FIN 30220: Macroeconomic Analysis Open Economy Macroeconomics
Dec 19, 2015
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 = $1,740,894M
Imports = $2,545,843M
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)
Exports Imports Net
Merchandise $892,619 $1,674,261 - $781,642
Services $379,603 $321,577 $58,026
Income $468,672 $467,111 $1,561
Unilateral Transfers $82,894 - $82,894
Total $1,740,894 $2,545,843 - $804,949
In 2005, the deficit in merchandise increased by 17% as imports grew faster than exports
The surplus in services increased by 21% in 2005 as receipts grew faster than payments
The 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
NX = Y – (C + I + G)Solving for Net Exports, we get
National Income
Aggregate Expenditures
A trade deficit signifies that we as a country are spending beyond our current income
Alternatively,
S = I + (G-T) + CA CA = S – [I + (G-T)]
National Savings
Aggregate Borrowing
A deficit signifies that we are borrowing more than we are saving
A trade deficit implies that the US is borrowing from the rest of the world (currently, we are borrowing at the rate of $2B 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
(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
2005 US Capital & Financial Account (in Millions)
Change in US owned Assets Abroad
US Official Reserve Assets
US Government Assets
US Private Assets
Foreign Direct Investment
Securities
Change in Foreign Ownership of US Assets
Foreign Official Assets
Private Foreign Assets
Foreign Direct Investment
Currency
Securities
Merchandise
Services
Income
Unilateral Transfers
Current Account Capital & Financial Account
Note that every credit (+) has to be matched with a debit (-).
Remember this: any transaction that involves money flowing into the US is a (+)
Change in US owned Assets Abroad
US Official Reserve Assets
US Government Assets
US Private Assets
Foreign Direct Investment
Securities
Change in Foreign Ownership of US Assets
Foreign Official Assets
Private Foreign Assets
Foreign Direct Investment
Currency
Securities
Merchandise
Services
Income
Unilateral Transfers
Current Account Capital & Financial Account
Example #1
Suppose that Wall Mart buys $20M worth or goods from a Chinese supplier. The Chinese company uses the $20M to buy stock in IBM.
- $20M
$20M
Change in US owned Assets Abroad
US Official Reserve Assets
US Government Assets
US Private Assets
Foreign Direct Investment
Securities
Change in Foreign Ownership of US Assets
Foreign Official Assets
Private Foreign Assets
Foreign Direct Investment
Currency
Securities
Merchandise
Services
Income
Unilateral Transfers
Current Account Capital & Financial Account
Example #2
Suppose that the US spends $80B on a foreign aid package to Iraq. The Iraqi government uses $40B to buy computers from Dell, $30B goes to pay employees of Haliburton, and $10B is deposited in a US bank.
- $80B
$30B
$40B
$10B
Change in US owned Assets Abroad
US Official Reserve Assets
US Government Assets
US Private Assets
Foreign Direct Investment
Securities
Change in Foreign Ownership of US Assets
Foreign Official Assets
Private Foreign Assets
Foreign Direct Investment
Currency
Securities
Merchandise
Services
Income
Unilateral Transfers
Current Account Capital & Financial Account
Example #3
Suppose that Nike spends $50M on a production facility in Korea - $20M is used to buy equipment from US suppliers, $30M is used elsewhere.
- $50B
$20B
$30B
-200
-150
-100
-50
0
50
100
150
200
250
Jan-80 Jan-88 Jan-96
Current Account FKA
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.
12 AM
12 PM
11 PM
5 PM
Eastern Time
Australia: 5PM - 2AM
3 AM
8PM - 5AM Tokyo
London: 3AM -11AM
9 PM
8 AM
New York City: 8AM -5PM
0
5000
10000
15000
20000
25000
30000
12:00AM 4:00AM 8:00AM 12:00AM 4:00PM 8:00PM
Tra
nsa
ctio
ns/
Hour
The foreign exchange market is unique not just because of its geographic dispersion, but also because of its extreme liquidity and tremendous volume – around $1.9T PER DAY!!
$600B in Spot market Transactions
$1.3T in Derivative Market Transactions
$200B in Forwards
$1T in Swaps
$100B in Options
Name % of Volume
Deutsche Bank 17
UBS 12.5
Citigroup 7.5
HSBC 6.4
Barclays 5.9
Merrill Lynch 5.7
JP Morgan Chase 5.3
Goldman Sachs 4.4
ABN Amro 4.2
Morgan Stanley 3.9
The ten most active traders account for 73% of the volume
USD/JPY20%
USD/EUR31%
EUR/All8%
USD/Other17%
USD/AUD4%
USD/CAD4%USD/CHF
5%USD/GBP
11%
US currency was involved in 89% of transactions, followed by the Euro (37%), the yen (20%) and sterling (17%).
An exchange rate is generally defined as the domestic currency price of a foreign currency, but be careful…
Most currencies are quoted two ways:
US Dollar Equivalent ($/-) Currency per US Dollar (-/$)
The Euro is currently trading at 1.601
An increase in the US dollar equivalent rate signifies a depreciation of the dollar
The Euro is currently trading at .6246
An increase in the currency per US dollar rate signifies an appreciation of the dollar
0.8000
0.9000
1.0000
1.1000
1.2000
1.3000
1.4000
Jan-99 Jul-00 Jan-02 Jul-03 Jan-05
The dollar has had quite a wild ride against the Euro since it began circulating in 1999.
Recession
Do
llar
s p
er E
uro
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 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 2Use the proceeds to buy Euro in New York
3Use your newly acquired Euro to pay off your short position
Suppose that a dealer in New York City was offering the following prices:
Euro/USD = $1.25
USD/JPY = Y115
Euro/JPY = Y135
1 Sell Euro short at $1.25
2 Use the dollars to buy Yen at Y115
3 Use the Yen to buy Euro at Y135
Repay your short position
USD/JPY = Y115Euro/JPY = Y135
The USD/JPY, and Euro/JPY rates imply a Euro/USD rate
Euro/USD =Y135
Y115= $1.17
r
SI ,
r
TGI
S ** STGI
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
r
SI ,
TGI
S
WWW STGI
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 world equilibrium interest rate
r
WW SI ,
r
WW TGI
WS
CA
At the equilibrium world interest rate, the US is running a trade deficit
r
SI ,
TGI
S
The extent to which a country can effect global interest rates depends on size. The US controls 35% of the global economy.
An increase in world investment demand has a negligible impact on world interest rates
r
WW SI ,
r
WW TGI
WS
The increase in domestic investment demand increases the domestic trade deficit
New Deficit
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.
P = $500/oz P = L 400/oz
Suppose we have the following gold prices in the US and England. The current exchange rate is $1.15/L
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 $500L400
= $1.25/L
The PPP method values exchange rates by looking at price indices across countries. For example, consider the US and England
England
CPI = 195.0 (March 2006)
USA
CPI = 199.8 (March 2006)
PPP Exchange Rate
e = CPI (USA)CPI (UK)
199.8195.0
= = $1.025/L
Currently, the British Pound is trading at $1.786
$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
England
CPI = 195.0 (March 2006)
USA
CPI = 199.8 (March 2006)
PPP Exchange Rate
e = CPI (USA)CPI (UK)
199.8195.0
= = $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
England
Inflation = 2.4%
(12 months)
USA
Inflation = 3.4%
(12 months)
*% e4.24.3
%1The dollar should depreciate by 1% against the pound
12 months ago, the British pound was trading at $1.904
$1.904 ( 1.01) = $1.923
$1.786 – $1.923$1.923
X 100 = -7.1%Now, it looks like the British pound is undervalued
The real exchange rate is the price level adjusted exchange rate. Its meant to capture the relative value of goods and services across countries
P
PeRER
*
Nominal Exchange Rate
Domestic CPI
Foreign CPI
By definition, the PPP explanation of exchange rates assumes that the real exchange rate is constant (and equal to one)
50
100
150
200
250
300
Jan-85 Jan-89 Jan-93 Jan-97
Yen/$ Real
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.
i = 6% i = 4%
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.
1Buy Pounds at $1.25 (you will get L800) and buy British bonds
2Short $1,000 in T-Bills (You will owe $1,060 in one year)
On maturity, your British bonds pay L832 (4%)3
Convert to dollars at $1.375 (You will have $1,144) and pay off loan
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.
i = 3.20%
(March 2005)
i = 4.59%
(March 2005)
Interest Parity
*% iie 59.42.3
1.39%The dollar should appreciate by 1.39% against the pound
12 months ago, the British pound was trading at $1.904
$1.904 ( .986) = $1.877
$1.786 – $1.877$1.877
X 100 = -4.8%
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.
*% iie Interest Parity Condition
The nominal interest rate equals the real interest rate plus inflation
**% rreIntegrated world capital markets insure that the real return is equalized across countries
*rr *% e 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 FinanceComing soon to a theatre near you!!