreign currency price of domestic currency. The real exchange

rate is the relative price of domestic goods. An increase in either of these variables is an appreciation

from the perspective of the domestic country.

ii. The balance of payments is a record of one country’s transactions with the rest of the world over a

given period of time. The balance of payments consists of a current account, which records transactions

in goods and services, and a capital account, which records transactions in assets. The chapter

introduces basic balance of payments accounting and the balance of payments identity, which states that

the current account and the capital account sum to zero.

iii. The uncovered interest parity condition equates the expected domestic currency returns on

domestic and foreign bonds. Absent transactions costs and assuming that investors do not care about

currency risk, investors will not be willing to hold both domestic and foreign bonds unless uncovered

interest parity holds.

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2. Assumptions

i. The text assumes that domestic residents do not use foreign currency to purchase goods. This

assumption is maintained throughout the formal work on the open economy. A footnote points out that

U.S. dollars are often used for illegal transactions throughout the world and sometimes for legal

transactions in economies with high inflation (or with a history of high inflation), but these phenomena

are ignored in the formal work of the text.

ii. The uncovered interest parity condition assumes that investors care only about expected returns and

not about risk. This assumption is maintained throughout the formal discussion of the open economy.

IV. SUMMARY OF THE MATERIAL

1. Openness in Goods Markets

Openness in goods markets means that domestic residents are able to buy foreign goods and sell domestic

goods abroad. Goods sold to foreigners are called exports. Goods bought from foreigners are called

imports. The difference between exports and imports is the trade balance. A negative trade balance is

called a trade deficit, and a positive one a trade surplus. In the closed economy model developed earlier

in the book, domestic residents made only one decision—how much to spend. In an open economy,

domestic residents make two decisions—how much to spend and how much to spend on domestic (as

opposed to foreign) goods. The latter decision depends on the real exchange rate, the relative price of

foreign goods in terms of domestic goods.

The real exchange rate depends on the nominal exchange rate (E), the domestic price level (P), and the

foreign price level (P*). The nominal exchange rate is defined as the foreign currency price of domestic

currency. So, for example, if the United States is the domestic country, and one dollar trades for 100 yen,

the nominal exchange rate is 100 yen/dollar. Given this definition, an increase in the exchange rate means

that the domestic currency gains value (i.e., one unit of the domestic currency is worth more units of the

foreign currency). A currency is said to depreciate when it loses value and to appreciate when it gains

value. Thus, an appreciation (depreciation) of the domestic currency means an increase (decrease) in E.

Suppose the United States, the domestic country, produces only one good; airplanes. If an airplane sells

for P dollars, its price in yen is EP. Note that E has units of yen/dollar, and P has units of

dollars/airplane, so EP has units of yen/airplane. Now assume that Japan, the foreign country, also

produces only one good; cars. One could compare the yen price P* of cars produced in the Japan to the

yen price of airplanes produced in the United States. This motivates the definition of the real exchange

rate ():

=EP/P*. (17.1)

The real exchange rate is the relative price of domestic goods. An increase in the relative price of

domestic goods is a real appreciation (an increase in ). A decrease in the relative price of domestic

goods is a real depreciation (a decrease in ).

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In the one-good-per–country example above, the real exchange rate has units of foreign goods per

domestic good (in this case it is cars per airplane). The nominal exchange rate has units of foreign

currency per domestic currency. Since in fact there are many goods, in practice the real exchange rate is

defined over baskets of goods, and P and P* refer to price indices. As such, the real exchange rate is also

an index: its level is arbitrary (since one can choose any base year for the price indices), but its rate of

change is well defined. In terms of price indices, the real exchange rate measures the price of a basket of

goods in the domestic country in terms of baskets of goods in the foreign country. So, for example, if the

real exchange rate is 2, the price of a domestic basket of goods is two foreign baskets of goods. The

composition of the basket of goods depends upon which price index is used. If P refers to the GDP

deflator, as in the text, then the real exchange rate measures the price of goods produced in the domestic

country in terms of goods produced in the foreign country.

Economists are often interested in the real exchange rate measured against all other countries, rather than

against just one country, so the bilateral real exchange rate defined above is often replaced by a

multilateral real exchange rate, which is a weighted average of the real exchange rate against all other

countries. The weight on a given country reflects two factors: the degree to which the country trades with

the domestic country and the degree to which the country competes with the domestic country in

international markets.

2. Openness in Financial Markets

Openness in financial markets means that domestic residents are able to exchange assets (stocks, bonds,

and money) with residents of other countries. There is link between trade in assets and trade in goods.

Trade in assets allows countries to borrow from one another. Thus, countries that run trade deficits can

finance them by borrowing from countries that run trade surpluses.1

The balance of payments summarizes the transactions of one country with the rest of the world. It has

two components. The first, the current account, is the sum of the trade balance, net investment income

received from abroad, and transfers. As such, the current account is a record of net income received from

the rest of the world. The second component of the balance of payments, the capital account, measures

the purchase and sale of foreign assets. The capital account is defined as the net decrease in foreign assets

(i.e., the increase in domestic assets held by foreigners minus the increase in foreign assets held by

domestic country residents). Apart from a statistical discrepancy, the current account and the capital

account sum to zero by construction.

The intuition behind balance of payments accounting is simple. Think of a country as a single person. A

country with a negative current account balance (a deficit) spends more than its income. To finance the

deficit, it can either sell some of its existing assets to foreigners or borrow from foreigners (sell bonds to

foreigners). By definition, these transactions have a positive sign in the capital account. Likewise, a

country with a positive current account balance (a surplus) spends less than its income. It can dispose of

the extra income by purchasing foreign assets or making loans to foreigners (buying foreign bonds). By

definition, these transactions have a negative sign in the capital account.

The capital account measures a country’s aggregate financial transactions with the rest of the world.

Individual portfolio investment decisions are governed by the relative returns on domestic and foreign

assets. The text assumes that domestic residents do not use foreign currency to purchase goods. Thus,

there is no transactions motive for domestic residents to hold foreign currency. In addition, the text

continues to assume that stocks and bonds are perfect substitutes, so it limits attention to domestic and

foreign bonds.

1 Strictly, countries that run current account deficits borrow from countries that run current account

surpluses.

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How does one choose between domestic and foreign bonds? Suppose a U.S. resident has a dollar to

invest. Let it be the interest rate on U.S. bonds and it* the interest rate on Japanese bonds. Consider the

choice between U.S. and Japanese bonds.

Option 1: Buy U.S. bonds

The return on one dollar equals 1+ it dollars.

Option 2: Buy Japanese bonds.

i. Exchange one dollar for Et yen.

ii. Invest Et yen in Japanese bonds, with a return of (1+it*)Et yen

iii. Exchange (1+it*)Et yen for (1+i*t)Et/Et+1 dollars.

The return on one dollar equals (1+it*)Et/Et+1 dollars.

The expected return on one dollar equals (1+it*)Et/Eet+1 dollars.

Note that to transfer the return from the second option into dollars, the investor must exchange the return

at the future period’s exchange rate Et+1, which is unknown at time t. The investor’s expectation of the

future exchange rate is given by Eet+1. If investors care only about expected returns and not about risk,

then they will choose the option with the higher expected return. If both U.S. and Japanese bonds are to

be held by the private sector, it must be that the expected returns are the same under either option. In

other words,

1+it = (1+it*)(Et/Eet+1) (17.2)

which can be approximated by

it ≈ it* – (Eet+1-Et)/Et. (17.4)

Equation (17.2) is called the uncovered interest parity condition. It is uncovered because an investor in

foreign bonds is not protected from exchange rate risk. If the actual value of the exchange rate turns out

to be higher than expected (i.e., the dollar is more valuable than expected), the investment in Japanese

bonds produces a smaller return than the investment in U.S. bonds.

In words, equation (17.4) says that the domestic interest rate equals (approximately) the foreign interest

rate minus expected appreciation of the domestic currency. Expected appreciation of the domestic

currency makes domestic assets more attractive, so investors are willing to hold them for less

compensation (a smaller interest rate).

3. Conclusions and a Look Ahead

Openness allows domestic residents two choices: the choice between domestic and foreign goods and the

choice between domestic and foreign assets. Chapter 18 integrates the choice between domestic and

foreign goods into the goods market equilibrium condition. Chapter 19 integrates the choice between

domestic and foreign assets into the financial market equilibrium condition. Chapter 19 also combines

goods and financial market equilibrium to analyze the short-run equilibrium of an open economy. Chapter

20 considers a medium run-model of an open economy with a fixed exchange rate, explores exchange rate

crises and the behavior of flexible exchange rates, and discusses the choice of exchange rate regime.

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V. PEDAGOGY

The balance of payments is presented only in a rudimentary fashion in the text. The intuition that (apart

from investment income and transfers) a trade deficit means that a country spends more than its income

will be reinforced in Chapter 19, which presents the GDP identify for an open economy. It may be

worthwhile to reinforce this intuition more than the text does. As far as the mechanics of balance of

payments accounting, it may help build intuition to imagine that all payments are made in terms of cash

(in any given currency, say dollars). In this case, transactions in which the domestic country receives a

cash payment get a positive sign in the balance of payments. Transactions in which the domestic country

makes a cash payment get a negative sign. For example, the purchase by a U.S. resident of a Japanese car

requires a cash payment to Japan. This gets a negative sign in the U.S. balance of payments. The

purchase of a U.S. Treasury bond by a Japanese resident requires a cash payment to the United States.

This transaction gets a positive sign in the U.S. balance of payments.

VI. Extensions

1. The Balance of Payments

The text presents the balance of payments in the traditional manner, with a current and capital account.

The U.S. presentation of the balance of payments has changed, however. Essentially, what was

previously called the capital account is now called the financial account. In addition, a new category—

called the capital account—has been created. The new capital account consists of a small set of asset

movements that were previously recorded in the current account. The value of the items in the new

capital account is typically very small for the United States.

The text also omits several details of balance of payments accounting. An important one is that changes

in official reserves are part of the financial account (which the text calls the capital account). Official

reserves are foreign financial assets held by the central bank. For historical reasons, reserves include

gold. An increase in reserves gets a negative sign in the financial account. Instructors may wish to

explain how reserves fit into the balance of payments and to note that reserves affect the money supply.

Doing so now helps prepare for a discussion of the central bank balance sheet in the context of fixed

exchange rates, a topic discussed in Chapter 19.

2. Uncovered Interest Parity

Although uncovered interest parity is a foundation of open economy models, it has not been an empirical

success. There are essentially two categories of explanation for this phenomenon. The first is that

investors care about risk and there is a time-varying risk premium for any given exchange rate. The

second is that investors make systematic forecast errors. Possibly forecast errors result from so-called

Peso problems, i.e., large-cost, low-probability events. If these events occur very rarely, then it will often

turn out (ex post) that expectations based on these events are incorrect (although not irrational).

Instructors may wish to point out how a risk premium on a currency increases the interest rate paid on

bonds denominated in that currency. Unfortunately, little is known about how or why the risk premium

changes over time.

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3. The Foreign Exchange Market

The text does not discuss alternative exchange rate regimes until Chapter 19. Instructors may wish to

distinguish fixed and flexible exchange rate regimes and to provide a brief history of the postwar

transition from fixed to flexible rates. Such a discussion fits naturally within the presentation of evidence

on U.S. bilateral exchange rates in the postwar period.

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