Figure 18.1 Australian exports and imports as ratios to GDP. 1900-2008
5
1900 1910 1920 1930 1940 1950 I 960 1970 1980 1990 2000
Exports and imports averaged 20 per cent and 17 per cent respectively, of GDP in the first half of the twentieth century. After the commodity price boom of the early 1950s, the ratios fell to below 15 per cent in 1960. but hove been steadily growing, to reach 21 per cent and 22 per cent in 2008.
10-
Exports/GDP
SOURCES: 1901-59: M Butlin. RBA Discussion Paper. 1977: 1960-2008: RBA.Tnblo Gil.
through thc now-infamous Smoot-Ilawiey Act ol 19.30. In a misguided attempt to help the LIS economy recover from the Great Depression, Smoot—Hawley sharply increased tariffs. Thc results were retaliation hy other countries fin the form of higher tariffs on US as well as other countries goodsi and a sharp decrease in world trade. Australian tarills were no exception, and so imports and exports fell at a time when the Australian economy could least afford it. Thc rise in protectionism— protecting domestic industries from foreign competition—was a major reason tor the spread ol the Great Depression Irom the Llnited States to countries around the world.
• Although imports and exports have followed broadly the same trend, they have also diverged lor long periods, generating sustained trade surpluses or trade delicits. Three episodes stand out:
1. The trade surpluses in the first half of the twentieth century, when exports usually exceeded imports. This was why Australia managed to establish such a high relative standard ol living (which you saw in Chapter 10).
2. The trade deficits in the 1980s iwc will return to them in Chaptcr 20).
3. The current trade dclicit. The ratio ol the trade delicit to GDP reached 1.6 per cent in 2008 (we will return to discuss its relevance in Chapter И) i.
Given all the talk in the media now about globalisation, a volume ot trade (measured by thc ratio of exports or imports to GDP) around 20 per cent of GDP may strike you as small. However, the volume of trade isn't necessarily a good measure of openness. Many sectors can be exposed to lorcign competition without the ellects ol this compeiition showing up in high imports. Hy being competitive and keeping their prices low enough, these sectors can retain their domestic market share and keep imports out. This suggests that a better index of openness than export or import ratios is the proportion of aggregate output composed of tradable goods—goods lhat compete with loreign goods in either domestic markets or foreign markets. Estimates from the ABS in 1997 suggest that tradable goods represent around one-quarter of aggregate output in Australia today, but this figure may easily be an underestimate. Tradables comprise 42 per cent of the consumer price index for Australia. Research on the Linked States indicates that around 60 per cent of its aggregate output is in tradables, the remaining 40 percent in non-tradablcs.
Ausiralia isn't an especially Open country. It is more open than the Llnited States and Japan in terms ol export ratios, but less open than many European and Asian countries. Table 18.1 gives these ratios for a number of rich countries in the period 2000-08.
Tl 1С OPEN ECONOMY chapter 18
Mr Smoot and Mr Hawley had a brief moment of renewed fame during a TV debate ^ on NAFTA in 1993, when the US vice- president AI Gore presented their picture to H. Ross Perot as a way of reminding Americans of die dangers of opposing free trade. From Chapter 3:The> trade balance is the difference between exports and imports: Exports > imports:Trade surplus (equivalently, positive trade balance). Exports < imports:Trade deficit (equivalently. negative trade balance).
Tradable goods: cars. ►
computers. Non-tradable goods: housing, medical services, haircuts.
The Llnited States lapan. India and Australia are at the low end of the range ot export ratios. Mainland China is opening rapidly and has reached 3 I per cent. New Zealand is smaller and more open than Australia. The large European countries, such as Germany and the United Kingdom have ratios that are two to three times larger than those for the Llnited States and Japan. And the smaller European countries have even larger ratios, Irom 18 per cent in Switzerland lo 85 per ceni in Belgium. Belgium's 85 percent ratio of exports to GDP raises an odd possibility: Could a country have exports larger than
Table 18.1 Ratios of exports to GDP for selected rich countries, 2000-08 average
Country Export ratio (%) Country Export ratio (%)
United States 1 1 New Zealand 31
Japan 13 Germany 39
India 17 Switzerland 48
Australia 20 Belgium 85
United Kingdom 27 Hong Kong 105
China (Mainland) 31 Singapore 126
its GDP—that is an export ratio greater than one? The answer is yes'; examples arc Hong Kong with a ratio of 105 per ccnt and Singapore with 126 per ccnt. The reason is given in the locus box Can exports exceed GDP?.
4 Iceland is both isolated and small. What would you expect its export ratio to be! (Answer: 37 per cent.)
4 In a closed economy, people face one decision: save or buy (consume). In an open economy, they face two decisions: save or buy (buy domestic, or buy foreign).
FOCUS 'BOX
Do these numbers indicate that the United States has more trade barriers than, say, the United Kingdom or Belgium? No. The main factors behind these differences are geography and size. Distance from other markets explains a good part ol the low Australian and lapanese ratio—the tyranny ol distance' impacts heavily on trade in goods and services. Size also matters: the smaller the country, the more it must specialise in only a few products, producing and exporting them, and relying on imports for the others. Belgium can hardly alford to produce the same range ol goods as the United States, a country roughly forty times its economic size. Trade harriers are an explanation in some cases, such as India. Trade theory shows that the larger a country is in its markets, the greater its ability to influence the prices at which it trades, and therelorc the more likely it can benelit from trade protection at the expense of its trade partners. Small countries can never benefit, except sometimes in the short term. This explains why so many countries like Australia have worked hard in the last few years lo negotiate preferential trade agreements with the United States Japan and Europe.
The choice between domestic goods and foreign goods
I low does openness in goods markets force us ю rethink the way wc look at equilibrium in the goods market?
Until now, when we were thinking about consumers decisions in the goods market, we focused on their decision lo save or to consume. When goods markets are open, domestic consumers face a second decision: whether to buy domestic goods or to buy foreign goods. Indeed, all buyers—other domestic buyers such as firms or the government, and foreign buyers face a similar decision. I his decision has a direct effect on domestic output. If buyers decide to buy more domestic goods, the demand lor domestic goods increases, and so does domestic output. II they decide to buy more lorcign goods, then foreign output increases rather than domestic output.
Central to this second decision no buy domestic goods or foreign goods) is the pricc of foreign goods relative to domestic goods. We call this relative pricc the real exchange rate. The real exchange rate isn't directly observable, and you won't lind it in the newspapers. What you will find in newspapers
CAN EXPORTS EXCEED GDP?
Can a country have exports larger than its GDP—that is, have an export ratio greater than one?
It would seem that the answer must be 'no'. Countries cannot export more than they produce, so the export ratio must be less than one. But not so.The key to the answer is to realise that exports and imports may include exports and imports of intermediate goods.
Take, for example, a country that imports intermediate goods for $ I billion. Suppose it transforms them into final goods using only labour. Say, total wages equal $200 million and there are no profits.The value of these final goods is thus equal to $1,200 million. Assume that $1 billion worth of final goods is exported and the rest is consumed domestically.
Exports and imports therefore both equal $ I billion.What is GDP in this economy? Remember that GDP is value added in the economy (see Chapter 2). So, in this example. GDP equals $200 million, and the ratio of exports to GDP equals $l,000/$200 = 5.
Hence, exports can exceed GDP. This is actually the case for a number of small countries where most economic activity is organised around a harbour and import-export activities.This is even the case for small countries where manufacturing plays an important role, such as Hong Kong and Singapore. (For more on Hong Kong and Singapore, look at the focus box in Chapter 12.) From 2000 to 2008. the ratio of exports to GDP in Hong Kong and Singapore averaged 105 and 126 per cent respectively.
are nominal exchange rales, the relative prices ol currencies. So, in the rest ol this section, wc start hy looking at nominal exchange rales and then sec how we can use them to construct real exchange rates.
Nominal exchange rates
Nominal exchange rates between two currencies can he quoted in one ol two ways:
• ,4s the price of the domestic currency in terms of the foreign currency. Il, lor example, we look at the United States and Ausiralia and think ol the Australian dollar (A$) as the domestic currency and the US dollar (US$i as the loreign currency, we can express lhe nominal exchange rate as the price ol an A$ in terms ol l.IS$s. On 3 October 2008, the exchange rate defined this way was 0.78 (1 A$ = 0.78 US$).
• As the price of the foreign currency in terms of the domestic currency. Continuing with the same example, wc can express the nominal exchange rate as thc price of a US$ in terms of A$s. On 3 October 2008, the exchange rate delined this way was 1.28 (I US$ = 1.28 A$).
Either definition is line: the important thing is lo remain consistent. In ibis book, we will always delinc the nominal exchange rate as the price ol the domestic currency in terms ol foreign currency and deno:c it by £. When looking, tor example, at the exchange rate between Australia and the United States (from the viewpoint ol Australia, so the A$ is the domestic currency E will denote the price ol an A$ in terms ot US$s—so. as ol 3 October 2008, L was 0.78. Wc choose this definition because it is the exchange rate that you see in the media every day, and it would be too confusing to use thc inverse definition.
Exchange rates between the dollar and most foreign currencies change every day, every minute ot the day. These changes are called nominal appreciations or nominal depreciations—appreciations or depreciations, tor short. An appreciation ol the domestic currency is an increase in the price ol the domestic currency in terms ol a foreign currency.
С liven our definition ol the exchange rate as the price ol the domestic currency in terms ol foreign currency, an appreciation ol the domestic currency corresponds lo an increase in the exchange rate, C. A depreciation of the domestic currency is a decrease in lhe price of the domestic currency in terms ol a foreign currency. So. given our definition ol the exchange rate as the price of the domestic currency in terms ot foreign currency, a depreciation ot thc domestic currency corresponds to a decrease in the exchange rate, £".
These definitions are intuitive. Consider again the Australian dollar and the US dollar from the viewpoint ol Australia1:
• An appreciation ol the Australian dollar (also called a dollar appreciation1 means that the price of an A$ in terms of a US$ goes up. Equivalently the price of a US$ in terms of an A$ goes down, thc same as saying that the Australian dollar exchange rale has increased.
• A depreciation of thc Australian dollar (a dollar depreciation means that the price ol an A$ in terms ol a US$ goes down. Equivalently. the price of a US$ in terms ol an A$ goes up, the same as saying that the Australian dollar exchange rate has decreased.
Figure 18.2 summarises the terminology. (You may have encountered two other words to denote movements in exchange rates: revaluations and devaluations. These two terms arc used when countries operate under fixed exchange rates—a system in which two or more countries maintain a constant exchange rate between their currencies. Under such a system, increases in the exchange rale E—which are intrequeni by definition—are called revaluations (rather than appreciations). Decreases in the exchange rate are called devaluations (rather than depreciations We discuss lixed exchange rates in Chapter 20.)
Keep these definitions in mind as we move on to Figure 18.3, which plots the nominal exchange rate between thc A$ and the US$ since 1960. Note four things in this figure:
• The near constancy of the exchange rate at 1.12 from I960 lo 1972. Ausiralia had a lixed exchange rate in that period.
Our chosen definition for the nominal exchange rate: price of domestic currency in terms of foreign currency. (From the point of view of Australia, the price of an A$ in terms of US$s.) ►
Warning:The alternative ► definition of exchange rates as the price of foreign currency in terms of domestic currency (or 1ie) is thc convention in economic articles and books on the US side of the Pacific and the Atlanuc. On the other side of the Atlantic and on our side of the Pacific, however, economists more often use our definition, defining exchange races as the price of domestic currency in terms of foreign currency (E).
• The sharp rise or appreciation of the Australian dollar in 1973. This was associated with the surge in global commodity prices. In Chapter 7 we discussed the effects of oil price hikes in thc 1970s. Oil
From the point of view of Australia looking at the United States
Nominal exchange rate E
Price of A$ in terms of US$
Appreciation of the AS
Price of A$ in US$s increases
(Equivalently, price of US$ in terms of A$ decreases) Nominal exchange rate increases E T
Depreciation of the A$
Price of A$ in US$s decreases
Figure 18.2 The nominal exchange rate between the Australian dollar and the US dollar (from the point of view of Australia): Appreciation and depreciation
(Equivalently, price of US$ in terms of A$ increases) Nominal exchange rate decreases El
US$/A$
Figure 18.3 The nominal exchange rate between the Australian dollar and the US dollar. 1960-2008
(A
D
1.60
1.40 -
1.20 -
0.80
0.60
While the Australian dollar has depreciated against the US currency since /975, this depreciation has come with some swings.
was only one ol many commodities whose price escalated. With Australia's exports then dominated by commodities, the AS appreciated reaching 1.49 in 1975.
The trend decrease in the exchange rate since 1975, when the A$ could buy US$1.49. It reached its all-time low ot US$0.48 in April 2001. By October 2008 the value of the A$ was US$0.78 and falling. Put another way, there was a strong depreciation ol the A$ over the period 1975-2008.
i Remember: Increase in the exchange rate о appreciation. Decrease in the exchange rate о depreciation.
The fluctuations in the exchange rate. In the space of less than ten years in the 1980s, the value ol the A$ dropped from US$1.14 in 1980 to US$0.60 in 1986, and then rose to US$0.89 by earlv 1989. Put another way, there was a large depreciation of the A$ in the first half of the 1980s, followed by a large appreciation later in the decade. What caused these swings? What effects did they have on the Australian economy? This is one ol the issues we will return to later in this chapter and in the next two chapters.
If wc are interested, however, in the choice between buying domestic goods or buying foreign goods, the nominal exchange rale gives us only part ol lhe information wc need. Figure 18.3, for example, tells us only about movements in the relative price of the two currencies, the Australian dollar and the LIS dollar. To American tourists thinking ot visiting Australia, lhe question isn't only how many Australian dollars they will get in exchange lor their LIS dollars hut how much goods will cost in Australia, relative lo how much they cost in the Llnited States. Later we will check to see whether American tourists to Australia in 2008 would find their trip cheaper than when their parents visited in I960. This takes us to our next step—the construction of real exchange rates.
From nominal to real exchange rates
How can we construct the real exchange rate between Ausiralia and the Llnited Stales—the price of Australian goods in terms ol LIS goods?
Suppose the Llnited States produced only one good, a Cadillac Seville Luxury Sedan, and Australia also produced only one good, a Holden Senator Luxury Sedan. (This is one ot those Suppose statements that run completely against the tacts, but we will become more realistic shortly, i Con¬structing the real exchange rate, the price of thc Australian good in terms ot the LIS good, would he straightforward.
• The lirst step would be lo take the price ol a Cadillac in LIS$ and convert it lo a price in A$. Suppose the price of a Cadillac in the United Slates is LIS$40,000. If one A$ is worth L1S$0.75, the price ol a Cadillac in A$ is US$40,000/US$0.75 per A$ - A$53,333.
• The second step would be to calculate the ratio ot the price ol the Holden in A$s to the price ot the Cadillac in A$s. The price of a luxury Holden in Ausiralia is A$72,000. So, the price ol the Holden in terms of Cadillacs—that is, the real exchange rate between Australia and the Llniied Stales— would be A$72,000/A$53,333 = 1.35.
The example is straightforward, but how do we generalise it? Australia and the United States produce more than Holdens and Cadillacs, and we want to construct a real exchange rate that reflecis the relative price ol nil the goods produced in Australia in terms of nil the goods produced in the Llnited Slates.
The calculation we just went through tells us how to proceed. Rather than use the Australian dollar price ol a I lolden and the LIS dollar price ol a Cadillac, we must use an Australian dollar price index for all goods produced in Ausiralia and a LIS dollar price index for all goods produced in the Llnited States. This is exactly what the CDF dcllators introduced in Chapter 2 do. Thcv are by definition price indexes lor the set ot linal goods and services produced in the economy.
So, let P be the GDI' deflator for Australia, P* be the GDP deflator tor the United States (as a rule, we will denote foreign variables by an asterisk! and £ be the LIS dollar-Australian dollar nominal exchange rate. Figure 18.4 goes through thc steps needed lo construct the real exchange rale.
Calculating the relative price of a Holden in ^ terms of Cadillacs: Senator: A$72.000 Cadillac: US$40.000/0.75 = AS53.333 Relative price of a Holden in terms of Cadillacs: 72.000/53,333 = I.3S.
e: Real exchange rate— price of domestic goods in terms of foreign goods (for example, from the point of view of Australia, the price of Australian goods in terms of US goods). *
• Thc price ol LIS goods in US$s is P*. Dividing it by the exchange rate, £—thc price ol the A$ in terms of LISSs—gives us the price of US goods in A$s. P*/£.
Figure 18.4 The construction of the real exchange rate
Price of Australian goods in AS, P
Price of US goods in US$, P*
Price of US goods in AS, P*/E
The* price of Australian goods in A$s is P. The real exchange rate, the price ot Australian goods in terms ol US goods, which wc will call e (the Creek lowercase epsilon), is thus given by
EP
p*
p*
h
The real exchange rate is constructed by multiplying the nominal exchange rate by the domestic price level, and then dividing by the foreign price level—a straightforward extension ol the calculation made in our Holden/CadiFac example. Mote. however, an important dillcrence between our example and this more general calculation.
Unlike the price ol I lo dens in terms ol Cadillacs the real exchange rate is an index number. That is, its level is arbitrary, and thus, uninlormative. It is uninlormative because the GDP deflators used in the construction of the real exchange rate are themselves index numbers,- as we saw in C hapter 2, they arc equal to I or 100) in whatever year is chosen as the base year. But all is not lost. Although the level of the real exchange rate is uninlormative. relative changes in the real exchange rate arc informative. Il, lor example, the real exchange rate between Australia and the United States increases by 10 per cent, this 10 per ccnt increase tells us that Australian goods arc now 10 per cent more expensive relative to LIS goods than they were before.
I ike nominal exchange rates real exchange rates move over time. An increase in the relative price ol domestic goods in terms ot foreign goods is called a real appreciation. A decrease in the relative price ol domestic goods in terms ot foreign goods is callcd a real depreciation.
Real • as opposed to nominal indicates we are referring to changes in the relative price ol goods, not the relative price of currencies.
• Given our definition of the real exchange rate as the pricc of domestic goods in terms ot foreign
goods, a real appreciation corresponds to an increase in the real exchange rate, e.
• Similarly, a real depreciation corresponds to a decrease in the real exchange rate, e.
Figure 18.5 The real exchange rate between Australian goods and US goods (from the point of view of Australia): Real appreciation and real depreciation
These definitions are summarised in Figure 18.5, which does lor the real exchange rate what Figure 18.2 did lor the nominal exchange rate.
From the point of view of Australia looking at the United States
Real exchange rate e
Price of Australian goods in terms of US goods
Real appreciation
Price of Australian goods in terms of US goods increases
(Equivalently, price of US goods in terms of Australian goods decreases) Real exchange rate increases ft
Real depreciation
Price of Australian goods in terms of US goods decreases
An index number s a number chac is set equal to an arbitrary value (often I or 100) in an arbitrary year, called the base year. Because the choice of both the value in the base year and the base year itself is 4 arbitrary, the level of an index number is arbitrary, and so contains no information. But the rate of change of an index number doesn't depend on the choice of the value in the base year and s therefore informabve. For example, the fact that the GDP deflator is. say. 200 is uninformative. The fact that the GDP deflator changes during the year from 200 to 210, a 5 per cent increase, is informative: it tells us that inflation was 5 per cent during the year.
18.1)
€ --
(Equivalently, price of US goods in terms of Australian goods increases) Real exchange rate decreases б!
Figure 18.6 plots the evolution of the real exchange rate between Australia and the United States from I960 to 2008. constructed using equation ( 18.1 >. For convenience, it also reproduces the evolution ol the nominal exchange rate from Figure 18.3. The GDI' deflators have both been set equal to 100 in 1995 so that in that year the nominal exchange rate and the real exchange rate are equal by construction.
Note two things about Figure 18.6: 1. In September 2008. the real exchange rate fell from 0.98 to equal 0.80, above its I960 value of 0.70. In other words, there was a (small real appreciation of Australian goods vis-a-vis US goods over the 48-vear period—an annual appreciation ol 0.3 per cent. In contrast, thc nominal exchange rate depreciated over the same period by 0.8 per cent annually.
How do we reconcile thc lact that there was a large nominal depreciation of the A$ vis-a-vis the US$) and a small real appreciation (ol Australian goods vis-a-vis US goods during the period? To see how, return to the definition ol the real exchange rate:
EP = p*
Two things have happened since I960:
• E has gone down. The A$ has gone down in terms ol the US$—this is the nominal depreciation wc saw earlier.
• Inflation has been higher in Australia over the past lorty-eight years than in the United States, leading to a larger increase in the Australian price level /'. than in the US price level, P*. This increase in P/P" has been a little greater than thc decrease in E. leading to a modest increase in e. a real appreciation.
1 ct's go back to our US tourists thinking ol visiting Australia in 2008. They can certainly buy more A$s per US$ than their parents did in I960. Does this imply that their trip will be much cheaper i in terms ol LIS goods >? No. When they arrive in Australia, they will discover that the prices ol goods in Australia have increased much more than the prices ot goods in the United States and this more than cancels out the decrease in the value of the A$ in terms of LIS$s. They will find that their trip in 2008 won't actually be cheaper (in terms ol LIS goods) than it was for their parents in I960.
Can there be з real appreciation with no nominal appreciation? Can there be a nominal | appreciation with no real appreciation! (The answer to both questions: Yes.)
There is a general lesson here. Over long periods ol time, depending on differences in inflation rates across countries, nominal exchange rates and real exchange rates can move quite dillerently. We will return to this issue in Chaptcr 20.
Figure 18.6 Real and nominal exchange races between the Australian dollar and the US dollar. 1960-2008
1.60 л
Nominal exchange rate, £
Real exchange rate, 6
—I 1 1 1—
1970 1975 1980 1985
1990
—I—
1995
2005
-C 0 0 M (Л
Э
W
0
1Л
E
Б о *j
с
.40-
1.20-
1.00-
-o
о 0.80 Ч w
0.60-
с
5
и <
0.40-
I960
1965
2000
ф I
2. The large fluctuations in the nominal exchange rate we saw in Figure 18.3 also show up in the real exchange rate. The reason isn't hard to litid. As inflation rates haven't been very different in Australia and the United Slates year-to-year movements in the price ratio, PIP*, have been small compared with the often sharp movements in the nominal exchange rate. £. Thus, from year to year, or even over a lew years, movements in the real exchange rate, e have been driven mostly by movements in the nominal exchange rate. £. Note that since the early 1990s the nominal exchange rate and the real exchange rates have moved nearly together. This reflects the fact that, since the mid-1980s, inflation rates have been very similar in the two countries.
From bilateral to multilateral exchange rates
Wc need one last step. Wc have concentrated so lar on the exchange rate between Australia and the United States. But Australia trades with many countries besides the United States. Table 18.2 gives the geographic composition of Australian trade for both exports and imports. The numbers refer only to merchandise trade—exports and imports ot goods. They don't include exports and imports ol services, such as travel services and tourism, for which the decomposition by country isnt available.
Europe, Japan, China and the United States account lor 50 to 58 per cent (depending on whether one looks at exports or imports) ol Australian merchandise trade. Trade with all ol Asia accounts lor a large and increasing proportion ot Australian merchandise trade—in 2007-08, 64 per ccnt ol exports and 53 per cent ot imports. Interestingly trade is in deficit with China, Europe and the United States, and in surplus with Japan. The deficit with China is largely because Chinese goods are now so cheap, or more accurately because the bilateral real exchange between Australia and China is so high. The merchandise trade deficit with Europe and the United States has indeed been a major source ol tension between Australia and these two economic superpowers lor some lime. In the case of Europe. Australians regard the Common Agricultural Policy as an unfair constraint on trade in rural products. With protectionism entrenched in many sectors ot the United States, Australia worked hard to establish a preferential trade agreement in 2005, but the likelihood ot eliminating the delicit with the United States is slim.
4 If inflation rates were equal, PIP* would be constant, and e and £ would move together.
4 Bi means two. Mub means many.
How do we go Irom bilateral exchange rates such as the real exchange rate between Australia and the United States, to multilateral exchange rates? The answer is straightforward. If we want to measure the average price ol Australian goods relative to the average pricc of goods of Australian trading partners, we should use the Australian share ot trade with each country as the weight for that country. Using export shares, we can construct an 'export real exchange rate, and using import shares we can constmct an import real exchange rate. Because economists usually don't want to keep track of two
Table I 8.2 The country composition of Australian merchandise trade, 2007-08
Exports to Imports from
Countries (A$ million) % Countries (A$ million) %
Japan 28,304 20 European Union 43,585 21
China 16,030 12 China 3 1,743 15
European Union 15,021 11 United States 24,772 12
South Korea 10,940 8 Japan 20,266 10
United States 9,261 7 New Zealand 7,277 3
New Zealand 9,001 6 South Korea 6,265 3
Asia (not Japan, China or Korea) 32.746 24 Asia (not Japan. China or Korea) 52,201 25
Others 17.318 12 Others 21.985 II
Total 138.621 100 Total 208,094 100
SOURCE. A8S. cat. no. 5368.Tabic 14.
dillercnt exchange rates, they typically use an exchange rate that takes an average ot export and import shares. I; is sometimes called the real trade-weighted index or the TWI. Another common name is thc real effective exchange rate. I his is the variable we will think ol when talking about the Australian multilateral real exchange rate or the Australian real exchange rate, tor short.
Figure 18.7 shows the evolution ol this multilateral real exchange rate, the average price of Australian goods relative to foreign goods from 1980 to mid-2008. Like the bilateral real exchange rales wc saw a few pages earlier, it is an index number. So, its level is also arbitrary- here it is set equal to 1 in 1996. The multilateral nominal exchange rate is also shown.
There are two remarkable differences between Figure 18.7 and Figure 18.6.
• The real multilateral exchange rate becomes higher than the nominal one as time goes backwards from 1995, whereas the real bilateral rate (with ihe LIS becomes smaller. This suggests thai Australia's competitiveness improved from I960 to 1995 with its non-US trade partners, largely due lo lower relative inllation.
• Going forward in time from 1995 to 2008, the nominal and real bilateral rates move together but the real multilateral rate appreciates more Australia's competitiveness seems to have deteriorated from 2001 to mid-2008 because goods prices rose more in Australia than in its non-US trade partner countries. The strengthening ol Australia's real multilateral exchange rate by 45 per ccnt from 2002 to 2008 did weaken Australia's export demand and helped to keep inflation in check However, as a counter-balance in this period, world commodity prices rose signilicantly, improving the revenue Australia received lor its exports. Due to the global financial crisis over two months to October 2008 the exchange rale fell 25 per cent, and in addition the world economy was predicted to slow down significantly. I he ellects on net exports are hard lo predict. In Chapter 19 we will explain the logic behind these statements.
Here is an example ► using Table 18.2. The share of exports to Japan in Australian exports is 20 per cent.
The share of imports from Japan in Australian imports is 11 per cent. The Japan share used to calculate the multilateral Australian exchange rate is (20%+ 1l%)/2 = 16%.
THE OPEN ECONOMY chapter 18
A most striking aspect ol Figure 18.7 is something we already saw when looking ai the bilateral exchange rate between Australia and thc Llnited States in Figure 18.6: thc large swing in the real exchange rate in the 1980s and 2000s. Foreign goods were substantially more expensive compared with Australian goods in 1986-87 than they were at either the beginning or lhe end ol the decade. In other words, there was a large real depreciation ot Australian goods in thc tirsi half ot the 1980s, followed by a 50 per cent smaller appreciation in the second half. This large swing evidently has its origins in thc movement ol thc nominal exchange rate. It was also evident in Australia's exchange rale with the LIS dollar shown in Figure 18.6. and this suggests that it had most to do with factors driving the LIS dollar
ISO-
135'
120-
105-
90
Nominal multilateral exchange rate
1980
1985
1990
I I I I
1995
x о ■a с
75-
-1—i
2000
Figure 18.7 The Australian multilateral nominal and real exchange rate. 1980-2008
The large depreciation in the mid-1980s of Australian money and goods was followed by a SO per cent recovery by 1990. From 2001 there was a gradual real depreaabon. but a significant appreciation until mid-2008. In the global financial crisis of late 2008, the Australian dollar depreciated 25 per cent
rather than the Australian dollar. The US dollars fluctuation was so striking that it has been given various names, Irom the US dollar cycle' to the more graphic dance ol the (US) dollar. Economists arc sure now that wc arc into a second large swing, a second dollar cycle. In the coming chapters wc will return to these swings to discover what effects these movements in the real exchange rate have had on the trade delicil and on economic activity.
4 Daily volume of foreign- exchange transactions with US dollars or one side of the transaction: US$3.2 trillion: with Australian dollars:
A$ 163 billion. Daily volume of trade of the United States with the rest of the world: US$11 billion (0.34 per cent of the volume of foreign-exchange transactions). Daily volume of Australian trade: A$2 billion (1.2 per cent of all transactions).
18.2 OPENNESS IN FINANCIAL MARKETS
Table 18.3 The Australian balance of payments, 2007-08 (A$ billion)
Current account
184.1 204.9
Exports of goods (I) Imports of goods (2)
-20.8 2.9
-17.9 -50.3
-68.2
Net exports of goods (I) - (2) = (3) Net exports of services (4) Trade balance (3) + (4) = (5) Net investment income and transfers (6) Current account balance (deficit = -) (5) + (6)
Capital account
Can a country have a trade deficit and no current account deficit?
A current account deficit and no trade deficit! (The answer to both questions: Yes.) ►
Net private portfolio investment inflows and transfers (7) Net private direct investment inflows (8)
Total net private investment inflows (7) + (8) = (9) Net general government borrowing (10) Net Reserve Bank inflows (II)
Total net public investment inflows (10) + (I I) = (12) Balancing item (13) Capital account balance (deficit = -) (12) + (13)
The capital account
The tact that Australia had a current account deficit of A$08.2 billion in 2008 implies that it had to borrow A$68.2 billion from the rest of the world or, equivalently, that net foreign holdings ol Australian assets had to increase by S68.2 billion The numbers below the line describe how this was achieved. Transactions below the line arc called capital account transactions.
Private foreign holdings ot Australian assets have changed, as well as private Australian holdings of foreign asset1-. These transactions could have been short-term portfolio flows or long-term direct investment flows. IA transaction is classified as direct investment il the investor owns more than 10 per cent of the target asset.) The net increase in private portlolio investment in 2008 into Australia was A$3.7 billion, while the net direct investment inflow was Л$ I Я.5 billion. Thus, the increase in net Australian private foreign indebtedness the increase in loreign holdings of Australian assets minus the increase in Australian holdings ol foreign assets', also callcd net private capital flows to Australia, was A$3.7 + A$13.5 = A$I7.2 billion.
The public sector also borrows and lends abroad Net general Australian government borrowings in 2008 were A$5.8 billion, while the Reserve Bank ol Australia conducted foreign-exchange intervention which reduced its net foreign assets by A$-44.3 billion. As you saw in Figure 18.7. the Australian dollar appreciated in 2007-08. and so the Reserve Bank chose to reduce its more expensive loreign reserves.
Another name for the measured sum ol private and public net capital flows is the capital account balance. Positive net capital flows arc called a capital account surplus negative net capital flows are called a capital account deficit. So, put another way, in 2008 Australia ran a measured capital account surplus of A$17.2 + A$50.1 - A$67.3 billion, or close to 6 per cent ol Australian GDI'.
Shouldn't net capital flows (equivalently, the measured capital account surplus) be exactly equal to ihe current account deficit (which we saw from above was equal to A$68.2 billion in 2008'>? In principle, yes. In practice, no.
The numbers tor current and capital account transactions are constructed using different sources- although they should give the same answers, they typically don't. In 2008 the difference between the two—the statistical discrepancy—was -A$0.9 billion, merely 0 I per cent of the current account balance. But don't think it s always so small. It has been much larger in other years in Australia. In the United States the discrepancy was US$41 billion in 2007, which was 6 per cent of its current account balance, and about equal to one-quarter ot Australia's exports! This is yet another reminder that economic data arc lar Irom pertcct. This problem of measurement manifests itself in another way as well. The sum ol the current account deficits ol all the countries in the world should be equal to zero: one country's delicit should show up as a surplus (or the other countries taken as a whole. This is not, however, the case in the data. II wc just add the published current account dciicits ol all the countries in the world, it would appear that the world is running a [measured] large current account deficit. Some economists speculate that the explanation is unrecorded trade with the Martians. Most others believe that mis-measurement is the explanation.
Having seen Australia's balance ot payment numbers in 2008, we will now look at the history ol her current accounts. Figure 18.8 presents the current account to GDP ratio since 1060. For the last fifty years, Australia's current account has been in delicit every year except 1973 (when there was a surge in world commodity prices). Sincc 1983, the delicit has averaged 4.5 per ccnt, and in 2008 it was 6.1 per cent. This currcnt account delicit has to be financed every day, month or year by capital account surpluses. It is a feature that makes the Australian dollar somewhat vulnerable to financial crises. If global linancial markets become less willing to lend to Australia, the dollar will have to depreciate. We discuss this problem further in the Chapter 20 focus box entitled Sudden stops, the strong US dollar, the vulnerable Australian dollar and the limits to the interest parity condition'.
4 A country that runs a current account deficit must finance it through positive net capital flows. Equivalently. it must run a capital account surplus.
Now that we have looked at the current account, we can return to an issue we touched on in Chapter 2, the difference between GDP, the measure ot output we have used so far, and GNP, another measure of aggregate output. This is done in the focus box 'GDP versus GNP: The example of Kuwait .
-7 i i i i i i i i i i i i i i i i II i i i i i i i II i i i i i i II i i i i i i i II i II i i
I960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Current account/GDP
Figure 18.8 The Australian current account to GDP ratio since I960
Table GDP. GNP and net factor payments in Kuwait. 1989-94
Year GDP GNP Net factor payments
1989 7,143 9,616 2,473
1990 5,328 7,560 2,232
1991 3,131 4,669 1,538
1992 1993 5,826 7.364 8.386 1,538
7,231 1,151
1994 7,380 8.321 941
1 1
SOURCt IMF. International Financial Statistics. All numbers are in millions of Kuwaiti dinars. I dinar - US$3.3 (2001
The choice between domestic and foreign assets
Openness in financial markets implies that linanciai investors lace a new financial decision, holding domestic assets versus foreign assets.
It would seem that we actually have to think about at least Iwo new decisions, the choice of holding domestic money versus foreign money, and the choice of holding domestic interest-paying assets versus foreign interest-paying assets. But remember why people hold money—to engage in transactions. For somebody who lives in Australia, and whose transactions are mostly or fully in Australian dollars, there is little point in holding foreign currency. Foreign currency cannot be used lor transactions in Australia, and, if the goal is to hold foreign assets, holding lorcign currency is clearly less desirable than holding lorcign bonds, which pay interest. This leaves us with only one- new choice to think about, the choice between domestic interest-paying assets and foreign interest- paying assets
l.ets think ol these assets lor now as domestic one-year bonds and foreign one-year bonds. To continue with our focus on Australia and the United States consider, lor example, the choice between Australian one-year bonds and US one-year bonds, Irom the point of view of an Australian investor.
• Suppose you decide to hold Australian bonds.
Let i, be the one-year Australian nominal interest rate. Then, as Figure 18.У shows, lor every dollar you put in Australian bonds, you will get (I + /,) dollars next year This is represented by the arrow pointing to the right at thc top of the figure.)
• Suppose you decide instead to hold LIS bonds.
Two qualifications:
• Non-US residents involved in illegal activities often hold US dollars, because US dollars can be exchanged easily and cannot be traced.
• In times of very high inflation, people sometimes switch to a foreign currency, often the US dollar, even for some domestic transactions.
The decision whether to invest abroad or at home depends on more , than interest rates. It also depends on what you think will be the course of the exchange rate in the future.
To buy US bonds, you must first buy LIS dollars. Let F., be the nominal exchange rate between the Australian dollar and the US dollar. For every Australian dollar, you get E, LIS dollars. This is represented by the arrow pointing downward in the figure, i
Year t +1
A$(1 +;,)
A$ Et(1 + |-)/Ef+1 t
Figure 18.9
Expected returns from holding one-year Australian bonds or US bonds
Yeart A$1
A$1
I
USSE,
Australian bonds US bonds
us$ £,(1 + .')
lb OPEN ECONOMY
chapter 18
Let i't denote the one-year nominal interest rate on LIS bonds * in LIS dollars). When next year comes, you will have £,( I + i', LIS dollars. This is represented by the arrow pointing right at the bottom of the figure.)
You will then have to convert your US dollars back into Australian dollars. If you cxpcct the nominal exchange rate next year to be £,, you can expect to have £,( I + i,) (!/£','.,) Australian dollars next year lor every Australian dollar you invested. This is represented by the arrow pointing upward in the ligure.
We will look at the expression just derived in more detail soon. But note its basic implication already: in assessing the attractiveness of LIS versus Australian bonds, you cannot look iust at the US interest rale and ihe Australian interest rate,- you must also assess what you think will happen to the Australian dollar/LIS dollar exchange rate between this year and next.
Let's now make the same assumption we made in Chaptcr 14 when discussing the choice between short-term bonds and long-term bonds, or between bonds and stocks. Let's assume that you and other financial investors care only about the expected rate of return and therefore want to hold only the asset with the highest expected rate ol return. In that case if both LIS bonds and Australian bonds arc to be held, they must have the same expected rate ol return, so that the following arbitrage relation must hold:
= £,18.2)
Whether holding US ► bonds or Australian bonds is more risky actually depends on which investors we are looking at. Holding US bonds is more risky from the point of view of Australian investors.
Holding Australian bonds is more risky from the point of view of US investors. (Why?)
сы
Reorganising that equation:
+ i, - (I + Отг~ i
liquation (18.2 > is called the uncovered interest parity relation, or simply the interest parity condition.
The assumption that linancial investors will hold only the bonds with the highest expected rate ol return is obviously too strong, for two reasons:
• It ignores transaction costs. Going in and out ol US bonds requires three separate transactions, cach with a transaction cost.
• It ignores risk. The exchange rate a year trom now is uncertain, this means that holding US bonds is more risky, in terms ol Australian dollars, than holding Australian bonds.
But as a characierisation of capital movements among the major world linancial markets (New York, Frankfurt, London, Tokyo, Sydney, Singapore), the assumption isn't lar olf. Small changes in interest rates and rumours of impending appreciation or depreciation can lead to movements of tens of billions ol dollars within minutes. For the rich countries ol ihe world, the arbitrage assumption in equation (18.21 is a good approximation ol reality. Other countries whose capital markets arc smaller and less developed, or countries that have various forms ol capital controls, have more leeway in choosing their domestic interest rate than is implied by equation (18.2). We will return to this issue at the end of Chapter 20.
Interest rates and exchange rates
1 18.3)
©
Let's get a better sense ol what the interest parity condition implies. Rewrite equation (18.2) as
+ if = (1 +
The word uncovered is to distinguish this relation from another relation called the
covered interest parity condition. The covered interest parity condition is derived by looking at the following choice: buy and hold Australian bonds for one year, or buy US dollars today, buy one-year US bonds with the proceeds, and agree to sell the US dollars for dollars a year ahead at a predetermined price, called the forward exchange rate. The rate of return of these two alternatives, which can both be realised at no risk today, must be the same.The covered interest parity condition is a risklcss arbitrage condition. ►
E'-/E,
4 This follows from proposition 6 in Appendix 2 at the end of the book.
18.4)
This gives a relation between the domestic nominal interest rate, I,, the foreign nominal interest rate. ;'*,, and thc expected rate ol appreciation, (£','., - £,)/£,. Remember, an increase in E is an appreciation, so that fE','^1 - F.t]/F.t is the expected rate ol appreciation of thc domestic currency. II the domestic currency is expected to depreciate, then this term is negative.) As long as interest rates or the expected rate of appreciation are not too large—say, below 20 per cent a year—a good approximation to this equation is given hy
I, = I, -
This is the relation you must remember: Arbitrage implies that the domestic interest rate must be ;approximately) equal to the foreign interest rate minus the expected appreciation rate of the domestic currency.
Let's apply this equation to Australian bonds versus US bonds. Suppose that in 2008 the one-year nominal interest rate is 5.5 per cent in Australia and 3 per cent in the Llnited States. Should you hold US bonds or Australian bonds? The answer:
• It depends on whether you expect the Australian dollar to depreciate vis-a-vis the LIS dollar over the coming year by more or less than the difference between the Australian interest rate and the US interest rate, 5.5% - 3% = 2.5%.
• If you expect the Australian dollar to depreciate by more than 2.5 per cent (that is. [£','., - £,)/£, <-0.025 or 2.5 per cent) then, despite the lact that the interest rate is lower in the Llnited States than in Australia, investing in LIS bonds is more attractive than investing in Australian bonds. By holding LIS bonds, you will get smaller interest payments next year, but the LIS dollar will also be expected to be worth more in terms ol Australian dollars next year, making investing in LIS bonds more attractive than investing in Australian bonds.
• But if you expect the Australian dollar to depreciate by less than 2.5 per cent, or even to appreciate, then the reverse holds, and Australian bonds arc more attractive than LIS bonds.
In other words, the uncovered interest parity condition tells us lhat financial investors must be expecting on average a depreciation of the Australian dollar with respect to the LIS dollar ol about 2.5 percent over the coming vear. and this is why ihev are willing to hold US bonds despite their lower interest rale. 'Another example is provided in the focus box Buying Brazilian bonds.
The arbitrage relation between interest rates and the exchange rate in equation 18.4) will play a central role in the following chapters. It suggests that, unless countries are willing to tolerate large movements in their exchange rate, domestic and foreign interest rates are likely to move very much together. Take thc extreme case ol two countries that commit to maintaining their bilateral exchange rate at a fixed value. II markets have laith in this commitment, they will expect the exchange rate to remain constant, and the expected depreciation will be zero. In that case, the arbitrage condition implies that interest rates in the two countries will have to move exactly together. Most of the time, as we will see, governments don't make such absolute commitments to maintain the exchange rate, but ihev oltcn do try to avoid large movements in the exchange rate. This puts sharp limits on how much they can allow their interest rate to deviate Irom interest rates elsewhere in the world.
4 An important relacion to remember: Under the uncovered interest parity condition, the domestic interest rate must approximately equal the foreign interest rate minus the expected appreciation of the domestic currency.
4 If £'., = £,. then the interest parity condition implies i, = /[.
Meanwhile, do the following. Look at the back pages of a recent issue of The Economist for short-term interest rates in different countries relative to Australia. Which are the currencies against which the Australian dollar is 4 expected to depreciate?
©
How much do nominal interest rates actually move together between countries like Australia and thc Llnited States? figure 18.10 plots the five-year nominal government bond interest rate in Australia and the live-year nominal government bond interest rale in the Llnited States since 1970. The impression from the figure is ol related but not identical movements. Interest rates were very high in both countries in thc early 1080s and high again—although much more so in Australia than in the United States—in the late 1980s. Both have been low since the early to mid-1990s. At the same time, dillerences between the two have sometimes been quite large. From 1985 to 1990, lor example, the Australian interest rate was on average nearly 5 per cent above the LIS interest rate. In 2008, the gap is iust above 2.5 per cent in favour ol Australia. In thc coming chapters, we will return to why such differences emerge and what their implications may be.
G В S
Assume that you are a US resident. Go back to September 1993. (The very high interest rate in Brazil at the time helps make the point we want to get across here.) Brazilian bonds are paying a monthly interest rate of
36.9 per cent. This seems very attractive compared with the annual rate of 3 per cent on US bonds— corresponding to a monthly interest rate of about 0.2 per cent. Shouldn't you buy Brazilian bonds rather than US bonds?
The discussion in this chapter tells you that, to decide, you need one more crucial element, the expected rate of change of the US dollar (now your home currency) vis-£-vis the cruzeiro (the name of the Brazilian currency at the time; the currency is now called the real). You need this information because (as Figure 18.8 makes clear) the return in US dollars from investing in Brazilian bonds for a month is
(1 + 'DTT- = (1-369) ТГ"
What rate of cruzeiro depreciation should you expect over the coming month? Assume that the rate of depreciation next month will be equal to the rate of depreciation last month.You know that US$1 was worth
4s
BOX
П IE OPEN ECONOMY
chapter 18
99.10 cruzeiros at the end of July 1993, but was worth 133,333 cruzeiros at the end of August 1993. If depreciation of the cruzeiro (or equivalently. appreciation of the US dollar) continues at the same rate, the return from investing in Brazilian bonds for a month is
99,010
(1369) ТззЗзз = 1017
(1
t+i
The expected rate of return in US dollars from holding Brazilian bonds is only 1.7 per cent per month (1.017 - 1), not the 36.9 per cent per month that looked so attractive. Note that 1.7 per cent per month is still much higher than the monthly interest rate on US bonds (about 0.2 per cent). But think of the risk and the transaction costs—all the elements we ignored when we wrote the arbitrage condition. When these are taken into account, you may well decide to keep your funds out of Brazil.
Figure 18.10
Australian interest rate
I I l II l
2005
I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I
1970 1975 1980 1985 1990 1995 2000
Five-year nominal interest rates in Australia and the United States. 1970-2008
Australian and US interest rates have largely moved together over the last thirty years.
8.3 CONCLUSIONS AND A LOOK AHEAD
We have now set the stage lor the study of the open economy:
• Openness in goods markets allows a choice between domestic goods and foreign goods. This choice depends primarily on the real exchange rate—the relative price of foreign goods in terms ol domestic goods.
• Openness in financial markets allows a choice between domestic assets and foreign assets. This choice depends on their relative rates of return, which, in turn, depend on domestic interest rates and loreign interest rates, and on the expected rate of appreciation of the domestic currency.
In the next chapter. Chapter 14, we look at the implications of openness in goods markets. Chapter 20 brings in openness in financial markets. In Chapter 21 we discuss the pros and cons ol dillerent exchange rate regimes.
SUMMARY
• Openness in goods markets allows people and firms to choose between domestic goods and foreign goods. Openness in financial markets allows linancial investors to hold domestic linancial assets or foreign financial assets.
• 1 he nominal exchange rate is the price of domestic currency in terms ol loreign currency. From the viewpoint of Australia, the nominal exchange rate between Australia and the Llnited States is the price of an Australian dollar in terms ol US dollars.
• A nominal appreciation tan appreciation, for short) is an increase in the price of the domestic currency in terms of foreign currency,- given the definition ol the exchange rate, a nominal appreci ation corresponds to an increase in the exchange rate.
A nominal depreciation (a depreciation, for short1 is a decrease in the price of the domestic currency in terms ol foreign currency,- a nominal depreciation corresponds to a decrease in the exchange rate.
• The real exchange rate is the relative pricc of domestic goods in terms of foreign goods. It is equal to the nominal exchange rate times the domestic pricc level divided by the foreign price level.
• A real appreciation is an increase in the relative pricc ol domestic goods in terms ol foreign goods- a real appreciation corresponds to an increase in the real exchange rate.
A real depreciation is a decrease in the relative price ol domestic goods; a real depreciation corresponds to a decrease in the real exchange rale.
• The multilateral real exchange rate—or real exchange rate, for short—is a weighted average of bilateral real exchange rates, with the weight for each foreign country equal to iis share in trade.
• The balance of payments records a country's transactions with the rest ol the world. The current account balance is equal lo the sum ol the trade balance, net investment income and net transfers received from the rest of the world. The capital account balance is equal to capital flows from the rest of the world minus capital llows to the rest of the world.
• The current account and the capital account arc mirror images ol each other. Leaving aside statistical problems, the current account balance plus the capital account balancc must sum to zero. A currcnt account deficit is financed by net capital flows from the rest ol the world, thus by a capital account surplus. Similarly, a current account surplus corresponds to a capital account delicit.
• Uncovered interest parity—or interest parity, for short—is an arbitrage condition stating that the expected rates ot return in terms ol domestic currency fin domestic bonds and foreign bonds must be equal. Interest parity implies that the domestic interest rate approximately equals the foreign interest rate minus the expected rate of appreciation ot the domestic currency.
KEY TERMS
• openness in goods markets, 406 • multilateral real exchange rate, 416
• tariffs, 406 • foreign exchange, 417
• quotas, 406 • balance of payments, 4 17
• openness in financial markets, 406 • above the line, below thc line, 417
• capital controls, 406 • current account, 418
• openness in factor markets, 406 • trade balance, 4 18
• North American free Trade Agreement • net investment income and transfers, 418
(NAFTA), 406 • lorcign aid, 41 8
• tradable goods. 408 • net debtor, 418
• real exchange rate, 409 • current account balance, 4 18
• nominal exchange rate, 410 • current account surplus/deficit, 4 18
• appreciation i nominal), 410 • capital account, 419
• depreciation (nominal), 410 • short-term portlolio llows. 419
• fixed exchange rates, 410 • long-term direct investment flows, 419
• revaluation, 410 • net private capital flows, 419
• devaluation, 410 • capital account balance, 419
• real appreciation, 41 3 • capital account surplus/delicil, 419
• real depreciation, 4 1 3 • statistical discrepancy, 419
• merchandise trade, 415 • gross domestic product (GDP), 420
• bilateral exchange rate, 415 • gross national product (GNP), gross national
• multilateral exchange rate, 415 income (GNI), 420
• trade-weighted index, 416 • uncovered interest parity relation, interest
• ellective exchange rate, 4 16 parity condition, 422
QUESTIONS AND PROBLEMS
Quick check
I. Using the information in this chaptcr, label each of the following statements 'true', 'false' or
'uncertain'. Explain brief!}/.
a. If there are no statistical discrepancies, countries with current account deficits must receive net capital inflows.
b. While thc export ratio can he larger than one—as it is in Singapore—the same cannot he true of the ratio of imports to GDP.
c. That a rich country like.lapan has such a small ratio ol imports to GDP is clear evidence of an unfair playing field for Australian exporters to Japan.
d. Uncovered interest parity implies that interest rales must be the same across countries.
e. II the dollar is expected to appreciate against the yen, uncovered interest parity implies that the Australian nominal interest rate will be greater than the lapanese nominal interest rate.
f. II the nominal exchange rate between the euro and the Australian dollar is 0.90, it means that one euro is worth 90 cents.
g. If the real exchange rate between Australia and the United Kingdom is 2, this means that goods arc twice as expensive in the United Kingdom as in Australia.
2. Consider two fictional economics, one called the domestic country and the other the foreign country. Construct the balance of payments for each country given the following list of transactions:
a. The domestic country purchased $100 in oil from the foreign country.
b. Foreign tourists spent $25 on domestic ski slopes.
c. Domestic residents purchased $45 in lile insurance in the foreign country.
d. Domestic residents purchased $5 in illegal substances from foreigners.
e. Foreign investors were paid $15 in dividends from their holdings of domestic equities.
g. Domestic residents gave $25 to foreign charities.
h. Foreign businessmen gave $35 in bribes to domestic government officials.
i. Domestic businesses borrowed $65 from foreign banks, j. Foreign investors purchased $15 in domestic junk bonds.
k. Domestic investors sold off $50 in holdings ot foreign government bonds.
3. Consider two bonds, one issued in euros ((') in Germany, one issued in Australian dollars in Australia. Assume that both government securities arc one-year bonds—paying the face value of the bond one year from now. The exchange rate, П, stands at AS'I - 0.50 euros. The face values and prices on the two bonds are:
Face value Price
Australia One-year bond A$ 10,000 A$9,615.38
Germany One-year bond €13,333 €12,698.10
1 1
a. Calculate the nominal interest rate on each of the bonds.
b. Calculate the expected exchange rate next year consistent with uncovered interest parity.
c. If you expect the Australian dollar to depreciate relative to the euro, which bond should you buy?
d. Assume that you are an Australian investor. You exchange Australian dollars lor euros and purchase the German bond. One year from now it turns out that £ is actually 0.55 (A$I = 0.55 euros). What is your realised rate ol return in Australian dollars compared with thc realised rate ol return you would have made had you held the Australian bond?
e. Arc thc dilferences in rates of return in (d) consistent with the uncovered interest parity condition? Why or why not?
Dig deeper
4. Consider a world with three equal-sized economies—A, If ami С—and three goods—clothes, cars and
computers.
Assume that consumers in all three economies desire to spend an equal amount on all three goods.
Suppose that the value of production of each good in the three economies is as follows:
A В С
Clothes 10 0 5
Cars 5 10 0
Computers 0 5 10
1 1
a. What is (".DP in each economy? II the total value of CDP is consumed, and no country borrows from abroad, how much will consumers in each economy spend on each of the goods?
b. If no country borrows from abroad, what will be the trade balance in each country? What will be the pattern of trade in this world (that is, which good will each country export and to whom)?
c. Given your answer to part ib), will country A have a zero trade balance with country B? With country G? Will any country have a zero trade balance with any other country?
d. Australia had a large trade deficit of 2 per cent of GDP in 2008. It also had a trade surplus with some of its major trading partners, and particularly large deficits with Europe. Suppose Australia eliminates its overall trade deficit (with the world as a whole). Do you cxpect it to have a zero trade balance with every one of its trading partners? Does the especially large trade deficit with Europe necessarily indicate that Europe doesn't allow Australian goods to compete on an equal basis with European goods?
5. The exchange rate and the labour market
Suppose that the domestic currency depreciates (E falls). Assume that I VP remain constant.
How docs the nominal depreciation affect the relative pricc of domestic goods (that is, the real exchange rate1? Given your answer, what ellect would a nominal depreciation be likely to have on 1 world1 demand for domestic goods? On the domestic unemployment rate?
Given the foreign price level, P* what is the price ol foreign goods in terms ol domestic currency? How does a nominal depreciation affect the price ol foreign goods in terms of domestic currency? How does a nominal depreciation affcct the domestic consumer price index?
Hint: Remember that domestic consumers buy foreign goods | imports] as well as domestic goods.)
II the nomina! wage stays constant, how does a nominal depreciation allect the real wage?
Comment on the following statement: 'A depreciating currency puts domestic labour on sale.
Explore further
6. Assume that there exists a market for buying and selling foreign exchange one year in the future, at a price determined today—this price is called the forward exchange rate. Denote the forward price of A SI in terms of euros by Г. In other words, you can enter into a contract today to sell AS'I for I- euros one year in the future.
a. Derive the following approximation to covered interest parity, where i denotes the one-year interest rate and an asterisk denotes a loreign variable:
i = Г - (F - E)/E
h. Given the two government bonds and exchange rate from problem 3, find the forward exchange rate of A$l consistent with covered interest parity.
c. What should you do if the forward exchange rate is actually different from the value you just derived?
d. Suppose the forward exchange rate is as you calculated it in (hi You buy euros today, buy the German bond today, and enter a contract today lo sell the euros you will receive in a year at :hc forward exchange rate.
Does a surprise in the exchange rate between now and next year affect the returns on your nvestment? Why or why not?
7. Retrieve the nominal exchange rates between lapan and Australia from the Internet. A useful and free Canadian site, which allows you to construct graphs on-line, is located at
a. Plot the yen versus the Australian dollar since 1979. During which period did the yen appreciate? During which period did the yen depreciate?
b. Given the current Japanese slump (which did show some encouraging signs of improvement in 2006-07 but will almost surely return in 2008 09), one way of increasing demand would be to make Japanese goods more attractive. Does this require an appreciation or a depreciation of the yen?
c. What has happened to the yen in the past few years? I las it appreciated or depreciated? Is this good or bad for Japan?
8. Retrieve lhe most recent World Economic Outlook from lhe website of the International Monetary Fund (www.imf.org). In the Statistical Appendix, find 'Balances on Current Account', which lists current account balances around the world. Use the most recent year's data to answer parts (a), (b) and (c).
a. Note the sum of current account balances across the world. As noted in the chapter, thc sum ol current account balances should equal zero. What does this sum actually equal? Why does this sum indicate some mis-measurement 1 that is, il the sum were correct, what would it imply)? h. Which regions of the world are borrowing and which are lending?
c. Compare the US current account balance with the current account balances of the other advanced economies. Is the United States borrowing only from advanced economies?
d. The statistical tables in the World Economic Outlook typically project data for two years into the luture. Look at the projected data on current account balances. Do your answers to parts (b) and (cl seem likely to change in the near future?
9. Saving and investment throughout the world
Retrieve the most recent World Economic Outlook from the website of the International Monetary Fund lwww.im f.org/. In the Statistical Appendix, find the table tilled 'Summary of Sources and Uses of World Saving', which lists saving and investment las a percentage of GDP) around the world. Use the data for the most recent year available to answer parts laI and (b).
a. Does world saving equal investment? 'You may ignore small statistical discrepancies.) Offer some intuition lor your answer.
b. How does US saving compare with US investment? How is the United States able to finance its investment? (We explain this explicitly in the next chapter, but your intuition should help you figure it out now.)
We invite you to visit the Blanchard-Sheen page on the Pearson Australia website at
www.pearson.com.au/highered/blanchardsheen3e
for many World Wide Web exercises relating to issues similar to those in this chapter.
FURTHER READINGS
CHAPTER
Domestic demand for ► goods' and 'demand for domestic goods' sound dose. But in an open economy they are not the same. Part of domestic demand falls on foreign goods. Part of foreign demand falls on domestic goods.
The Goods Market in an Open Economy
A
t the time of writing, countries around the world are hoping for a strong and lasting recovery in the United States sooner rather than later. Their hopes aren't for the United States but for themselves.To them a US expansion means higher exports to the United States, an improve¬ment of their trade position, and stronger growth at home.
Are their hopes justified? Does the US economy really drive other economies? If there are such strong interactions between countries, shouldn't macroeconomic policies be coordinated between countries? If so. why does it seem so difficult to achieve such coordination? To answer these questions, we must expand our treatment of the goods market in The Core (Chapter 3) to take into account openness in goods markets. This is what we do in this chapter.
• Section 19.1 characterises equilibrium in the goods market for an open economy.
• Sections I 9.2 and 19.3 show the effects of domestic shocks and foreign shocks on the domestic economy's output and trade balance.
• Sections 19.4 and 19.5 look at the effects of a real depreciation on output and on the trade balance.
• Section 19.6 gives an alternative description of the equilibrium, which shows the close connection between saving, investment and the trade balance.
19.1 THE IS RELATION IN THE OPEN ECONOMY
When we were assuming that the cconomy was closed to trade, there was no need to distinguish between the domestic demand for goods and the demand for domestic goods—they were clcarly the same. Now, we must distinguish between the two. Some domestic demand falls on foreign goods, and some of the demand for domestic goods comes from foreigners. Let's look at this distinction more closely.
The demand for domestic goods
In an open cconomy, the demand for domestic goods is given by
Z = С + I + G - lM/e + X (19.1)
The first three terms—consumption, C, investment, I, and government spending, G—constitute the domestic demand for goods. If the economy were closed, С + / + G would also be the demand for domestic goods. This is why, until now, wc looked only at С + 1 + G. But now we have to make two adjustments:
• First, we must subtract imports—that part of domestic demand that falls on foreign goods rather than on domestic goods.
Wc must be carelul here. Foreign goods are different from domestic goods, so we cannot iust subtract the quantity of imports, IM. II we were to do so, we would be subtracting apples (foreign goods) from oranges (domestic goods). We must first express the value of imports in terms of domestic goods. This is what IM/e in equation (19.1) stands for. As wc saw in Chapter 18, e is the real exchange rate -the pricc of domestic goods in terms ol foreign goods. "I he value of imports in loreign currency is IM P"; the value in domestic currency is IM P*/E: and the value in terms ol domestic goods is IM P*/(EP) or IM/e. So, IM/e (the quantity ol imports times the relative price) is the value of imports in terms ol domestic goods.
• Second, we must add exports, the demand for domestic goods that comes from abroad. This is captured by the term X in equation (19.1).
The determinants of the demand for domestic goods
Having listed the five components of demand, our next task is to specify their determinants. Let's start with the first three: С, I and G.
The determinants of С, 1 and G
Now that we arc assuming that the economy is open, how should wc modify our earlier descriptions of consumption, investment and government spending? The answer: Not very much, il at all. How much consumers decide to spend still depends on their income and their wealth. While the real exchange rate surely alfects the composition of consumption spending between domestic goods and foreign goods, there is no obvious reason why it should affect the overall level of consumption. The same is taic of investment. The real exchange rate may allect whether firms buy domestic machines or foreign machines, but it shouldn't aflect total investment.
Domestic demand. (С + I + G). depends on income. У. the interest rate, r. taxes. T, and the level of government 4 spending, G.
Again, we cheat a bit here. Our discussion suggests that we should be using domestic demand. С + I + G. instead of income. V.You might also dispute die assumption that imports depend on total domestic demand and not on its composition. For example, many poor countries import most of their capital equipment but consume mostly domestic goods. In that case, the composition of demand would matter for imports. We leave these 4 complications aside fere.
This is good news, because it implies that we can use the descriptions of consumption, investment and government spending that wc developed earlier. Therefore,
Domestic demand-.
I + G = C(Y - T) + l(Y,r) + G ( + ) (+,-)
Wc assume that consumption depends positively on disposable income, Y— T and that investment depends positively on production, Y, and negatively on the real interest rate, r. We continue to take government spending, G, as given. Note that we leave aside the refinements introduced in Chapters 14 to 17, where wc looked at the role of expectations in affecting spending. We want to take things one step at a time and understand the effects of opening the economy,- we will reintroduce some of those refinements later.
In Chapter 3 we ignored the real exchange rate and subtracted IM. not IM.'t.This was a cheat: we didn't want to have to talk about the real exchange rate—and complicate matters—so
4 early in the book.
4 Domestic demand for goods (С + I + G) minus Domestic demand for foreign goods (imports. IMIe) plus
Foreign demand for domestic goods (exports, X) equals Demand for domestic goods (C + l + G-IMIf + X).
The determinants of imports
(19.2)
Imports are the part of domestic demand that falls on foreign goods. What does the quantity of imports, IM, depend on? It depends primarily on the overall level ol domestic income, and thus domestic demand: the higher the level ot domestic income and demand, the higher the demand for all goods, both domestic and foreign. But IM also clearly depends on the real exchange rate. The higher the price of domestic goods relative to the price of foreign goods, the higher the domestic demand lor foreign goods relative to the domestic demand lor domestic goods, and so the higher the quantity of imports. Thus, we write imports as
IM = lM(Y,e)
The quantity ol imports depends on income (or, equivalently, on output—income and output are still equal in an open economy), Y-. higher income leads to higher imports.
• Thc quantity of imports also depends on the real exchange rale. Recall that thc real exchange rate, e, is delined as the price of domestic goods in terms of foreign goods. A higher real exchange rale makes lorcign goods relatively cheaper, leading to an increase in the quantity of imports, IM. This positive ellect of the real exchange rate on the quantity ol imports is captured by the positive sign under e in equation (19.2). (As IM goes up while e goes up. note that what happens to IM/e, the value ol imports in terms of domestic goods, is ambiguous. We return to this point shortly.)
The determinants of exports
The quantity of imports. ►
IM. depends positively on the level of output. Y. and positively on the real exchange rate, e.
Recall that asterisks refer to foreign variables.
Exports depend positively on the level of foreign output. V", and negatively on the real exchange rate, e.
(19.3)
For a given real ► exchange rate. t. IMIt (the value of imports in terms of domestic goods) moves exacdy with IM (the quantity of imports).
Exports are the part of foreign demand that lalls on domestic goods. The export ol one country is, by definition, thc import of another. In thinking about what determines exports, we can ask, equivalently, what determines foreign imports. From our discussion ol the determinants ol imports in the preceding paragraph, we know that foreign imports are likely lo depend on foreign activity and on the relative price ot foreign goods. Let Y* denote output in the rest of the world—call it 'lorcign output. Thus, we can write exports as
X = X(Y",e)
• An increase in foreign output leads to an increase in the foreign demand lor all goods, some ol which falls on domestic goods, leading to higher domestic exports.
• An increase in e—an increase in the relative price ol domestic goods in terms ol foreign goods— makes domestic goods less attractive relative lo lorcign goods, leading to a decrease in exports.
Putting the components together
We can show graphically what we have learned so lar in Figure 19.1, which plots the various components of demand against output, keeping constant all other variables (the interest rate, taxes, government spending, foreign output and the real exchange rate) that affect demand.
In Figure 19.1, panel (a', the line DD plots domestic demand, С + I + C, as a function ol output, Y. This relation between demand and output is familiar from Chapter 3. Llnder our standard assumptions, thc slope of the relation between demand and output is positive but less ihan I. An increase in output— equivalently, an increase in income, as output and income are still the same in an open economy increases demand but less than one for one. (In ihe absence ol good reasons to the contrary, we draw the relation between demand and output, and the other relations in this chapter, as lines rather than curves. This is purely lor convenience, and none of thc discussions that follow depend on this assumption.)
To arrive at lhe demand for domestic goods, we must first subtract imports. This is done in Figure 19.1, panel (b) and gives us the line A A. The line A A represents the domestic demand tor domestic goods. The distance between DD and A A equals the value ol imports. IM/e. Because the quantity of imports increases with income, the distance between thc two lines increases with income. We can establish two lacts about line AA, which will he usclul later in lhe chapter:
1. AA is flatter than DD. As income increases, some ol the additional domestic demand falls on lorcign goods rather than on domestic goods. As income increases, the domestic demand for domestic goods increases less than total domestic demand.
2. As long as some of the additional demand lalls on domestic goods, AA has a positive slope. An increase in income leads to some increase in the demand for domestic goods.
Next, wc must add exports. This is done in Figure 19.1, panel (c) and gives us the line ZZ, which is above AA. The line ZZ represents the demand for domestic goods. The distance between ZZ and AA equals exports. Because exports don't depend on domestic output, the distance between ZZ and AA is constant, which is why the two lines are parallel. Because AA is llatter than DD, ZZ is flatter than DD as well.
©
Output
4 Recall that net exports are synonymous with trade balance. Positive net exports correspond to a trade surplus, negative net exports to a trade deficit
4 Equilibrium in the goods market requires that domestic output be equal to the demand for domestic goods
The domestic demand for goods is an increasing function of income. The demand for domestic goods is obtained by subtracting die value of imports from domestic demand and then adding exports. The trade balance is a decreasing function of output
Figure 19.1 The demand for domestic goods and net exports
This equilibrium condition determines output as a function of all the variables we take as given, from taxes to the real exchange rate to loreign output. This isn't a simple relation.- Figure 19.2 represents it graphically, in a more user-friendly way.
In Figure 19.2, panel (a), demand is measured on the vertical axis, output (equivalently production or income) on the horizontal axis. The line ZZ plots demand as a function ot output. This line iust replicates the line ZZ in Figure 19.1: ZZ is upward sloping, but with slope less than 1.
Equilibrium output is at the point where demand equals output, at the intersection of the line ZZ and the 45-dcgrec line—point A in the figure, with associated output level V.
Figure 19.2, panel (b) replicates Figure 19.1, panel (d>, drawing net exports as a decreasing function of output. There is in general no reason why the equilibrium level of output, V, should be the same as the level ol output at which trade is balanced, Y)H. As wc have drawn the ligure, equilibrium output is associated with a trade deficit, equal to the distance ВС.
We now have the tools needed to answer the questions wc asked at the beginning of the chapter
19.3 INCREASES IN DEMAND, DOMESTIC OR FOREIGN
The equilibrium level of ► ojcput is given by :he condition У = Z.The level of output at which there is a trade balance is given by the condition X = IMIe.These are two different conditions.
How do changes in demand affect output in an open economy? Let's start with an old favourite- an increase in government spending—then turn to a new exercise, the effects of an increase in foreign activity.
Figure 19.2 Equilibrium output and net exports
N "O
(a) |
Output, У
ai О
Increases in domestic demand
Suppose lhat the economy is in recession and the government decides to increase government spending—so as to increase domestic demand and output. What will be the effects on output and on the trade balance?
The answer is given in Figure 19.3. Before the increase in government spending, demand is given by ZZ in panel i a), and the equilibrium is at point A, where output equals У Let's assume—though, as we have seen, there is no reason why this should be true in general—that trade is initially balanced, so, in panel (b), У = YTB.
What happens il the government increases spending by AG? At any level of output, demand is higher by AG, shifting thc demand relation up by AG from ZZ to ZZ'. The equilibrium point moves from A to A' and output increases Irom У to У. The increase in output is larger than the increase in government spending—there is a multiplier elfect.
So tar, the story sounds the same as the story for a closed economy in Chapter 3. There are two important differences, however:
• There is now an effect on the trade balance. Because government spending enters neither the exports relation nor the imports relation directly, the relation between net exports and output in Figure 19.3, panel (b) doesn't shift. So the increase in output from У to У leads to a trade deficit equal to ВС.
4 As in The Core, we start with the goods markec the conclusions we derive here will still largely be correct when we introduce financial markets and labour markets lacer.
• Not only does government spending now generate a trade deficit, but the effect of government spending on output is smaller than it would be in a closed economy. Recall Irom Chapter 3 that thc
Figure 19.3 The effects of an increase in government spending
smaller the slope ot the demand relation, the smaller the multiplier (for example if ZZ were horizontal, the multiplier would he I). And recall from Figure 19.1 that the demand relation, ZZ is flatter than the demand relation in the closed cconomy, DD. That means the multiplier is smaller in the open economy.
I he trade deficit and the smaller multiplier have the same origin. An increase in demand now falls not only on domestic goods but also on foreign goods. So, when income increases, the effect on the demand tor domestic goods is smaller than it would be in a closed cconomy, leading to a smaller multiplier. And, because some of the increase in demand tails on imports—and exports are unchanged— the result is a trade delicit.
These two implications are important. In an open economy, an increase in domestic demand has a smaller elfect on output than in a closed economy, as well as an adverse effect on the trade balance. Indeed, the more open the economy, the smaller the elfect on output and the larger the adverse elfect on the trade balance. Take Belgium, and its ratio of imports lo GDI' of close lo 90 per cent. When domestic demand increases in Belgium, most of the increase in demand is likely to take the form ol an increase in the demand lor foreign goods rather than an increase in the demand lor domestic goods. The effect of an increase in government spending is thus likely to be a large increase in Belgium's irade deficit and only a small increase in its output, making domestic demand expansion a rather unattractive policy lor Belgium. Even (or Australia, which has an import ratio of only about 20 percent, an increase in demand will he associated with a worsening of ihe trade balance.
Increases in foreign demand
Consider now an increase in foreign output, an increase in V*. This could he due to an increase in foreign government spending, G"—the policy change we iust analysed, but now taking place abroad. But we don't need to know where ihe increase comes from to analyse the effects on the Australian economy.
I igure 19.4 shows ihe effects of an increase in foreign activity on domestic output and the trade balance. The initial demand lor domestic goods is given by ZZ in panel a . The equilibrium is at point A, with output level Y. I cts assume lhal trade is balanced, so that in panel • h: the net exports associated with Y are equal to zero (Y - Y,(!).
It will be useful to draw the line which gives the domestic demand lor goods С + / + G as a function ol income. This line is denoted by DD in Figure 19.4, panel >a*. Recall from Figure 19.1 that DD is steeper than ZZ. I he difference between ZZ and DD equals net exports, so that it trade is balanced at point A, then ZZ and DD intersect at point A.
Now consider the effects of an increase in foreign output, AY*. Higher foreign output means higher foreign demand, including higher foreign demand for Australian goods. So, the direct effect of the increase in foreign output is to increase Australian exports by some amount call it AX.
• For a given level of output, this increase in exports leads to an increase in the demand lor Australian goods by AX so the line giving the demand lor domestic goods as a function ol output shilts up by AX, :rom ZZ to ZZ'.
• For a given level of output, net exports go up by AX. So. the line giving net exports as a function ol output in Figure 19.4. panel (hi also shifts up by AX Irom NX to NX'.
The new equilibrium is at poini A' in Figure 19.4, panel ,a>, with output level Y'. The increase in foreign output leads ю an increase in domestic output. The channel is clear: higher foreign output leads to higher exports ol domestic goods, which increases domestic output and the domestic demand lor goods through the multiplier.
Starting from trade ► balance, an increase in government spending leacs to a trade deficit.
An increase in ► government spending increases output.The multiplier is smaller than in the closed economy.
The smaller multiplier ► and the trade deficit have the same underlying cause: some domestic demand falls on foreign goods, not on domestic goods.
Recall that DO is the domestic demand for ^ goods. ZZ is the demand for domestic goods. The difference between the two is equal to the trade deficit.
Y* directly affects exports and so enters the relation between the demand for domestic goods and output. An increase in Y* shifts ZZ up. Y* doesn't affect consumption, investment or government spending direcdy. and so doesn't enter the relation between the domestic demand for goods and output. An increase in Y* doesn't shift DO. ►
What happens lo the trade balance? We know that exports go up. But could it be that the increase in domestic output leads to such a large increase in imports that ihe trade balance actually deteriorates? No. Ihe trade balance must improve. To see why, note that, when loreign demand increases, the demand for domestic goods shilis up from ZZ to ZZ'; but the line DD. which gives domestic demand lor gooes as a function of output, doesn't shilt.
An increase in foreign demand leads to an increase in output and a trade surplus.
At the new equilibrium level of output Y', domestic demand is given by the distance DC, and the demand lor domestic goods is given by DA'. Net exports arc thus given by the distance CA'—which, because DD is necessarily below ZZ', is necessarily positive. Thus, while imports increase, the increase doesn't offset the increase in exports and thc trade balance improves.
Games that countries play
We have derived two basic results so Ian
1. An increase in domestic demand leads to an increase in domestic output, but leads also to a trade deficit. (We looked at an increase in government spending, but thc results would have been the same lor a decrease in taxes, an increase in consumer spending, and so on.)
2. An increase in foreign demand (which could come from the same types ol changes taking place abroad) leads to an increase in domestic output and a trade surplus.
These results have a number of important implications.
An increase in foreign output increases domestic output and 4 improves the trade balance.
N
■a с л
£
Domestic demand for goods
DD
Demand for domestic goods
(a)
Figure 19.4 The effects of an increase in foreign demand
NX
NX
Output, У
First, they imply that demand shocks in one country can aflect other countries. The stronger the trade links, the stronger the interactions and the more the countries will move together. This implication is consistent with the lacts. For example, most OliCD countries had similar expansions in thc late 1990s, followed by a slowdown in the early 2000s, and then major contractions beginning in 2008. Though there may have been other reasons lor these common movements, trade linkages certainly played a role.
Sccond. these interactions complicate the task of fiscal policy. Why is that? Governments don't like trade dclicits, and for good reasons. The main reason: a country that consistently runs a trade dclicit accumulates debt vis-a-vis the rest of the world, and therefore has to pay steadily higher interest payments to the rest of the world. Thus, it is no wonder that countries prefer increases in foreign demand (which lead to an improvement in the trade balance) to increases in domestic demand (which lead to a deterioration in the trade balance).
However, these preferences may have disastrous implications. Consider a group of countries, all doing a large amount of trade with each other, so that an increase in demand in any one country Ialls largely on the goods produced in the other countries. Suppose that all these countries arc in recession and each has roughly balanced trade. Each country may be very reluctant to take measures to increase domestic demand. Were it to do so, this might result in a small increase in output but also a large trade deficit, Fach country may just wait for the other countries to increase demand. Hut if they all wait, nothing happens and the recession may last a long time.
Is there a way out of this situation? There is—at least in theory. II all countries coordinate their macroeconomic policies to increase domestic demand simultaneously, each can expand without increasing its trade deficit (vis-a-vis the others; their combined trade deficit with respect to the rest of the world will still increase). The reason is clear: the coordinated increase in demand leads to increases in both exports and imports in each country. It is still true that domestic demand expansion leads to larger imports,- but this increase in imports is oflset by the increase in exports, which comes Irom the foreign demand expansions.
Coordination is a word governments often invoke. The eight major countries ol the world—the so- called G-8 (the United States, Japan, France, Germany, the United Kingdom, the Russian Federation, Italy and Canada,- the G stands tor 'group of)—meet regularly to discuss their economic situation,- the communiqud at the end of the meeting rarely fails to mention coordination. There are many other country organisations, such as the OECD, ASEAN and the G-20, that also arrange regular meetings of economic ministers, and they frequently raise issues of coordination. But the evidence is that there is in fact very limited macro-coordination between countries. Here arc some reasons why:
• Coordination may imply that some countries have to do more than others. They may not want to do so. Suppose that only some countries are in recession. Countries that arc not in a recession will be reluctant to increase their own demand,- but il they don't, the countries that expand will run a trade deficit vis-a-vis countries that don't.
Or suppose that some countries are already running a large budget deficit. These countries won't want to cut taxes or increase spending further, and will ask other countries to take on more of the adjustment. Those other countries may be reluctant to do so.
• Countries have a strong incentive to promise to coordinate and then not deliver on that promise. Once all countries have agreed, say. to an increase in spending, each country has an incentive not to deliver, so as lo benefit from the increase in demand elsewhere and thereby improve its trade position. But if each country cheats, or doesn't do everything it promised, there will be insufficient demand expansion to get out oi the recession.
European countries ► embarked on fiscal expansion too late. By the time they increased spending, their economies were already recovering, and there was no longer a need for higher government spending.
:ONOMY
These reasons are lar Irom abstract concerns. Countries in the European Union, which are highly integrated with one another, have in the past thirty years often sulfered trom such coordination problems. In the late 1970s a bungled attempt at coordination left most countries wary of trying again. In the early 1980s an attempt by the French socialists lo go at it alone led to a large French trade deficit, and eventually to a change in policy. (This is described in the locus box The French Socialist expansion, 1981-83'.) Thereafter, most countries decided that it was better to wait lor an increase in foreign demand than to increase their own demand. There has been very little coordination of fiscal policy since then in Europe.
THE FRENCH SOCIALIST EXPANSION. 1981-83
In May 1981 the Socialist Party won the elections in France. Faced with an economy suffering from more than 7 per cent unemployment, the Socialists offered a program aimed at increasing demand through more generous social policies and subsidies for job creation. Welfare benefits and pensions were increased. Public jobs were created, as were new training programs for the young and the unemployed.Table I summarises the macroeconomic results of the policy.
The fiscal expansion is quite visible in the data. The budget, which was balanced in 1980, was in deficit by 2.8 per cent of GDP in 1982. The effects on growth are equally visible. Average growth in 1981-82 was 1.85 per cent—not an impressive growth rate, but still much above thc European Union's dismal 0.45 per cent average growth rate over the same two years.
4 Given P and P*. E I =>e = EP/P' I
In words: Given the domestic price level and the foreign price level, a nominal depreciation leads to a real depreciation.
Nevertheless, the Socialists abandoned their policy in March 1983.The last line of Table I tells us why. As France was expanding faster than its trading partners.it experienced a sharp increase in its trade deficit.While the government may have tolerated those trade deficits, financial markets—which were very nervous about the Socialists in the first place—forced three devaluations of the franc in eighteen months. (Recall from Chapter 18 that when countries try to maintain a fixed exchange rate—as was the case for France at the time—depreciations are called 'devaluations'. We will see the mechanisms that lead to such devaluations in the next two chapters.) The first was in October 1981. by 8.5 per cent against the deutschmark; the second was in June 1982, by 10 per cent against the deutschmark; and the third was in March 1983, by 8 per cent against the deutschmark. In March 1983. unwilling to face further attacks on the franc and worried about the trade deficits, the French government gave up its attempt to use demand policies to decrease unemployment and shifted to a new policy of'austerity'—a policy aimed at achieving low inflation, budget and trade balances, and no further devaluations. This policy has been maintained by the various French governments, from both the left and the right, to this day.
Table I Macroeconomic aggregates. France. 1980-83
1980 1981 1982 1983
GDP growth (%) 1.6 1.2 2.5 0.7
EU growth (%) 1.4 0.2 0.7 1.6
Budget surplus 0.0 -1.9 -2.8 -3.2
Current account surplus -0.6 -0.8 -2.2 -0.9
1 1
The budget and current account surpluses are measured as ratios to CDP, in per cent A minus sign indicates a deficit EU growth refers to the average growth rate for the countries of the European Union. SOt/ЯСЕ. OECD Economic Outlook.. December 1993.
19.4 DEPRECIATION,THE TRADE BALANCE AND OUTPUT
Suppose that the Australian government takes policy measures that lead to a depreciation ol the Australian dollar. (We will see in Chapter 20 how this can be achieved using monetary policy,- for the moment, we assume that the government can simply choose thc exchange rate.) Recall that the real exchange rate is given by
EP
The real exchange rate, e (the price of domestic goods in terms of foreign goods equals the nominal exchange rate, F. (the pricc of domestic currency in terms of foreign currency), times the domestic price level, P, divided by the foreign pricc level, P*. Under the assumption made in this chaptcr that the price levels arc given, it follows that a nominal depreciation is reflected one-lor-one in a real depreciation. More concretely, if the Australian dollar depreciates vis-a-vis the yen by 10 percent (a If) per cent nominal depreciation), and il the price levels in Australia and Japan don i change, Australian goods will be 10 per cent cheaper compared with Japanese goods (a 10 per cent real depreciation).
Let's now ask what the effects ol this real depreciation will be on the Australian trade balance and on Australian output
Depreciation and the trade balance: the Marshall-Lerner condition
Return to the definition ol net exports:
NX = X - IM/e
Replace X and IM by their expressions Irom equations 119.2) and (19.3 :
NX = X(Y*,e) - IM(Y,eVe
Note that as the real exchange rate, e enters the right side ol the equation in three places, the real depreciation—a decrease in e—affects the trade balance through three separate channels.
1. Exports. X, increase. The real depreciation makes Australian goods relatively less expensive abroad. This leads to an increase in foreign demand lor Australian goods—an increase in Australian exporrs.
2. Imports, IM, decrease. The real depreciation makes foreign goods relatively more expensive in Australia. This leads to a shift in domestic demand towards domestic goods—a decrease in the quantity of imports.
3. The relative pricc of foreign goods, He. increases. This increases the import bill, IM f The same quantity ol imports now costs more to buy «in terms of domestic goods i.
a real depreciation leads :o an increase in net
For the trade balance to improve following a depreciation, exports must increase enough the first channel) and imports must decrease enough < the second channel I to compensate lor the increase in the relative price of imports i the third channel The condition under which a real depreciation leads to an increase in net exports is known as the Marshall-Lerner condition. It is derived formally in the appendix, 'Derivation of the Marshall-Lerner condition . at the end of the chapter. It turns out—with a caveat wc will state when we introduce dynamics later in this chapter—that this condition is satisfied in reality. So, lor the rest of the book wc will assume that a real depreciation—a decrease in e—leads to an increase in net exports—-an increase in NX.
The effects of a depreciation
We have just looked at the direct effects ot a depreciation on the trade balance—that is. the cffccts given Australian and foreign output. But the elfects don't end there. The change in net exports changes domestic output, which allccts net exports lurther.
Because the effects of a real depreciation are very much like those ol an increase in foreign output, we can use Figure 19.4 the same ligure that we used to show the eflects of an increase in foreign output earlier.
A look ahead: ► In Chapter 21 we will look at the effects of a nominal depreciation when we allow the price level to adjust over time. You will see that a nominal depreciation leads to a real depreciation in the short run but not in the medium run.
If the Australian dollar depreciates against the yen by 10 per cent • Australian goods will be cheaper in japan.
leading to a larger quantity of Australian exports to Japan. • Japanese goods will * be more expensive in
Australia, leading to a
smaller quantity of imports of Japanese goods to Australia. • Japanese goods will be more expensive, leading to a higher import bill for a given quantity of imports of Japanese goods to Australia.
The condition is ► named after the two economists. Alfred Marshall and Abba Lerner. who were the first to derive it.
Just like an increase in foreign output, a depreciation leads lo an increase in net exports (assuming, Marshall-Lerner > as we do, that the Marshall-Lerner condition holds) at any level of output. Both the demand relation condition:given output. (ZZ |n |.jgun. ,9 4 pnnc| [a]) ant| thc net exports relation (NX in Figure 19.4, panel [b]) shilt up. The equilibrium moves from A to A'; output increases Irom У to V'. By thc same argument we used earlier, the trade balance improves. The increase in imports induced by the increase in output is less than the expo ts. ,jjrect improvement in the trade balance induced by the depreciation.
To summarise: The depreciation leads to a shift in demand, both foreign and domestic, towards domestic goods. This shift in demand leads iu turn to both an increase in domestic output and an improvement in the trade balance.
While a depreciation and an increase in lorcign output have the same effect on domestic output and thc trade balance there is a subtle but important difference between the two. A depreciation works by making loreign goods relatively more expensive. But this means that given their income, people—who now have to pay more to buy foreign goods because of the depreciation—arc worse off. This mechanism is strongly fell in countries that undergo a large depreciation. Governments trying to achieve a large depreciation often find themselves with strikes and riots in the streets, as people react to the much higher prices of imported goods. For example, this was the case in Mexico in 1994-95, where a large depreciation ol the peso Irom 0.29 US dollar per peso in November 1994 to 0.17 US dollar per peso in May 1995—led to a large decline in workers' living standards. Thc depreciation helped the Mexican economy recover but not without substantial social unrest. During the Asian financial crisis in 1997—98, the Indonesian rupiah sharply depreciated, reducing to one-third of its 1996 value. The Indonesian authorities didn't want the depreciation, nor were they able to control it. and it led tt> political and economic turmoil.
Combining exchange rate policies and fiscal policies
Suppose that a government wants to reduce the trade delicit without changing the level of output. A depreciation alone won't do: it will reduce thc trade deficit, but it will also increase output. Nor will a liscal contraction do: it will reduce the trade deficit, but it will also decrease output.
What should the government do? It should use the right combination ol depreciation and liscal contraction. Figure 19.5 'overleaf) shows what this combination should be.
1 he initial equilibrium in Figure 19.5, panel (a), is at A. associated with output Y The trade delicit is given by the distance ВС in panel (b). Il the government wants to eliminate the trade deficit without changing output, it must do two things:
1. It must achieve a depreciation sufficient to eliminate the trade delicil at thc initial level ol output. So. the depreciation must be such as to shift the net exports relation Irom NX lo NX' in Figure 19.5, panel (b).
Thc problem is thai this depreciation and the associated increase in net exports, also shifts the demand relation in Figure 19.5 panel ia> from ZZ lo ZZ'. In the absence ol other measures, the equilibrium would move from A to A', and output would increase Irom У to 1".
2. In order to avoid thc increase in output, the government must reduce government spending so as to shilt ZZ' back to ZZ This combination ot a depreciation and a fiscal contraction leads to the same level of output and an improved irade balance.
4 There is an alternative to riots—asking for and obtaining an increase in wages. But. if wages increase, the prices of domestic goods will follow and increase as well, leading to a smaller real depreciation. To discuss this mechanism, wc need to look at the suoply side in more detail than we have done so far. We return to the dynamics of depreciation. and wage and price movemerts. in Chapter 21.
4 A general lesson: if you want to achieve two Drgets (here, output and trade balance), you'd better have two instruments (here, fiscal policy and the exchange rate).
There is a general point behind this example. To thc extent that governments care about both the level ol output and the trade balance, they have to use both liscal policy and the exchange rate. We iusi saw one such combination. Table 19.1 shows others, depending on thc initial output and trade situation. Take, lor example, the formula in the top right corner of the table. Initial output is too low t put another way, unemployment is loo high 1 and the economy has a trade delicil. A depreciation will help on both the trade front and the output front: il reduces thc trade deficit and increases output. But there is no reason for the depreciation to achieve both the correct increase in output and the elimination ol the trade deficit. Depending on the initial situation and the relative ellects of the depreciation on output and the trade balance, the government may need to complement the depreciation with either an increase or a decrease in government spending. This ambiguity is captured by the question mark in thc formula. Make sure that you understand the logic behind each of the olher three formulas. An application ol the arguments developed in this section is given in the focus box The LIS trade delicit: Origins and implications'.
To reduce die trade deficit without changing output the government must both achieve a depreciation and decrease government spending.
Table 19.1 Exchange rate and fiscal policy combinations
Initial conditions Trade surplus Trade deficit
Low output High output e ? G T etG? eiG ?
f?cl
1 1
The current US trade deficit is a major imbalance that has implications for both the US and the rest of the world.
Figure I shows the evolution of US exports and imports as ratios to GDP since 1990. It shows how. since the mid-1990s. exports and imports have steadily diverged. The import ratio has continued to increase, reaching 18.5 per cent in 2008, while the export ratio went from 11.5 per cent in 1997 to 9.5 per cent in
I I I I I I I I I I I I I I I Г
1990
1992 1994 1996 1998 2000 2002 2004 2006
to I J.3 per cent in ZWO.AS a result, tne UI traoe aericit nas steaany increased; in 2005 it stood at a huge 6.1 per cent, but moderated in 2008 to 5 per cent.The current account deficit stood at an even higher 5.2 per cent of GDP in 2008. (The current account deficit, you will remember, is equal to the trade deficit, plus transfers from the United States to the rest of the world, minus net income payments from the rest of the world to the United States, and tells us how much the United States has to borrow from the rest of the world.)
The 2005-06 trade and current account deficits were by far the largest (both absolutely and in proportion to GDP) in recorded US history. And. given the size of the US economy, a current account deficit of 6.25 per cent of GDP represents a very large amount—more than US$800 billion—which the United States had to borrow from the rest of the world.This raises two main questions: Where do these deficits come from, and what do they imply for the future? Let's take up each question in turn.
Where does the trade deficit and, by implication, the current account deficit come from?
Three factors appear to have played roughly equal roles.
20
18
16 -
6? 14-
12 -
10-
Imports
Exports
Figure I US imports and exports as ratios to US GDP since 1990
• The first is the high US growth rate since the mid-1990s, relative to the growth rate of its trading partners.Table I gives the average annual growth rate for the United States,Japan and the European Union for three periods. 1991-95, 1996-2000 and 2001 -07. The United States has grown faster than the other two major economies throughout. From 1996 to 2000. however, US growth was much higher, reflecting
Table I Average annual real GDP growth, 1991-2007 (per cent per year)
1991-95 1996-2000 2000-07
United States 2.5 4.1 2.5
Japan 1.6 1.0 1.6
Europe (OECD) 1.6 2.9 1.9
SOURCES: Bureau of Economic Analysis. Eurostac. Bank of Japan.
the New Economy boom, which we have discussed at many points in the book. US growth has decreased since 2000 (recall that the United States went through a recession in 2001). but it is still higher than growth in Europe, which slowed less; Japan's growth improved significantly after 2002.
Higher growth doesn't necessarily lead to a higher trade deficit. If the main source of the increase in demand and growth in a country is an increase in foreign demand, the country can grow fast and maintain a trade balance, or even sustain a trade surplus. In the case of the United States since the mid-1990s. however, the main source of increased demand has been domestic demand, with high consumption and investment demand as the main factors behind the sustained expansion.Thus, higher growth has come with an increasing trade deficit.
• The second factor is the steady real appreciation of US goods—the increase in the real US effective exchange rate. Even if, at a given real exchange rate, growth leads to an increase in the trade deficit, a real depreciation can help maintain trade balance by making domestic goods more competitive. But just the opposite happened to the US real exchange rate in the late 1990s.The United States experienced a real appreciation, not a real depreciation. As shown in Figure 2. the multilateral real exchange rate (normalised to equal 100 in 2000) increased from 80 in 1995 to 105 in 2002—a 20 per cent real appreciation. The dollar has depreciated significantly in real terms since 2002, reaching down to 71 in mid-2008, its lowest value ever recorded. And yet the trade deficit remained virtually as wide as ever. (The exchange rate recovered by 10 per cent in late 2008, as investors returned funds to the US during the global financial crisis. This is because the US dollar is considered a relatively safe haven in times of crisis.)
• The third factor is shifts in the export and import functions—that is, changes in exports or imports due neither to changes in activity nor to changes in the exchange rate.The evidence is that these shifts have played an important role as well, explaining up to one-half of the increase in the trade deficit. At a given level of income, and a given exchange rate, US consumers, for example, buy a higher proportion of foreign goods—say more foreign cars, fewer domestic cars.
Figure 2 The US
multilateral real exchange rate
70
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
since 1990
SOURCE: IMF. International Financial Statistics.
This is a good place to make sure we can tell the story in terms of saving and investment, along the lines of Section 19.6.There is a clear story about US saving (net of depreciation) and US investment (net of depreciation) since 1996. The investment to GDP ratio has remained roughly constant since 1996. Therefore, the increase in the trade deficit (which, as you will recall, is equal to the difference between investment and saving) has come primarily from a decrease in saving. And, when one looks closely at the
data, it is clear that this decrease in saving has come mostly from a decrease in private saving, S. rather than an increase in the budget deficit—the ratio of the budget deficit to GDP is roughly the same in 2008 as it was in 1996. and the ratio of private saving to GDP is more than 3 percentage points lower in 2008 than it was in 1996. Thus, another way of describing what lies behind the trade deficit is that US consumers are saving substantially less than they were twelve years ago. Should they be saving more? We discussed this issue in Chapter 16. The answer: Most of them appear to be saving enough.
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