Week 9: Open Economy [Interest Parity, Trade In Goods And Assets] Flashcards
International economics: components & Net exports
■ International trade (goods, services, commitment of production factors);
■ International finance (financial assets in international financial markets);
■ Net exports (aka trade balance) emerge from economies’ trading goods and services with each other;
Trade globalization & international financial system: size
■Substantial growth in international trade in the second half of the XXth to the early XXIst century;
Expedited by various technological and institutional developments
‘Vertical disintegration’ + outsourcing/offshoring; Lower transport costs;
- Formation of various regional trade blocs (ASEAN, EEA, Mercosur, NAFTA, SCO, etc.);
■ Trade globalisation has been accompanied by liberalisation of international financial markets and growth in international finance;
■ The average daily volume of transactions in international financial markets amounted to $10 965 648 mln in 2022 (data source: BIS);
■ By comparison, annual world GDP in 2022 added up to $164 155 327 mln (data source WB WDI);
■ That means that on average, the daily volume of international financial transactions is 24.4 times larger than the daily value added by all of the world;
Nominal exchange rate & conversion
■ Nominal exchange rate E is the price of one currency in terms of another;
■ Two quotation traditions: direct and indirect;
If there is a price, there is a market with demand and supply;
■ Currencies are traded in the foreign exchange market (Forex,
FX);
■ The bulk of demand for currencies comes from the desire to acquire financial assets;
■ American (direct) quote: units of the domestic currency per unit of the foreign currency ;
■ European (indirect) quote: units of foreign currency per unit of the home currency;
Example
Exchange rate movements:
■ Currency A’s increases in value relative to currency B ⇒ currency A appreciates;
■ The opposite ⇒ currency A depreciates;
■ This has opposing implications for the quotes;
■ Home currency appreciates ⇒ the direct quote falls, while the indirect quote rises;
■ Both quotation systems are used, so to avoid confusion, it is better to report movements in terms: ‘currency A has appreciated/depreciated’ rather than ‘the exchange rate has increased/decreased’;
Uncovered interest parity & Domestic return on Foreign investments
■ Suppose an investor is considering investing either in domestic or foreign financial assets for 1 year;
■ For domestic assets, the rate of return is i, for foreign assets it is iF ;
■ The domestic return is 1 + i;
■ What is the return for investing in foreign assets?
■ Not a trivial question, as it involves currency conversion!
■ Similar to 1 + i, we would like to derive the domestic return on a foreign investment 1 + iD/F ;
1 First the investor needs the foreign currency;
With 1 domestic pound they can buy Et foreign dollars;
2 Investing Et dollars yields Et (1 + iF ) dollars in 1 year;
3 Repatriation: the sum needs to be converted back into pounds
Use Et (1+iF) to buy Et+1 1+iD/F pounds;
4 We buy Et+1 1+iD/F=Et(1+iF)⇒1+iD/F = Et (1+iF);
iD/F = E/Ee (1+iF) -1
i = iD/F = iF − (Ee − E/ E)
■ Risk-neutral investors are indifferent between investing domestically and abroad when the rates of return are the same
■ This is the uncovered interest parity condition (UIP);
■ If i < iF , investors expect to suffer a loss when repatriating
the income, and vice versa;
■ Uncovered because investors bear the risk of fluctuations in future exchange rates;
■ UIP is expected to maintain in efficient exchange markets with risk-neutral investors;
■ UIP holds through adjustments in the exchange rate E;
Real Exchange rate: Exchange set of goods and Purchasing power Parity
1 Starting with 1 domestic representative set, sell it for the price level P;
2 Buy P · E foreign dollars for P domestic pounds;
3 Use P ·E to spend on ε foreign sets at the price of PF each;
4 We buy P ·E=PFε⇒ε= P/PF E
ε=P/Pf E
■ If the sets are the same and there is free and costless cross-border movement of goods, 1 domestic set can be exchanged exactly for 1 foreign set;
■ Equivalently, in an efficient market for goods the real exchange rate equals ε = 1;
■ This is purchasing power parity (PPP) 1=P/Pf E
PPP and implication for prices
1=P/PF E
■ To see a slightly different perspective on the PPP, rewrite the above as
PF =P·E
■ Suppose PPP holds and the same set costs PF = 100 foreign
dollars and 80 domestic pounds; the exchange rate E is 1.25;
■ Then 80 domestic pounds can buy the set both domestically and in the foreign coutry by converting it into 80 · 1.25 = 100 foreign dollars;
PF =P·E
■ PPP predicts that when converted to the same currency, the
price of the same set of goods is the same in every country;
■ This aligns with the law of one price, except that PPP concerns not individual goods, but sets of goods;
■ Main idea – deviations result in excess demand/supply of sets of goods, which creates pressure on prices until (ultimately) the equality is restored and ε = 1;
Performance:
■Note that PPP relies on a very strict assumption of efficient markets with costless movements of goods;
- That does not accommodate a few important features of real-life markets
- Transport costs: if they are high enough, goods are not tradeable (e.g., a haircut, a dwelling);
- Trade barriers;
- Different degrees of market competitiveness;
- Differences in sets for which price indices are calculated (as underlain by different consumption patterns);
- Overall, PPP fails even for sets of tradable goods in the long run, but that does not make it useless;
Living Standards Comparision
■ The central idea of PPP is indispensable when comparing standards of living across countries (International Comparison Programme, ICP);
■ The standard way of comparing GDP/GDPpc is exactly through deriving PPP prices for individual goods categories and using those for constructing comparable GDP values;
■ Intuition: a country might have lower income per person, but that tends to translate into lower prices (Balassa–Samuelson effect) – using the same PPP prices eliminates this factor of difference;
■ Important as well for comparing meaningfully the evolution of living standards over time when studying economic growth;
Tracking international transactions
■ An open economy can interact with others through both financial markets and international trade;
■ Both are interlinked (more on that in a second);
■ The way to keep track of both financial assets and goods and
services is through the balance of payments (BoP);
■ The BoP records transactions between an economy and the rest of the world (RoW);
comments on the diagram:
■ The first component of receipts from the RoW includes payments for exports and income from abroad;
■ In addition, the agents in the country can borrow from the RoW, which brings about liabilities to the RoW;
■ The receipts can be spent on imports, paying income to the RoW or lending to the RoW, creating financial assets – financial claims on RoW;
■ BoP links together net values deriving from the above
■ Net exports (NX) = Exports − Imports;
■ Net income from abroad (NI) = Income from RoW − Income to RoW;
■ Change in the net international investment position (∆NIIP) = Claims on RoW − Liabilities to RoW;
Keynesian cross: import conversion and exports
ExpD = c0 + c1 Y − T ̄ + I ̄+ G ̄ + NX
NX = Ex − Im/ ε
■ Imports are foreign goods (f.g.), ExpD are in terms of
domestic goods (d.g.) ⇒ need to convert;
■ Recall that 1 piece of domestic GDP is worth ε foreign pieces;
■ Spending on imports in terms of domestic goods is
1 f.g. = 1/ε d.g.
Im f.g. = Im/ε d.g.
NX = Ex − Im / ε
■ Same logic applied to RoW
E x = E x ( Y F ; −ε )
■ Exports increase in income/output abroad Y :
■ Exports decrease in the real exchange rate ε:
Insight in investment, saving and borrowing
■ Without any further analyses, the model can already elaborate on the BoP equivalence F A = CA + KA;
■ Starting from equilibrium
Y = C + I ̄ + G ̄ + N X
Y − T ̄ − C + T ̄ − G ̄ = I ̄ + N X
Y +NI−T ̄−C+T ̄−G ̄=I ̄+NX+NI SPr +SPub =I ̄+CA
SPr +SPub =I ̄+CA
■ Savings do not have to be directed only to domestic fixed
̄ investment (SP r + SP ub > I );
■ Instead, they can be used for lending to RoW/become international financial assets (CA > 0 ⇒ FA > 0);
■ Conversely, investment projects can be financed not only through saving, but also through borrowing in international
̄ markets (SP r + SP ub < I );
■ Financing budget deficit SP ub < 0 can be accomplished not at the private expense, but through borrowing in international markets;
Increase in domestic G ̄ comments, foreign G ̄ comments
Domestic
■ When G ̄ ↑ by ∆G, the expenditure line shifts by ∆G;
■ ExpD shifts by as much: even though part of G ̄ falls on imports, we already account for that in subtracting imports from all of spending;
■ N X does not shift, since changes in G ̄ affect only output Y , and N X is plotted explicitly against Y ;
■ When G ̄ increases, not all of the extra spending is directed to domestic goods, and there is more spending on imports;
■ As a result, net exports drop/trade balance worsens;
Foreign
■ When G ̄ ↑ abroad, so does spending;
■ More spending abroad implies more spending on exports from the economy (imports for foreigners);
■ More exports ⇒ more spending on domestic goods, which leads to more production at home;
■ Note that the effect on domestic net exports is in general ambiguous: there are more exports, but at the same time larger output/income leads to more imports as well
NX=mF (YF↑)−m(Y↑)−nεε
■ Ambiguity arises from the presence of the direct (YF ↑) and the indirect effect (Y ↑) of foreign fiscal policies;
Fiscal policy in OE: Summary & Keynesian cross
■ Fiscal expansions/contractions have spillover effects on trading partners;
■ More spending resulting from extra G is partly directed to foreign goods and services;
■ This reduces the potency of fiscal policies (lower multiplier);
■ Greater involvement in international trade (m↑) makes fiscal
policies even weaker;
■ Creates potential scope for policy coordination, but in general very impractical;
■ We have seen that the real exchange rate ε affects the international competitiveness of goods and services;
■ How do movements in ε affect macroeconomic outcomes?
■ Note first that since prices are fixed, the only source of
changes in the real rate ε are those in the nominal rate E;
■ We will consider the case of a real depreciation ∆ε < 0;
■ Mathematically, there is going to be more output
∆Y = − nε / 1-c1+m ∆ε > 0
OE Keynesian cross; taking stock, exchange rates, currency value movements
■ Engagement in international trade modifies the effect of macroeconomic policies (fiscal spillovers);
■ Such spillovers also imply shock propagation through international trade links;
■ There is one more new source of shocks coming from fluctuations in the exchange rate;
■ In order to assess monetary policies, we need to incorporate financial markets;
Exchange rates:
■ Direct (American) quotation – a quotation system for nominal exchange rates, whereby the price of the foreign currency is quoted in units of the domestic currency;
■ Indirect (European) quotation – a quotation system for nominal exchange rates, whereby the price of the domestic currency is quoted in units of the foreign currency;
■ Currency appreciation – an increase in the value of a currency. For the domestic currency corresponds to an increase in the indirect exchange rate and a decrease in the direct exchange rate;
■ Currency depreciation – a decrease in the value of a currency. For the domestic currency corresponds to a decrease in the indirect exchange rate and an increase in the direct exchange rate;
International financial markets:
■ Uncovered interest parity – the nominal exchange rate pricing condition for FX markets, whereby returns on financial assets are the same when converted to the same currency;
■ Merchandise – tangible goods that change their economic ownership between a resident and a non-resident (excluding a few categories to do with direct reselling of goods (merchanting), construction, and some more). Examples are agricultural and manufactured goods, fuels and mineral products;
Purchasing power parities
■ Absolute purchasing power parity (or just purchasing power parity, PPP) – a theory of pricing in international trade, whereby the real exchange rate between identical representative sets of goods equals 1. Equivalently, the same representative set of goods has the same price when denominated in the same currency;
■ Relative purchasing power parity (rPPP) – a weaker version of aPPP, allowing for the possibility that the real exchange rate can be different from 1, but is still constant;
Balance of payments components
■ Current account (CA) – a summary of transactions between an economy and RoW to do with trade in goods and services and flows of primary income (labour income, investment income) and secondary income (various transfers, including benefits, remittances, scholarships, transactions with international organisations);
■ Capital account (KA) – a summary of transactions to do with the acquisition and disposal of non-produced non-financial
assets (natural resources, contracts, leases, licences, marketing assets) and capital transfers (debt forgiveness, debt assumption, non-life insurance claims, investment grants);
■ Financial account (FA) – a summary of financial transactions between an economy and RoW, comprising direct investment, portfolio investment, investment in financial derivatives and operations with international reserves;
