Intermediate Macroeconomics

Lecture 19: openness in goods and financial markets

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 This lecture

1- Introduction to open economy macro

2- Exchange rate concepts

3- Demand for goods and equilibrium output in the open economy

4- Reading: Blanchard, chapter 17, chapter 18, sections 18.1-18.2

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 International business cycles

Business cycle movements are correlated across countries. While the financial crisis started in the United
States, it affected nearly all countries in the world, with nearly all countries going into a growth slowdown
about the same time.
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 Openness in goods and financial markets

• Key aspects

(1) Openness in goods markets. Restrictions on trade include tariffs and quotas

(2) Openness in financial markets. Capital controls can place restrictions on ownership of
foreign assets and foreign ownership of domestic assets

(3) Openness in factor markets. The ability of firms to choose where to locate operations
and workers to choose where to work

• With technological change, many more goods and services become tradeable —
offshoring is not a new phenomenon

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 Openness in goods markets: US

20 15
Percent of GDP
10 5

1960q1 1970q1 1980q1 1990q1 2000q1 2010q1 2020q1

Quarter

Exports/GDP
Imports/GDP

Since 1960, exports and imports have more than tripled in relation to GDP. The US has become a much
more open economy.
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 Openness in goods markets: Australia

30
25
Percent of GDP
15 20
10
5

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
Quarter

Exports/GDP
Imports/GDP

Australia’s sensitivity to world commodity prices is not a new phenomenon either.

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 Composition of Australia’s exports, 2020

$285B

Agriculture
Services Other
Minerals
9.93% 7.77%
Chemicals Machinery
Stone
3.58% 2.25%
Textil… Elect…

Metals
17.31% 46.86% 6.53% 3.44%
0.82% 0.80%

In 2020, 17% of Australia’s total exports were services. Among goods exports, over 80% were commodities
related to agriculture and mining.

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 Composition of Australia’s imports, 2020

$229B

Chemicals Electronics Textiles

Services Machinery

8.60% 7.14%
16.71% 11.72% Minerals
Stone Other

Agriculture
Vehicles 4.56%
Metals
16.98% 6.65%
12.08% 8.95% 4.30%
2.32%

In 2020, 17% of imports were services. Among imported goods, manufactured goods made up the majority
of imported goods accounting for over 50% of imported goods.

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 Export intensities for OECD countries

20 40 60 80 100 120
Exports as percent of GDP
0

United States
Brazil
Colombia
Japan
China
India
Indonesia
Australia
New Zealand
Chile
Russian Federation
Israel
South Africa
United Kingdom
France
Italy
Canada
Turkey
Costa Rica
Spain
Norway
Mexico
Republic of Korea
Finland
Greece
Portugal
Iceland
Germany
Sweden
Poland
Austria
Denmark
Latvia
Switzerland
Czech Republic
Estonia
Lithuania
Hungary
Belgium
Netherlands
Slovenia
Slovakia
Ireland
Other things equal, countries have high export intensities when they are small and/or geographically close
to large markets. Can exports exceed GDP? In 2019, the ratio of exports to GDP in Ireland was 128%!
Countries like Ireland have export/GDP ratios in excess of 100 because they import a lot of intermediate
goods and then re-export them. But only final goods are counted in GDP.
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 Choice between domestic and foreign goods

• With open goods markets, domestic consumers must decide not only how much to
consume and save, but also whether to buy domestic goods or to buy foreign goods
(imports)

• What is the price of domestic goods relative to foreign goods?

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 Nominal exchange rate

1.4 1.2
US$ perA$
1 .8
.6

01jan1970 01jan1980 01jan1990 01jan2000 01jan2010 01jan2020

Date

Nominal exchange rate is the relative price of domestic currency in terms of foreign currency. [Aside: note
the different foreign exchange rate regimes — fixed or ‘hard peg’ to 1972 (Bretton Woods system),
‘crawling peg’ against a basket of currencies to 1983, and then floating since 1983.]
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 Real exchange rate

• Real exchange rate is relative price of domestic goods in terms of foreign goods

P = Australian price index in $A

P ∗ = US price index in $US
E = nominal exchange rate, $US per $A

• So price of US goods in $A is P ∗ /E and real exchange rate is

P EP price domestic goods

real exchange rate = ε ≡ = =
P ∗ /E P ∗ price foreign goods

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 Real exchange rate

Bilateral real exchange rate ε = EP/P ∗ , the price of Australia goods in terms of US goods. An increase in
the relative price of domestic goods in terms of foreign goods is a real appreciation, an increase in ε. A
decrease in the relative price of domestic goods in terms of foreign goods is a real depreciation, a decrease
in ε.

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 Real and nominal exchange rates: US

Close co-movement of nominal and real exchange rates is typical for countries with low and stable inflation.

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Real and nominal exchange rates: Australia

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 From bilateral to multilateral exchange rates
Table: Australia’s top trading partners in 2020

Countries Exports from % Countries Imports from %

($US billions) ($US billions)

China 95.45 41 China 51.84 27

Japan 29.62 13 USA 23.02 12
South Korea 15.55 7 Japan 12.40 7
USA 11.51 5 Thailand 9.95 5
United Kingdom 10.15 4 Germany 9.80 5
Singapore 7.69 3 South Korea 6.02 3
Taiwan 6.72 3 Singapore 5.89 3
India 6.45 3 Malaysia 5.60 3
New Zealand 5.85 3 United Kingdom 5.17 3
Malaysia 4.78 2 New Zealand 5.13 3

Total 233.77 100 Total 190.19 100

The US only accounts for 5% of Australian exports and 12% of Australian imports. China, Japan and the
(combined) Euro area are Australia’s most important trade partners.
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 Multilateral exchange rates

Again, close co-movement of nominal and real multilateral exchange rates. Large appreciation since
mid-2000, associated with mining boom.

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 Openness in financial markets

• A country’s transactions with the rest of the world including trade flows and financial
flows are summarized by a set of accounts called the balance of payments

• The current account: sum of net exports, net income from abroad and net transfers
received

– current account surplus if net exports + net income + net transfers >0
– current account deficit if net exports + net income + net transfers <0

• The capital account: net capital flows

– capital account surplus if positive net capital flows

– capital account deficit if negative net capital flows

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 Choice between domestic and foreign assets
• Openness in financial markets implies that people need to decide whether to hold
domestic assets or foreign assets

• Compare the return of one-year domestic (Australia) bonds and the return of one-year
foreign (US) bonds

– return of domestic bonds: 1 + it

– return of foreign bonds: (1 + i∗t )Et /Et+1
e

• Uncovered interest parity condition

Et
1 + it = (1 + i∗t ) e
Et+1

1- ignore transaction costs

2- ignore risk
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 Interest rates and exchange rates

• The interest parity condition can be rewritten as

1 + i∗t
1 + it = e
1 + (Et+1 − Et )/Et

• A good approximation is
e
Et+1 − Et
it ≈ i∗t −
Et
A nice interpretation: domestic interest rate must be equal to the foreign interest rate
minus the expected appreciation of the domestic currency

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 How much do interest rates move together?

20
15
Percent
10
5

1970q1 1980q1 1990q1 2000q1 2010q1 2020q1

Quarter

US Interest rate
UK Interest rate

Three-month nominal interest rates in the US and in the UK since 1970

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 Demand for goods in open economy

• Demand for domestic goods is given by

Z ≡ C + I + G + X − IM/ε

• In open economy

domestic demand for goods 6= demand for domestic goods

• Expenditure C, I, G on mixture of domestically produced goods and foreign goods

(imports)

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 Determining imports and exports
• Imports

IM (Y, ε)

– increasing in domestic output Y and in real exchange rate ε

– higher real exchange rate makes foreign goods relatively cheap in domestic economy,
increases demand for imports

• Exports

X(Y ∗ , ε)

– increasing in foreign output Y ∗ but decreasing in real exchange rate

– higher real exchange rate makes domestic goods relatively expensive in foreign economy,
decreases demand for exports

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 Marshall-Lerner condition
• Overall influence of real exchange rate on net exports

N X(ε) ≡ X(Y ∗ , ε) − IM (Y, ε)/ε

Real exchange rate ε enters in three places:

(i) exports X(Y ∗ , ε) decreasing in ε

(ii) imports IM (Y, ε) increasing in ε (these are ‘substitution’ effects)

and

(iii) denominator of IM (·)/ε (this is a ‘valuation’ effect)

• Net exports said to satisfy the Marshall-Lerner condition if N X(ε) is overall

decreasing in the real exchange rate

• In short, ‘valuation’ effect (iii) of change in real exchange rate smaller than the
‘substitution’ effects (i)-(ii)
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 Demand for domestic goods and net exports

Domestic demand for goods DD is increasing in output. To obtain domestic demand for domestic goods
AA, subtract the value of imports from domestic demand.
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 Demand for domestic goods and net exports

Adding the amount of exports to domestic demand for domestic goods AA, we obtain total demand for
domestic goods ZZ. Trade balance is decreasing in domestic output. YT B is the value of output that
corresponds to balanced trade.
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 Equilibrium output and net exports

The goods market is in equilibrium when production Y is equal to the demand for domestic goods Z. At
the equilibrium level of output, trade balance may be in deficit or surplus.
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 Next

• More open economy macro: goods market equilibrium

– Blanchard: chapter 18, sections 18.3–18.6

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