Prof.

Fei DING
The Hong Kong University of Science and Technology

ECON 2123: Macroeconomics

OPEN MARKETS

PREVIOUSLY
Ch12: Technological Progress and Growth

LEARNING OBJECTIVES

Explain the effects of technological progress and capital accumulation on growth.

Derive and explain the dynamic relation between capital and output with
technological progress and population growth.

Define and derive steady-state capital, output, and balanced growth.

Apply what we learned to explain trends in the data on economic growth.

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Outline of the Course:

PART I: OVERVIEW (CH1-2)
PART II: SHORT-RUN MODEL (CH3-5)
PART III: MEDIUM-RUN MODEL (CH6-7)
PART IV: LONG-RUN MODEL (CH10-11&12.1)
PART V: OPEN ECONOMY (CH18-20)

Ch18: Openness in Goods and Financial Markets

LEARNING OBJECTIVES
Explain how people choose between domestic and foreign goods in terms of
nominal and real exchange rates.

Understand the role and components of balance of payments.

Explain how people choose between domestic and foreign assets, and derive the
relation between interest rates and exchange rates.

QUOTE OF THE DAY

TRADE EXPORT AND IMPORT

Up to now we assumed closed economy.

All demand and supply are contained within the

same group of participants.

New issues arise in open economy as we buy

from and sell to foreigners.

Balance of payment; exchange rate; trade

restrictions/barriers; etc.

Will fiscal and monetary policy have different

impacts in open economies?
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US EXPORTS AND IMPORTS

Figure 18-2 U.S. Exports and Imports as Ratios of GDP since 1960

EXPORT RATIOS
Table 18-1 Ratios of Exports to GDP for Selected OECD Countries, 2010

http://data.worldbank.org/indicator/NE.EXP.GNFS.ZS/coun
tries/1W-CN-US?display=graph

Can Exports Exceed GDP?

Countries can have export ratios larger than the value

of their GDP because exports and imports may include
exports and imports of intermediate goods.

Singapores exports to GDP ratio was 211% in 2010.

What about Hong Kong?

TRADE FACTS

Tradable goods: some goods are more likely to

be traded.

What are non-tradable goods?

How to choose between domestic vs. foreign

goods?

The price of domestic goods relative to foreign

goods real exchange rate

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TRADE EXCHANGE RATE

What is the (nominal) exchange rate?

Conversion ratio (price) between two currencies.

Example: 1 USD = 7.8 HKD

We can compare the price of the same good in

HK and in US with the exchange rate.

But the exchange rate is very volatile.

Huge trading volume and price fluctuations in the

FOREX market.
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TRADE EXCHANGE RATE

Figure 18 - 3
The Nominal
Exchange Rate
between the Dollar and
the Pound since 1971

Although the dollar has appreciated

relative to the pound over the past four
decades, this appreciation has come
with large swings in the nominal
exchange rate between the two
currencies, especially in the 1980s.

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TRADE EXCHANGE RATE

Flexible vs. fixed exchange rate

Flexible: conversion ratio is determined by demand

and supply in the market.

Fixed: price is maintained at certain level (range) by

certain method.

Examples

USD to GBP? USD to HKD?

How about RMB (Chinese Yuan)?

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TRADE EXCHANGE RATE

Nominal vs. real exchange rate

Goods can be generally more expansive in one country after

currency conversions.

Real exchange rate gives us the relative price of goods in

different regions.

Real exchange rate:

E: nominal exchange rate (price of home currency in terms

of foreign currency)

P: home price level; P*: foreign price level

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TRADE EXCHANGE RATE

Figure 18 - 3 The Construction of the Real Exchange Rate

EP

P
*

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TRADE EXCHANGE RATE

Figure 18-5 Real and Nominal Exchange Rates between the United States and
the United Kingdom since 1971

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TRADE EXCHANGE RATE

How to interpret the gap between nominal and real

exchange rates?

Nominal appreciation of USD in early 1970s: E

P/P* decreased and more than offset the increase in E

inflation was higher in the UK than in the US.

Real exchange rate dropped ( ).

Since the 1990s, nominal and real exchange rates

have moved closely together US and UK have
similar inflation rates.
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TRADE EXCHANGE RATE

So nominal and real exchange rates can move in

different directions.

Appreciation (E ) vs. depreciation (E ) of currency

For fixed regime, revaluation vs. devaluation

Real appreciation ( ) vs. real depreciation ( )

EP

P
*

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TRADE EXCHANGE RATE

Bilateral exchange rates: between two countries

Multilateral exchange rates: between several countries

To measure the average price of US goods relative to

the average price of goods of US trading partners, we
use the US share of import and export trade with each
country as the weight for that country the
multilateral real US exchange rate, or the US real
exchange rate for short.

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REFRESH
1. A real appreciation means that domestic goods become
less expensive relative to foreign goods. (True, false, or
uncertain?)
2. When the dollar appreciates relative to the pound, the
pound price of the dollar
A) increases.
B) decreases.
C) does not change.
D) increases or decreases, depending on the amount of the
depreciation.
E) changes in the next period.
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REFRESH
Suppose there is a real depreciation of the dollar. Which
of the following may have occurred?
A) foreign currency has become more expensive in dollars.
B) foreign goods have become more expensive to Americans.
C) the foreign price level has increased relative to the U.S.
price level.
D) all of the above
E) none of the above
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OPENNESS IN FINANCIAL MARKETS

Foreign currencies are needed for the trading

of goods and services.

Trade surplus: exports > imports

Trade deficit: exports < imports

People can also invest in domestic and foreign

assets. Trading of global assets also involves
foreign currencies.

What is the link/relation between the two?

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BALANCE OF PAYMENTS (BOP)

Table 18-3 The U.S. Balance of Payments, 2010, in Billions of U.S. Dollars

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BALANCE OF PAYMENTS (BOP)

Current account balance + Capital account balance =

0 (in principle; statistical discrepancy in reality)

Current account balance: sum of net payments to and

from the rest of the world.

When current account is in deficit, what does it mean?

Have to borrow from the rest of the world! But how?

Sell financial assets to the world (money inflow today, but

obligated to return in the future)

So, Current account deficit = Capital account surplus

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BALANCE OF PAYMENTS PECULIARITY

In principle, a countrys BoP should be zero.

But the capital accounts for some countries are closed

or controlled.

For example: China

Double surplus until recently

The degree of control/restriction is being reduced.

http://www.simontaylorsblog.com/2012/09/18/chinasbalance-of-payments-current-and-capital-accounts-nowpulling-in-different-directions/

Whats going to happen to RMB exchange rate?

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DOMESTIC VS. FOREIGN ASSETS

How to make the choice? Risk and return!

To diversify (reduce risk), maybe you dont want to

hold all in domestic assets.

To get higher return, you also dont want to hold all

in cash.

Choose domestic vs. foreign currency and

domestic vs. foreign (interest-paying) assets.

Focus on domestic vs. foreign assets.

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DOMESTIC VS. FOREIGN ASSETS

Figure 18 - 7 Expected Returns from Holding One-Year U.S. Bonds or One-Year U.K. Bonds

Whether to invest abroad or at home depends not only on interest rate differences, but also
on your expectation of what will happen to the nominal exchange rate.
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DOMESTIC VS. FOREIGN ASSETS

If both foreign (with a *) and home bonds are to be

held, they must offer the same expected rate of return.

1
(1 + i ) ( E )(1 + i )

E
*

t 1

Uncovered interest parity: you have to expect the

future exchange rate your risk is not covered.

E
(1 + i ) (1 + i )

E
*

t 1

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DOMESTIC VS. FOREIGN ASSETS

Rewrite

. Then,

E
(1 + i ) (1 + i )

E
*

(1 + i )
(1 + i ) =
[1 + ( E E ) / E )]
*

t 1

t 1

If interest rates and exchange rate changes are small (no more than 20%),
we can use (1+x)(1+y) 1 + x + y approximation to obtain:

E
E
i i
e

t 1

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DOMESTIC VS. FOREIGN ASSETS

E
E
i i
e

t 1

LHS: differences between foreign and domestic bond

interest rates
RHS: expected appreciation rate of domestic currency

You are willing to hold domestic bonds at a lower interest

rate than foreign bonds only because you expect home
currency to appreciate relative to that foreign currency.
e
t 1

If E

Et ,then it i
*
t

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DOMESTIC VS. FOREIGN ASSETS

If either i or E deviates from the Uncovered

Interest Parity relation, we can trade and earn
profits.

If US i = 2%, UK i = 5%, expect 4% USD

appreciation relative to GBP. Should we invest
in US or UK bonds?

E
E
i i
e

t 1

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DOMESTIC VS. FOREIGN ASSETS

Figure 18-8 Three-Month Nominal Interest Rates in the United States
and in the United Kingdom since 1970

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Buying Brazilian Bonds

Back in Sep. 1993, Brazilian bonds were paying a monthly interest
rate of 36.9%, compared to 0.2% monthly rate for US bonds!
Should we buy Brazilian bonds?
Whats the depreciation rate of Brazilian currency relative to the USD?
VERY BIG!
Taking into account the rate of deprecation, monthly return dropped to
1.6%.
Think about the transaction costs and the risk, was it worth it?

(1 + i )
(1 + i ) =
[1 + ( E E ) / E )]
*

t 1

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IMPLICATIONS AND CAVEAT

If we want the exchange rate between two

currencies to stay stable, domestic and foreign
interest rates must move very closely together.

Example: Hong Kong and the US

The assumption that investors only hold bonds

with the highest expected return is too strong.

It ignores transaction costs.

It ignores risk.
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REFRESH
1.

If there are no statistical discrepancies, countries with current

account deficits must receive net capital inflows. (?)

2.

Uncovered interest parity implies that interest rates must be

the same across countries. (?)

3.

Which of the following will cause a real appreciation, holding

everything else constant?
A) a reduction in E
B) a decrease in P
C) an increase in P*
D) none of the above
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REFRESH
Suppose two countries make a credible commitment to
fix their bilateral exchange rate and also allow capital to
flow freely between two countries. In such a situation,
we know that
A) the uncovered interest parity condition no longer holds.
B) the real exchange rate must be constant as well.
C) each country can freely allow its interest rate to diverge
from that of the other country.
D) the interest rate in the two countries must be equal.
E) neither country will run a trade deficit.
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REFRESH
Assume that the uncovered interest parity condition
holds. Also assume that the U.S. interest rate is less
than the U.K. interest rate. Given this information, we
know that investors expect
A) the pound to depreciate.
B) the pound to appreciate.
C) the dollar-pound exchange rate to remain fixed.
D) the U.S. interest rate to fall.
E) none of the above
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SEE YOU NEXT TIME

Assigned reading:

Textbook Chap. 18

Textbook Chap. 19 (for next time)

Suggested exercises for Ch. 18:

Textbook end-of-chapter questions 1-5

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