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Openness in Goods and Financial Markets Openness has three distinct dimensions: 1. Openness in goods markets. Free trade restrictions include tariffsand quotas. 2. Openness in financial markets. Capital controlsplace restrictions on the ownership of foreign assets. 3. Openness in factor markets. The ability of firms to choose where to locate production, and workers to choose where to work. The North American Free Trade Agreement (NAFTA)is an example of this.
International Financial market and Korean Economy Prepared by Seok-Kyun HUR IS-LM Framework for an Open Economy Based on Blanchard’s Chapter18~20 Openness in Goods and Financial Markets Openness has three distinct dimensions: Openness in goods markets Free trade restrictions include tariffs and quotas Openness in financial markets Capital controls place restrictions on the ownership of foreign assets Openness in factor markets The ability of firms to choose where to locate production, and workers to choose where to work The North American Free Trade Agreement (NAFTA) is an example of this Exports and Imports U.S Exports and Imports as Ratios of GDP since 1960 Since 1960, exports and imports have more than doubled in relation to GDP Exports and Imports The behavior of exports and imports in the United States is characterized by: The U.S economy is becoming more open over time, and trades more than twice as much (relative to its GDP) with the rest of the world as it did just 40 years ago Although imports and exports have followed broadly the same upward trend, they have also diverged for long periods of time, generating sustained trade surpluses and trade deficits Exports and Imports Table 18-1 Ratios of Exports to GDP for Selected OECD Countries, 2006 Country Export Ratio (%) Country Export Ratio (%) United States 11 Switzerland 54 Japan 18 Austria 62 United Kingdom 30 Netherlands 80 Germany 48 Belgium 92 The main factors behind differences in export ratios are geography and country size: - Distance from other markets - Size also matters: The smaller the country, the more it must specialize in producing and exporting only a few products and rely on imports for other products The Choice between Domestic Goods and Foreign Goods When goods markets are open, domestic consumers must decide not only how much to consume and save, but also whether to buy domestic goods or to buy foreign goods Central to the second decision is the price of domestic goods relative to foreign goods, or the real exchange rate Nominal Exchange Rates Nominal exchange rates between two currencies can be quoted in one of two ways: As the price of the domestic currency in terms of the foreign currency As the price of the foreign currency in terms of the domestic currency Nominal Exchange Rates The nominal exchange rate is the price of the foreign currency in terms of the domestic currency An appreciation of the domestic currency is an increase in the price of the domestic currency in terms of the foreign currency, which corresponds to a increase in the exchange rate A depreciation of the domestic currency is a decrease in the price of the domestic currency in terms of the foreign currency, or a decrease in the exchange rate Nominal Exchange Rates When countries operate under fixed exchange rates, that is, maintain a constant exchange rate between them, two other terms used are: Revaluations, rather than appreciations, which are decreases in the exchange rate, and Devaluations, rather than depreciations, which are increases in the exchange rate From Nominal to Real Exchange Rates Let’s look at the real exchange rate between the United States and the UK If the price of a Cadillac in the US is $40,000, and a dollar is worth 0.50 pounds, then the price of a Cadillac in pounds is $40,000 X 0.50 = £20,000 If the price of a Jaguar in the UK is £30,000, then the price of a Cadillac in terms of Jaguars would be £20,000/ £30,000 = 0.66 To generalize this example to all of the goods in the economy, we use a price index for the economy, or the GDP deflator Domestic Bonds versus Foreign Bonds An increase in the U.S interest rate, say, after a monetary contraction, will cause the U.S interest rate to increase, and the demand for U.S bonds to rise As investors switch from foreign currency to dollars, the dollar appreciates The more the dollar appreciates, the more investors expect it to depreciate in the future The initial dollar appreciation must be such that the expected future depreciation compensates for the increase in the U.S interest rate When this is the case, investors are again 54 indifferent and equilibrium prevails Equilibrium in Financial Markets The Relation between the Interest Rate and the Exchange Rate Implied by Interest Parity A higher domestic interest rate leads to a higher exchange rate—an appreciation 55 Putting Goods and Financial Markets Together Goods-market equilibrium implies that output depends, among other factors, on the interest rate and the exchange rate Y= C (Y − T ) + I (Y , i ) + G + NX (Y , Y , E ) * On the other hand, the interest rate is determined by the equality of money supply and money demand: M = YL(i ) P 56 20-3 Putting Goods and Financial Markets Together 1+ i E= E 1+ i * e i↑ ⇒ E ↓ i↓ ⇒ E ↑ (From a Korean’s Perspective) The interest-parity condition implies a negative relation between the domestic interest rate and the exchange rate (From an American’s Perspective) The interest-parity condition implies a positive relation between the domestic interest rate and the exchange rate 57 The Open Economy Version of IS-LM Framework 1+ i IS : Y= C (Y − T ) + I (Y , i ) + G + NX Y , Y , E 1+ i M LM : = YL(i ) P * e * An increase in the interest rate now has two effects: The first effect, which was already present in a closed economy, is the direct effect on investment The second effect, which is present only in the open economy, is the effect through the exchange rate 58 Putting Goods and Financial Markets Together The IS–LM Model in an Open Economy An increase in the interest rate reduces output both directly and indirectly (through the exchange rate): The IS curve is downward sloping Given the real money stock, an increase in output increases the interest rate: The LM curve is upward sloping 59 The Effects of Fiscal Policy in an Open Economy The Effects of an Increase in Government Spending An increase in government spending leads to an increase in output, an increase in the interest rate, and an appreciation The increase in government spending shifts the IS curve to the right It shifts neither the 60 LM curve nor the interest-parity curve The Effects of Fiscal Policy in an Open Economy Can we tell what happens to the various components of aggregate demand when the government increases spending: Consumption and government spending both go up The effect of government spending on investment was ambiguous in the closed economy, it remains ambiguous in the open economy Both the increase in output and the appreciation combined decreases net exports 61 The Effects of Monetary Policy in an Open Economy The Effects of a Monetary Contraction A monetary contraction leads to a decrease in output, an increase in the interest rate, and an appreciation A monetary contraction shifts the LM curve up It shifts neither the IS curve nor the interest-parity curve 62 Fixed Exchange Rates Central banks act under implicit and explicit exchange-rate targets and use monetary policy to achieve those targets Some countries operate under fixed exchange rates These countries maintain a fixed exchange rate in terms of some foreign currency Some peg their currency to the dollar Some countries operate under a crawling peg These countries typically have inflation rates that exceed the U.S inflation rate 63 Fixed Exchange Rates Some countries maintain their bilateral exchange rates within some bands The most prominent example is the European Monetary System (EMS) Under the EMS rules, member countries agreed to maintain their exchange rate vis-á-vis the other currencies in the system within narrow limits or bands around a central parity Some countries moved further, agreeing to adopt a common currency, the euro, in effect, adopting a “fixed exchange rate.” 64 Pegging the Exchange Rate and Monetary Control The interest parity condition is: + 𝑖𝑖𝑡𝑡∗ 𝐸𝐸𝑡𝑡 + 𝑖𝑖𝑡𝑡 = 𝐸𝐸 𝑒𝑒 Pegging the exchange rate turns the interest parity relation into: (1 + i ) = (1 + i ) ⇒ i = i * t t t * t In words: Under a fixed exchange rate and perfect capital mobility, the domestic interest rate must be equal to the foreign interest rate 65 Pegging the Exchange Rate and Monetary Control Increases in the domestic demand for money must be matched by increases in the supply of money in order to maintain the interest rate constant, so that the following condition holds: M = YL(i ) P * To sum up: Under fixed exchange rates, the central bank gives up monetary policy as a policy instrument 66 Fiscal Policy under Fixed Exchange Rates The Effects of a Fiscal Expansion under Fixed Exchange Rates Under flexible exchange rates, a fiscal expansion increases output from YA to YB Under fixed exchange rates, output increases from YA to YC The central bank must accommodate the resulting increase in the demand for money 67 Fiscal Policy under Fixed Exchange Rates There are a number of reasons why countries choosing to fix its interest rate appears to be a bad idea: By fixing the exchange rate, a country gives up a powerful tool for correcting trade imbalances or changing the level of economic activity By committing to a particular exchange rate, a country also gives up control of its interest rate, and they must match movements in the foreign interest rate risking unwanted effects on its own activity Although the country retains control of fiscal policy, one policy instrument is not enough A country that wants to decrease its budget deficit cannot, under fixed exchange rates, use monetary policy to offset the contractionary effect of its fiscal policy on output 68 ... goods and the demand for domestic goods Some domestic demand falls on foreign goods, and some of the demand for domestic goods comes from foreigners The Demand for Domestic Goods In an open economy, ... selling foreign currency—sometimes called foreign exchange Openness in financial markets allows: (1) Financial investors to diversify—to hold both domestic and foreign assets and speculate on foreign...Openness in Goods and Financial Markets Openness has three distinct dimensions: Openness in goods markets Free trade restrictions include tariffs and quotas Openness in financial markets