FIN 30220 Macroeconomic Analysis Open Economy Macroeconomics Open

FIN 30220: Macroeconomic Analysis Open Economy Macroeconomics

Open economy macroeconomics looks at the interactions between the US and the rest of the world Exports Imports 2005 Exports = $1, 740, 894 M Imports = $2, 545, 843 M Net Exports = - $804, 949 The current account keeps track of the flow of goods and services in and out of the US

2005 US Current Account (in Millions) Merchandise Services Income Exports $892, 619 $379, 603 $468, 672 Imports Net $1, 674, 261 - $781, 642 $321, 577 $58, 026 $467, 111 $1, 561 Unilateral Transfers Total $82, 894 - $82, 894 $1, 740, 894 $2, 545, 843 - $804, 949 ØIn 2005, the deficit in merchandise increased by 17% as imports grew faster than exports ØThe surplus in services increased by 21% in 2005 as receipts grew faster than payments ØThe surplus in income decreased by 94% as payments increased faster than receipts

What’s the meaning of a trade deficit? To answer this, lets look back at the national accounting identities… Y = C + I + G + NX Solving for Net Exports, we get NX = Y – (C + I + G) A trade deficit signifies that we as a country are spending beyond our current income Aggregate Expenditures National Income Alternatively, S = I + (G-T) + CA A deficit signifies that we are borrowing more than we are saving National Savings CA = S – [I + (G-T)] Aggregate Borrowing

A trade deficit implies that the US is borrowing from the rest of the world (currently, we are borrowing at the rate of $2 B per day). A equivalent statement is that the rest of the world is acquiring US assets Suppose that, while on vacation in France, you buy a case of French wine for $1, 000. You pay for the wine with cash The French wine maker uses the $1, 000 to buy a computer from Dell – Net exports equals zero (no change in asset holdings). The French wine maker uses the $1, 000 to buy a US Treasury – Net exports are negative (Increase in French holdings of US assets). The French wine maker uses the $1, 000 to buy stock in a French company from an American– Net exports are negative (Decrease in US holdings of French assets). Changes in Assets are recorded in the Capital and Financial Account

2005 US Capital & Financial Account (in Millions) (1) Capital Account Transactions - $5, 647 (2) Change in US owned Assets Abroad - $491, 731 US Official Reserve Assets $14, 096 US Government Assets $7, 580 US Private Assets - $513, 407 Foreign Direct Investment - $21, 483 Securities - $491, 924 (3) Change in Foreign Ownership of US Assets $1, 292, 697 Foreign Official Assets $220, 676 Private Foreign Assets $1, 072, 021 Foreign Direct Investment $128, 632 Currency $19, 416 Securities $923, 973 Total (1) + (2) + (3) $795, 319

Current Account Merchandise Capital & Financial Account Change in US owned Assets Abroad Services US Official Reserve Assets Income US Government Assets Unilateral Transfers US Private Assets Foreign Direct Investment Note that every credit (+) has to be matched with a debit (-). Securities Change in Foreign Ownership of US Assets Foreign Official Assets Remember this: any transaction that involves money flowing into the US is a (+) Private Foreign Assets Foreign Direct Investment Currency Securities

Current Account Merchandise - $20 M Capital & Financial Account Change in US owned Assets Abroad Services US Official Reserve Assets Income US Government Assets Unilateral Transfers US Private Assets Foreign Direct Investment Example #1 Suppose that Wall Mart buys $20 M worth or goods from a Chinese supplier. The Chinese company uses the $20 M to buy stock in IBM. Securities Change in Foreign Ownership of US Assets Foreign Official Assets Private Foreign Assets Foreign Direct Investment Currency Securities $20 M

Current Account Merchandise Capital & Financial Account $40 B Services Income Change in US owned Assets Abroad US Official Reserve Assets $30 B Unilateral Transfers - $80 B US Government Assets US Private Assets Foreign Direct Investment Example #2 Suppose that the US spends $80 B on a foreign aid package to Iraq. The Iraqi government uses $40 B to buy computers from Dell, $30 B goes to pay employees of Haliburton, and $10 B is deposited in a US bank. Securities Change in Foreign Ownership of US Assets Foreign Official Assets Private Foreign Assets Foreign Direct Investment Currency Securities $10 B

Current Account Merchandise Capital & Financial Account $20 B Change in US owned Assets Abroad Services US Official Reserve Assets Income US Government Assets Unilateral Transfers US Private Assets Foreign Direct Investment - $50 B Example #3 Suppose that Nike spends $50 M on a production facility in Korea - $20 M is used to buy equipment from US suppliers, $30 M is used elsewhere. Securities Change in Foreign Ownership of US Assets Foreign Official Assets Private Foreign Assets Foreign Direct Investment Currency Securities $30 B

As the US trade (current account) deficit worsens, it is matched by an equally large capital account surplus – that is, capital is flowing into the US as foreigners acquire our assets. By definition, the Balance of Payments (KFA + CA) should equal zero.

With trading centers in New York City, London, Tokyo and Sydney, currency markets operate 24 hours a day, 5 days a week. Eastern Time 12 AM 3 AM 8 AM 12 PM 5 PM 9 PM Australia: 5 PM - 2 AM 8 PM - 5 AM Tokyo London: 3 AM -11 AM New York City: 8 AM -5 PM 11 PM

The foreign exchange market is unique not just because of its geographic dispersion, but also because of its extreme liquidity and tremendous volume – around $1. 9 T PER DAY!! Name % of Volume v$600 B in Spot market Deutsche Bank 17 Transactions UBS 12. 5 v$1. 3 T in Derivative Market Citigroup 7. 5 Transactions HSBC 6. 4 Ø $200 B in Forwards Barclays 5. 9 Ø $1 T in Swaps Merrill Lynch 5. 7 Ø $100 B in Options JP Morgan Chase 5. 3 Goldman Sachs 4. 4 ABN Amro 4. 2 Morgan Stanley 3. 9 The ten most active traders account for 73% of the volume

US currency was involved in 89% of transactions, followed by the Euro (37%), the yen (20%) and sterling (17%).

An exchange rate is generally defined as the domestic currency price of a foreign currency, but be careful… Most currencies are quoted two ways: US Dollar Equivalent ($/-) Currency per US Dollar (-/$) The Euro is currently trading at 1. 601 The Euro is currently trading at. 6246 An increase in the US dollar equivalent rate signifies a depreciation of the dollar An increase in the currency per US dollar rate signifies an appreciation of the dollar

The dollar has had quite a wild ride against the Euro since it began circulating in 1999. Dollars per Euro Recession

Suppose that a dealer were offering Euro at $1. 22 in New York City while a dealer in London was offering Euro at $1. 24 1 Sell Euro short in London 3 Use your newly acquired Euro to pay off your short position 2 Use the proceeds to buy Euro in New York Arbitrage insures that currency prices will be the same at different locations around the world. (Arbitrage will raise the price in NYC and lower the price in London)

Suppose that a dealer in New York City was offering the following prices: Euro/USD = $1. 25 USD/JPY = Y 115 Euro/JPY = Y 135 2 1 Use the dollars to buy Yen at Y 115 3 Sell Euro short at $1. 25 Use the Yen to buy Euro at Y 135 Repay your short position The USD/JPY, and Euro/JPY rates imply a Euro/USD rate USD/JPY = Y 115 Euro/JPY = Y 135 Euro/USD = Y 135 Y 115 = $1. 17

Recall that in a closed economy, all borrowing had to be supplied by domestic savings – the domestic interest rate will insure that this happens. At the equilibrium interest rate

In the global economy, interest rates are determined in an integrated global capital market. The world interest rate equates world saving with world borrowing. At the equilibrium world interest rate, the US is running a trade deficit At the world equilibrium interest rate

The extent to which a country can effect global interest rates depends on size. The US controls 35% of the global economy. The increase in domestic investment demand increases the domestic trade deficit New Deficit An increase in world investment demand has a negligible impact on world interest rates

One method for valuing exchange rates is known as Purchasing Power Parity. This simply states that the same good should cost the same everywhere when its price is expressed in the same currency. Suppose we have the following gold prices in the US and England. The current exchange rate is $1. 15/L P = $500/oz P = L 400/oz Given these prices, you could make money by shorting gold in the US, converting your dollars to pounds, and then buying gold in England to cover your short position. The ‘PPP’ Exchange Rate should be $500 = $1. 25/L L 400

The PPP method values exchange rates by looking at price indices across countries. For example, consider the US and England PPP Exchange Rate e= USA CPI = 199. 8 (March 2006) = CPI (USA) CPI (UK) England 199. 8 195. 0 CPI = 195. 0 (March 2006) = $1. 025/L Currently, the British Pound is trading at $1. 786 – $1. 025 $1. 205 X 100 = 74% Is the British pound really overvalued by 74%?

The PPP method values exchange rates by looking at price indices across countries. For example, consider the US and England PPP Exchange Rate e= USA CPI = 199. 8 (March 2006) = CPI (USA) CPI (UK) England 199. 8 195. 0 CPI = 195. 0 (March 2006) = $1. 025/L Problems: 1. The CPI in the US and Britain are different bundles of goods 2. The CPI in the US and Britain are benchmarked by different base years A better method is to look at changes rather than levels

The PPP method values exchange rates by looking at price indices across countries. For example, consider the US and England USA Inflation = 3. 4% (12 months) England The dollar should depreciate by 1% against the pound Inflation = 2. 4% (12 months) 12 months ago, the British pound was trading at $1. 904 ( 1. 01) = $1. 923 $1. 786 – $1. 923 X 100 = -7. 1% Now, it looks like the British pound is undervalued

The real exchange rate is the price level adjusted exchange rate. Its meant to capture the relative value of goods and services across countries Foreign CPI Nominal Exchange Rate Domestic CPI By definition, the PPP explanation of exchange rates assumes that the real exchange rate is constant (and equal to one)

Empirically, real exchange rates are clearly not constant. In fact, the correlation between real and nominal exchange rates is nearly one. This casts some serious doubt on PPP.

One difficulty with PPP is that it requires arbitrage of goods, which can be costly (shipping costs, tariffs, taxes, etc). Arbitrage with assets is relatively costless. Suppose we have the following interest rates in the US and England. The current exchange rate is $1. 25/L and the brtish pound is expected to appreciate by 10% to $1. 375/L over the next year. i = 6% 1 4 i = 4% Short $1, 000 in T-Bills (You will owe $1, 060 in one year) Convert to dollars at $1. 375 (You will have $1, 144) and pay off loan 2 Buy Pounds at $1. 25 (you will get L 800) and buy British bonds 3 On maturity, your British bonds pay L 832 (4%)

Interest Rate Parity is an arbitrage condition for assets. It states that assets with similar risk characteristics should produce the same common currency yield. Interest Parity i = 3. 20% (March 2005) i = 4. 59% The dollar should appreciate by 1. 39% against the pound 12 months ago, the British pound was trading at $1. 904 (. 986) = $1. 877 $1. 786 – $1. 877 X 100 = -4. 8% (March 2005)

Interest parity fails just as miserably as PPP does for predicting exchange rate movements…actually, if you look closely, they are actually the same condition. Interest Parity Condition The nominal interest rate equals the real interest rate plus inflation Integrated world capital markets insure that the real return is equalized across countries Purchasing Power Parity

So, if both interest parity and purchasing power parity fail, then how are we supposed to predict movements in exchange rates? FIN 40500: International Finance Coming soon to a theatre near you!!