Bonds differ in two basic dimensions-.
1. Default risk, the risk that the issuer of the bond (it could be a government or a company) won't pay back the lull amount promised by the bond.
2. Maturity, the length of time over which the bond promises to make payments to the holder of the bond. A bond that promises to make one payment of $1,000 in six months has a maturity of six months,- a bond that promises $100 per year for the next twenty years and a final payment of $1,000 at the end of those twenty years has a maturity of twenty years.
Maturity is the more important dimension lor our purposes here and we will focus on it in this chapter. However, default risk can be crucially important if it spreads across the financial system, leading to a financial crisis. We will discuss default risk in the context of financial crises in Chapter 22 in the 'Pathologies' extension to the book.
Bonds of different maturities have a price and an associated interest rate called the 'yield to maturity', or simply the yield. Yields on bonds with a short maturity, typically a year or less, are called short-term
We have so far focused on bonds But while governments finance themselves hy issuing bonds thc same isn't true of firms. Firms raise lunds in two ways: through debt finance (bonds and loans) and through equity finance (through issues ol stocks, or shares, as stocks are also called). Instead ot paying predetermined amounts as bonds do stocks pay dividends in an amount decided by the rirm. I )ividends arc paid from the lirms profits. They are typically less than prolits, as firms retain some of their profits to finance their investment. But dividends move with profits—when profits increase, so do dividends.
Our focus in this section is on thc determination of stock prices. As a way ol introducing the issues. Figure 15.5 shows the behaviour ol an index ol Australian stock prices, the Standard & Poor's ASX 200 Index (or the S&P Index, lor short Irom 1480 lo 2008. The S&P Index measures movements in the average stock price ol 200 large companies, representing about 90 percent ol the total value of the Australian market. Another popular Australian index is the All-Ordinaries Index, which has a slightly broader coverage than the S&P. The equivalent to the latter in the Llnited States is the S&P 500 Composite Index. A better known LIS index is the Dow Jones Industrial Index, an index ol stocks of industrial lirms only and there-lore less representative ol the average price of stocks than the S&P Index. Similar indexes exist for other countries. The Nikkei Index reflects movements in stock prices in Tokyo, and the FT, the CAC and the I lang Seng indexes reflect stock price movements in London Paris and
• There are many had books written about the stock market. A good one, and fun to read, is Burton Malkiel, /1 Random Walk Down Wall Street. 7th edn (New York: Norton, 2000).
• Peter Garber gives an account of historical bubbles in famous lirst bubbles', Journal of Lconomic Perspectives, Spring 1990, pp. 35-54.
The shaded columns represent recession periods. Relative movements in investment are much larger than relative movements in
consumption.
SOURCE: ABS. cat no. 5206.Table 54.
• Investment is much more volatile than consumption. Relative movements in investment range Irom -18 per cent to 22 per cent, while relative movements in consumption range from only -О. I per cent to 6 per cent. The standard deviation of investment growth is more than six times greater than that of consumption.
• Another way of stating the same fact is that, whereas the level of investment is much smaller than the level of consumption 'recall that business investment accounts lor 14 per cent of GDP. versus 60 per cent for consumption) changes in investment from one year to the next are typically of thc same magnitude as changes in consumption. Both components contribute roughly equally to fluctuations in output over time.
Consumption depends on both wealth and current income. Wealth is thc sum of non-human wealth i financial wealth and housing wealth) and human wealth (thc present value of expected after-tax labour income).
The response of consumption to changes in income depends on whether consumers perceive these changes as transitory or as permanent.
Consumption is likely to respond less than one-lor-one to movements in income, and consumption may move even if current income doesn't change.
Investment depends on both current prolit and thc present value ot expected future profits. Llnder the simplifying assumption that lirms expect profits and interest rates to be the same in the future as they are today, we can think of investment as depending on the ratio ot prolit to the user cost of capital, where the user cost is the sum of the real interest rate and the depreciation rate. Movements in profit arc closely related to movements in output. Hence, we can think of investment as depending indirectly on current and expected future output movements. Firms that anticipate a long output expansion, and thus a long sequence of high prolits, will invest. Movements in output that arc not expected to last will have a small effect on investment.
Investment is much more volatile than consumption. While business investment accounts only for 14 per cent ot Australian GDP today and consumption accounts for 60 per cent, movements in investment and consumption arc of roughly equal magnitude.
Let's start by reviewing what you have learned, and then discuss how we should modify the characterisation of goods and financial markets—the IS-LM model—we developed in The Core.
Expectations, consumption and investment decisions
The theme of Chaptcr 16 was lhal both consumption and investment decisions depend very much on expectations of future income and interest rates. The channels through which expectations aftcct consumption and investment spending are summarised in Figure 17.1.
Note the many channels through which expected future variables affect current decisions, both directly and through asset prices:
• An increase in current and expected future after-tax real labour income, or a decrease in current and expected future real interest rates increases human wealth (the expected present discounted value of after-tax real labour income), which in turn leads lo an increase in consumption.
• An increase in current and expected future real dividends, or a decrease in current expected future real interest rales, increases stock prices, which lead to an increase in non-human wealth and, in turn, to an increase in consumption.
Given expectations, a decrease in the real interest rate leads to a small increase in output the IS curve is steeply downward sloping. Increases in government spending, or in expected future output shift the IS curve to the right Increases in taxes, in expected future taxes or in the expected future real interest rale shift the IS curve to the left
large changes in spending. For example, lirms aren't likely to change their investment plans very much in response to a decrease in the current real interest rate il they don't expect luture real interest rates lo he lower as well.
• The multiplier is likely to he small. Recall that the size ol the multiplier depends on the size ol the effect of a change in current income (output) on spending. Bui a change in current income, given unchanged expectations of future income, is unlikely to have a large effect on spending. The reason: changes in income that aren't expected to last have only a limited effect on both consumption and investment. Consumers who expect their income to be higher only lor a year will increase con¬sumption, but by much less than the increase in income. Firms that expect sales to be higher only for a year arc unlikely to change their investment plans much, il at all.
Putting things together, a large decrease in the current real interest rate—from Г ; to Гц in Figure 17.2—leads to only a small increase in output, Irom Yл to The IS curve, which goes through points A and B, is steeply downward sloping.
Changes in all variables in equation (17.2) other than У and r shift the IS curve:
• Changes in current taxes (T) or in current government spending (G) shilt the IS curve. An increase in current government spending increases spending ai a given interest rate, shifting the IS curve to ihe right. An increase in taxes shifts the IS curve to the left. These shilts are represented in Figure 17.2.
In the basic IS-LM model we developed in Chapter 5, there was only one interest rate, i which entered both thc IS relation and the LM relation. When the RBA eased monetary policy, the' interest rate went down and spending increased. From the previous three chapters, you have learned that there are in fact many interest rates and that we must keep two distinctions in mind:
1. the distinction between the nominal interest rate and the real interest rate
2. the distinction between current and expected future interest rates.
The interest rate that enters the I.M relation, which is the interest rate that the RBA affects directly, is the currcnt nominal interest rate. In contrast, spending in the IS relation depends on both current and expected future real interest rates. Economists sometimes state this distinction even more starkly hy saying lhat, while the RBA controls the slwrt-term nominal interest rate, what matters lor spending and output is thc long-term real interest rate.
Let's look at this distinction more closely. Recall from Chaptcr 14 that the real interest rate is equal to thc nominal interest rate minus expected currcnt inflation:
r = i - 7T('
Similarly, the expected luture real interest rate is equal to the expected future nominal interest rate minus expected luture inflation.
r'e = i"r - тг'1'
The IS curve is steeply downward sloping. Other things being equal, a change in the current interest rate has a small effect on output The LM curve is upward sloping. The equilibrium is at the intersection of the IS and LM curves. We assume that the central bank fixes the current interest rate.
The effects of monetary policy on output depend very much on whether and how monetary policy affects expectations.
When account is taken of its effect on expectations, a decrease in government spending need not lead to a decrease in current output
smaller thc adverse effect on spending today. Note also that the larger the decrease in expected future government spending (G'c), the larger the eflect on expected future output and real interest rates,- thus, the larger the favourable effect on spending today. This suggests that backloading the delicil reduction program towards the future, with small cuts today and larger cuts in the luture, is more likely to lead to an increase in output
On the other hand, backloading raises other issues. Announcing the need for painful cuts in spending, and then leaving them to the luture, is likely to seriously decrease the program's credibility— thc perceived probability that the government will do what it has promised when the lime comes to do it. The government must play a delicate balancing act: enough cuts in the current period to show a commitment to deficit reduction, and enough cuts left to the future to reduce the adverse effects on the economy in thc short run.
More generally, our analysis suggests that anything in a deficit reduction program that improves expectations ol how the future will look is likely to make the short-run effects of deficit reduction less painful. Let's give two examples:
W
e have assumed so far that the economy was closed—that it didn't interact with the rest of the world. We had to start this way, to keep things simple and build up your intuition for the basic macroeconomic mechanisms.We are now ready to relax this assumption. Understanding the macroeconomic implications of openness will occupy us for this and the next three chapters.
Openness has three distinct dimensions:
1. Openness in goods markets—the ability of consumers and firms to choose between domestic goods and foreign goods.
In no country is this choice completely free of restrictions. Even the countries most committed to free trade have tariffs (taxes on imported goods) and quotas (restrictions on the quantity of goods that can be imported) on at least some foreign goods. At the same time, in most countries average tariffs are low and getting lower.
2. Openness in financial markets—the ability of financial investors to choose between domestic financial assets and foreign financial assets.
Until recendy, even some of the richest countries, such as France and Italy, had capital controls—restrictions on the foreign assets their domestic residents could hold as well as on the domestic assets foreigners could hold. These restrictions are rapidly disappearing. As a result, world financial markets are becoming more and more closely integrated.
3. Openness in factor markets—the ability of firms to choose where to locate production, and the ability of workers to choose where to work.
Here also trends are clear. Multinational companies operate plants in many countries and move their operations around the world to take advantage of low costs. Much of the debate about the North American Free Trade Agreement (NAFTA), signed in 1993 by the United States, Canada and Mexico, centred on its implications for the relocation of US firms to Mexico. And immigration from low-wage countries is a hot political issue in countries ranging from Germany through to Australia.
In the short run and in the medium run—the focus of this and the next three chapters—openness in factor markets plays much less of a role than openness in either goods markets or financial markets. Thus, we will ignore openness in factor markets, and focus on the implications of the first two dimensions of openness.
• Section 18.1 looks at openness in the goods market, the determinants of the choice between domestic goods and foreign goods, and the role of the real exchange rate.
• Section 18.2 looks at openness in financial markets, the determinants of the choice between domestic financial assets and foreign financial assets, and the role of interest rates and exchange rates.
• Section 18.3 gives the map to the next three chapters.
I I I I I I
1980 1985 1990 1995 2000 2005
Openness in financial markets allows financial investors to hold both domestic assets and loreign assets, to diversify their portfolios, and lo speculate on movements in foreign interest rates versus domestic interest rates, on movements in exchange rates, and so on.
Diversify and speculate they do. Given that buying or selling foreign assets implies buying or selling foreign currency—sometimes callcd foreign exchange the volume of transactions in foreign exchange markets gives a sense ol the importance of international financial transactions. "I he Bank of International Settlements (www.bis.orgi reported daily global volume of foreign-exchange transactions in 200/ equal to about LIS$3.2 trillion, ot which 86 per cent involved US dollars on one side of any transaction, and 37 per cent involved the euro. The LIS dollar/euro was the most traded pair, with 27 per cent of all transactions. The Australian foreign-exchange market was the seventh largest in the world, and the Australian dollar featured in 6.7 per cent of all transactions—about A$163 billion per day.
To get a sense of the magnitude ol these numbers, the sum of US exports and imports in 2007 totalled US$4 trillion lor the year, or about US$ I I billion a day. Suppose that the only US$ transactions in foreign-exchange markets had been on one side by LIS exporters selling their foreign currency earnings, and on the other side by LIS importers buying the foreign currency they needed to buy foreign goods. Then, the volume of transactions would have been US$11 billion a day, or a mere 0.3 1 per cent of the actual daily volume ol dollar transactions US$3.2 trillion) involving dollars in loreign-exchange markets. Doing a similar calculation (or Australia A$ transactions lor trade in goods and services in 2008 were about A$2 billion per day. or 1.2 per cent of all A$ transactions. These calculations tell us that most (actually about 40 per cent1 ol the foreign-exchange transactions arc associated not with trade but with purchases and sales ot financial assets. And much ol it is simply transactions between dealers and brokers on the global wholesale foreign-exchange market. The volume ol transactions in loreign-exchange markets is not only high but also rapidly increasing. The volume ol global foreign-exchange transactions in 2001 was double what it was in 1988 and increased by a huge 126 per ccnt Irom 2001 to 2007. Again, this activity rctlccts mostly an increase in financial transactions, rather than an increase in goods trade over the period. The lact that financial transactions dominate trade transactions by such a big margin indicates that exchange rates in the short term will be driven primarily by international portfolio considerations—in particular, by international parity relations, which we will discuss shortly.
I or a country as a whole, openness in financial markets has another important implication. It allows the country to run trade surpluses and trade deficits Recall that a country running a trade dclicit is buying more from the rest of the world than it is selling to the rest ol the world. In order to pay for the difference between what it buys and what it sells, the country must borrow from the rest of the world. It borrows by making it attractive for loreign linancial investors to increase their holdings ol domestic assets—in effect, to lend to the country.
Let's start by looking more closely at the relation between trade flows and financial flows. When this is done, wc will then be able to look at the determinants ol these financial flows.
The balance of payments
A country's transactions with the rest of the world, including both trade flows and financial Hows, arc summarised by a set ol accounts called the balance of payments. Table 18.3 presents the Australian balance ol payments for the year ending in June 2008. The table has two parts, separated by a line. Transactions are referred to cither as above the line or below the line
SOURCE ABS. cat. no. 5302.
The current account
Thc transactions above the line record payments to and Irom the rest ol the world. They are called current account transactions.
• Thc first two lines record the exports and imports ol merchandise' goods. Exports lead to payments from the rest ol the world imports to payments to the rest ot the world. In 2008. merchandise imports exceeded exports, leading to an Australian merchandise trade deficit of A$20.8 billion.
Note that the numbers lor exports and imports are slightly different from those in Table 18.2,- this is bccausc the numbers in Table 18.2 refer to the year ending August 2008.)
• Services such as insurance and shipping) are also imported and exported, and Australia had a net service trade surplus ol A$2.9 billion in 2008. Adding thc merchandise and service deficits, we get the trade balance tor Australia as a A$I7.C) billion deficit.
• Exports and imports arcn t thc only sources ot payments to and from thc rest ot thc world. Australian residents receive investment income on their holdings ol loreign assets, and foreign residents receive investment income on their holdings ol Australian assets. Also, Australia makes net transfers to foreign residents, largely through foreign aid. In 2008. net investment income and transfers which includes foreign aid paid to the rest ol the world was A$50.3 billion, this huge delicil reflects the fact that Australia is a net debtor country.
"I he sum of net payments to and from the rest of the world is called the current account balance. II net payments from thc rest ol the world are positive the country is running a current account surplus: ii they are negative the country is ninning a current account deficit. Adding all payments to and Irom the rest of the world net payments from Australia to the rest of the world in 2008 were equal to -A$I7.9 - A$50.3 -A$68.2 billion. Put another way, in 2008 Ausiralia ran a current account deficit ol $68.2 billion, a deficit equal to iust above 6 per cent ol its GDP.