FIN 30220: Macroeconomic Analysis Open Economy Macroeconomics

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Text of FIN 30220: Macroeconomic Analysis Open Economy Macroeconomics

  • Slide 1
  • FIN 30220: Macroeconomic Analysis Open Economy Macroeconomics
  • Slide 2
  • Open economy macroeconomics looks at the interactions between the US and the rest of the world Exports Imports 2005 Exports = $1,740,894M Imports = $2,545,843M Net Exports = - $804,949 The current account keeps track of the flow of goods and services in and out of the US
  • Slide 3
  • 2005 US Current Account (in Millions) ExportsImportsNet Merchandise$892,619$1,674,261- $781,642 Services$379,603$321,577 $58,026 Income$468,672$467,111 $1,561 Unilateral Transfers$82,894- $82,894 Total$1,740,894$2,545,843- $804,949 In 2005, the deficit in merchandise increased by 17% as imports grew faster than exports The surplus in services increased by 21% in 2005 as receipts grew faster than payments The surplus in income decreased by 94% as payments increased faster than receipts
  • Slide 4
  • Whats the meaning of a trade deficit? To answer this, lets look back at the national accounting identities Y = C + I + G + NX NX = Y (C + I + G) Solving for Net Exports, we get National Income Aggregate Expenditures A trade deficit signifies that we as a country are spending beyond our current income Alternatively, S = I + (G-T) + CACA = S [I + (G-T)] National Savings Aggregate Borrowing A deficit signifies that we are borrowing more than we are saving
  • Slide 5
  • A trade deficit implies that the US is borrowing from the rest of the world (currently, we are borrowing at the rate of $2B per day). A equivalent statement is that the rest of the world is acquiring US assets Suppose that, while on vacation in France, you buy a case of French wine for $1,000. You pay for the wine with cash The French wine maker uses the $1,000 to buy a computer from Dell Net exports equals zero (no change in asset holdings). The French wine maker uses the $1,000 to buy a US Treasury Net exports are negative (Increase in French holdings of US assets). The French wine maker uses the $1,000 to buy stock in a French company from an American Net exports are negative (Decrease in US holdings of French assets). Changes in Assets are recorded in the Capital and Financial Account
  • Slide 6
  • (1) Capital Account Transactions- $5,647 (2) Change in US owned Assets Abroad- $491,731 US Official Reserve Assets $14,096 US Government Assets $7,580 US Private Assets- $513,407 Foreign Direct Investment - $21,483 Securities - $491,924 (3) Change in Foreign Ownership of US Assets$1,292,697 Foreign Official Assets $220,676 Private Foreign Assets $1,072,021 Foreign Direct Investment $128,632 Currency $19,416 Securities $923,973 Total (1) + (2) + (3)$795,319 2005 US Capital & Financial Account (in Millions)
  • Slide 7
  • Change in US owned Assets Abroad US Official Reserve Assets US Government Assets US Private Assets Foreign Direct Investment Securities Change in Foreign Ownership of US Assets Foreign Official Assets Private Foreign Assets Foreign Direct Investment Currency Securities Merchandise Services Income Unilateral Transfers Current AccountCapital & Financial Account Note that every credit (+) has to be matched with a debit (-). Remember this: any transaction that involves money flowing into the US is a (+)
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  • Change in US owned Assets Abroad US Official Reserve Assets US Government Assets US Private Assets Foreign Direct Investment Securities Change in Foreign Ownership of US Assets Foreign Official Assets Private Foreign Assets Foreign Direct Investment Currency Securities Merchandise Services Income Unilateral Transfers Current AccountCapital & Financial Account Example #1 Suppose that Wall Mart buys $20M worth or goods from a Chinese supplier. The Chinese company uses the $20M to buy stock in IBM. - $20M $20M
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  • Change in US owned Assets Abroad US Official Reserve Assets US Government Assets US Private Assets Foreign Direct Investment Securities Change in Foreign Ownership of US Assets Foreign Official Assets Private Foreign Assets Foreign Direct Investment Currency Securities Merchandise Services Income Unilateral Transfers Current AccountCapital & Financial Account Example #2 Suppose that the US spends $80B on a foreign aid package to Iraq. The Iraqi government uses $40B to buy computers from Dell, $30B goes to pay employees of Haliburton, and $10B is deposited in a US bank. - $80B $30B $40B $10B
  • Slide 10
  • Change in US owned Assets Abroad US Official Reserve Assets US Government Assets US Private Assets Foreign Direct Investment Securities Change in Foreign Ownership of US Assets Foreign Official Assets Private Foreign Assets Foreign Direct Investment Currency Securities Merchandise Services Income Unilateral Transfers Current AccountCapital & Financial Account Example #3 Suppose that Nike spends $50M on a production facility in Korea - $20M is used to buy equipment from US suppliers, $30M is used elsewhere. - $50B $20B $30B
  • Slide 11
  • As the US trade (current account) deficit worsens, it is matched by an equally large capital account surplus that is, capital is flowing into the US as foreigners acquire our assets. By definition, the Balance of Payments (KFA + CA) should equal zero.
  • Slide 12
  • With trading centers in New York City, London, Tokyo and Sydney, currency markets operate 24 hours a day, 5 days a week. 12 AM 12 PM 11 PM 5 PM Eastern Time Australia: 5PM - 2AM 3 AM 8PM - 5AMTokyo London: 3AM -11AM 9 PM 8 AM New York City: 8AM -5PM
  • Slide 13
  • The foreign exchange market is unique not just because of its geographic dispersion, but also because of its extreme liquidity and tremendous volume around $1.9T PER DAY!! $600B in Spot market Transactions $1.3T in Derivative Market Transactions $200B in Forwards $1T in Swaps $100B in Options Name% of Volume Deutsche Bank17 UBS12.5 Citigroup7.5 HSBC6.4 Barclays5.9 Merrill Lynch5.7 JP Morgan Chase5.3 Goldman Sachs4.4 ABN Amro4.2 Morgan Stanley3.9 The ten most active traders account for 73% of the volume
  • Slide 14
  • US currency was involved in 89% of transactions, followed by the Euro (37%), the yen (20%) and sterling (17%).
  • Slide 15
  • An exchange rate is generally defined as the domestic currency price of a foreign currency, but be careful Most currencies are quoted two ways: US Dollar Equivalent ($/-)Currency per US Dollar (-/$) The Euro is currently trading at 1.601 An increase in the US dollar equivalent rate signifies a depreciation of the dollar The Euro is currently trading at.6246 An increase in the currency per US dollar rate signifies an appreciation of the dollar
  • Slide 16
  • The dollar has had quite a wild ride against the Euro since it began circulating in 1999. Recession Dollars per Euro
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  • Arbitrage insures that currency prices will be the same at different locations around the world. (Arbitrage will raise the price in NYC and lower the price in London) Suppose that a dealer were offering Euro at $1.22 in New York City while a dealer in London was offering Euro at $1.24 1Sell Euro short in London2 Use the proceeds to buy Euro in New York 3 Use your newly acquired Euro to pay off your short position
  • Slide 18
  • Suppose that a dealer in New York City was offering the following prices: Euro/USD = $1.25 USD/JPY = Y115 Euro/JPY = Y135 1 Sell Euro short at $1.25 2 Use the dollars to buy Yen at Y115 3 Use the Yen to buy Euro at Y135 Repay your short position USD/JPY = Y115 Euro/JPY = Y135 The USD/JPY, and Euro/JPY rates imply a Euro/USD rate Euro/USD = Y135 Y115 = $1.17
  • Slide 19
  • Recall that in a closed economy, all borrowing had to be supplied by domestic savings the domestic interest rate will insure that this happens. At the equilibrium interest rate
  • Slide 20
  • In the global economy, interest rates are determined in an integrated global capital market. The world interest rate equates world saving with world borrowing. At the world equilibrium interest rate At the equilibrium world interest rate, the US is running a trade deficit
  • Slide 21
  • The extent to which a country can effect global interest rates depends on size. The US controls 35% of the global economy. An increase in world investment demand has a negligible impact on world interest rates The increase in domestic investment demand increases the domestic trade deficit New Deficit
  • Slide 22
  • One method for valuing exchange rates is known as Purchasing Power Parity. This simply states that the same good should cost the same everywhere when its price is expressed in the same currency. P = $500/ozP = L 400/oz Suppose we have the following gold prices in the US and England. The current exchange rate is $1.15/L Given these prices, you could make money by shorting gold in the US, converting your dollars to pounds, and then buying gold in England to cover your short position. The PPP Exchange Rate should be $500 L400 = $1.25/L
  • Slide 23
  • The PPP method values exchange rates by looking at price indices across countries. For example, consider the US and England England CPI = 195.0 (March 2006) USA CPI = 199.8 (March 2006) PPP Exchange Rate e = CPI (USA) CPI (UK) 199.8 195.0 == $1.025/L Currently, the British Pound is trading at $1.786 $1.786 $1.025 $1.205 X 100 = 74% Is the British pound really overvalued by 74%?
  • Slide 24
  • The PPP method values exchange rates by looking a