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FIN 30220: Macroeconomic Analysis

Open Economy Macroeconomics

Open economy macroeconomics looks at the interactions between the US and the rest of the world

Exports

Imports

2005

Exports = $1,740,894M

Imports = $2,545,843M

Net Exports = - $804,949

The current account keeps track of the flow of goods and services in and out of the US

2005 US Current Account (in Millions)

Exports Imports Net

Merchandise $892,619 $1,674,261 - $781,642

Services $379,603 $321,577 $58,026

Income $468,672 $467,111 $1,561

Unilateral Transfers $82,894 - $82,894

Total $1,740,894 $2,545,843 - $804,949

In 2005, the deficit in merchandise increased by 17% as imports grew faster than exports

The surplus in services increased by 21% in 2005 as receipts grew faster than payments

The surplus in income decreased by 94% as payments increased faster than receipts

What’s the meaning of a trade deficit? To answer this, lets look back at the national accounting identities…

Y = C + I + G + NX

NX = Y – (C + I + G)Solving for Net Exports, we get

National Income

Aggregate Expenditures

A trade deficit signifies that we as a country are spending beyond our current income

Alternatively,

S = I + (G-T) + CA CA = S – [I + (G-T)]

National Savings

Aggregate Borrowing

A deficit signifies that we are borrowing more than we are saving

A trade deficit implies that the US is borrowing from the rest of the world (currently, we are borrowing at the rate of $2B per day). A equivalent statement is that the rest of the world is acquiring US assets

Suppose that, while on vacation in France, you buy a case of French wine for $1,000. You pay for the wine with cash

The French wine maker uses the $1,000 to buy a computer from Dell – Net exports equals zero (no change in asset holdings).

The French wine maker uses the $1,000 to buy a US Treasury – Net exports are negative (Increase in French holdings of US assets).

The French wine maker uses the $1,000 to buy stock in a French company from an American– Net exports are negative (Decrease in US holdings of French assets).

Changes in Assets are recorded in the Capital and Financial Account

(1) Capital Account Transactions - $5,647

(2) Change in US owned Assets Abroad - $491,731

US Official Reserve Assets $14,096

US Government Assets $7,580

US Private Assets - $513,407

Foreign Direct Investment - $21,483

Securities - $491,924

(3) Change in Foreign Ownership of US Assets $1,292,697

Foreign Official Assets $220,676

Private Foreign Assets $1,072,021

Foreign Direct Investment $128,632

Currency $19,416

Securities $923,973

Total (1) + (2) + (3) $795,319

2005 US Capital & Financial Account (in Millions)

Change in US owned Assets Abroad

US Official Reserve Assets

US Government Assets

US Private Assets

Foreign Direct Investment

Securities

Change in Foreign Ownership of US Assets

Foreign Official Assets

Private Foreign Assets


Currency

Securities

Merchandise

Services

Income

Unilateral Transfers

Current Account Capital & Financial Account

Note that every credit (+) has to be matched with a debit (-).

Remember this: any transaction that involves money flowing into the US is a (+)




US Private Assets


Securities





Currency

Securities

Merchandise

Services

Income



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




US Private Assets


Securities





Currency

Securities

Merchandise

Services

Income



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




US Private Assets


Securities





Currency

Securities

Merchandise

Services

Income



Example #3

Suppose that Nike spends $50M on a production facility in Korea - $20M is used to buy equipment from US suppliers, $30M is used elsewhere.

- $50B

$20B

$30B

-200

-150

-100

-50

0

50

100

150

200

250

Jan-80 Jan-88 Jan-96

Current Account FKA

As the US trade (current account) deficit worsens, it is matched by an equally large capital account surplus – that is, capital is flowing into the US as foreigners acquire our assets. By definition, the Balance of Payments (KFA + CA) should equal zero.

With trading centers in New York City, London, Tokyo and Sydney, currency markets operate 24 hours a day, 5 days a week.

12 AM

12 PM

11 PM

5 PM

Eastern Time

Australia: 5PM - 2AM

3 AM

8PM - 5AM Tokyo

London: 3AM -11AM

9 PM

8 AM

New York City: 8AM -5PM

0

5000

10000

15000

20000

25000

30000

12:00AM 4:00AM 8:00AM 12:00AM 4:00PM 8:00PM

Tra

nsa

ctio

ns/

Hour

The foreign exchange market is unique not just because of its geographic dispersion, but also because of its extreme liquidity and tremendous volume – around $1.9T PER DAY!!

$600B in Spot market Transactions

$1.3T in Derivative Market Transactions

$200B in Forwards

$1T in Swaps

$100B in Options

Name % of Volume

Deutsche Bank 17

UBS 12.5

Citigroup 7.5

HSBC 6.4

Barclays 5.9

Merrill Lynch 5.7

JP Morgan Chase 5.3

Goldman Sachs 4.4

ABN Amro 4.2

Morgan Stanley 3.9

The ten most active traders account for 73% of the volume

USD/JPY20%

USD/EUR31%

EUR/All8%

USD/Other17%

USD/AUD4%

USD/CAD4%USD/CHF

5%USD/GBP

11%

US currency was involved in 89% of transactions, followed by the Euro (37%), the yen (20%) and sterling (17%).

An exchange rate is generally defined as the domestic currency price of a foreign currency, but be careful…

Most currencies are quoted two ways:

US Dollar Equivalent ($/-) Currency per US Dollar (-/$)

The Euro is currently trading at 1.601

An increase in the US dollar equivalent rate signifies a depreciation of the dollar

The Euro is currently trading at .6246

An increase in the currency per US dollar rate signifies an appreciation of the dollar

0.8000

0.9000

1.0000

1.1000

1.2000

1.3000

1.4000

Jan-99 Jul-00 Jan-02 Jul-03 Jan-05

The dollar has had quite a wild ride against the Euro since it began circulating in 1999.

Recession

Do

llar

s p

er E

uro

Arbitrage insures that currency prices will be the same at different locations around the world. (Arbitrage will raise the price in NYC and lower the price in London)

Suppose that a dealer were offering Euro at $1.22 in New York City while a dealer in London was offering Euro at $1.24

1 Sell Euro short in London 2Use the proceeds to buy Euro in New York

3Use your newly acquired Euro to pay off your short position

Suppose that a dealer in New York City was offering the following prices:

Euro/USD = $1.25

USD/JPY = Y115

Euro/JPY = Y135

1 Sell Euro short at $1.25

2 Use the dollars to buy Yen at Y115

3 Use the Yen to buy Euro at Y135

Repay your short position

USD/JPY = Y115Euro/JPY = Y135

The USD/JPY, and Euro/JPY rates imply a Euro/USD rate

Euro/USD =Y135

Y115= $1.17

r

SI ,

r

TGI

S ** STGI

Recall that in a closed economy, all borrowing had to be supplied by domestic savings – the domestic interest rate will insure that this happens.

At the equilibrium interest rate

r

SI ,

TGI

S

WWW STGI

In the global economy, interest rates are determined in an integrated global capital market. The world interest rate equates world saving with world borrowing.

At the world equilibrium interest rate

r

WW SI ,

r

WW TGI

WS

CA

At the equilibrium world interest rate, the US is running a trade deficit

r

SI ,

TGI

S

The extent to which a country can effect global interest rates depends on size. The US controls 35% of the global economy.

An increase in world investment demand has a negligible impact on world interest rates

r

WW SI ,

r

WW TGI

WS

The increase in domestic investment demand increases the domestic trade deficit

New Deficit

One method for valuing exchange rates is known as Purchasing Power Parity. This simply states that the same good should cost the same everywhere when its price is expressed in the same currency.

P = $500/oz P = L 400/oz

Suppose we have the following gold prices in the US and England. The current exchange rate is $1.15/L

Given these prices, you could make money by shorting gold in the US, converting your dollars to pounds, and then buying gold in England to cover your short position.

The ‘PPP’ Exchange Rate should be $500L400

= $1.25/L

The PPP method values exchange rates by looking at price indices across countries. For example, consider the US and England

England

CPI = 195.0 (March 2006)

USA

CPI = 199.8 (March 2006)

PPP Exchange Rate

e = CPI (USA)CPI (UK)

199.8195.0

= = $1.025/L

Currently, the British Pound is trading at $1.786

$1.786 – $1.025$1.205

X 100 = 74%Is the British pound really overvalued by 74%?


England

CPI = 195.0 (March 2006)

USA

CPI = 199.8 (March 2006)

PPP Exchange Rate

e = CPI (USA)CPI (UK)

199.8195.0

= = $1.025/L

Problems:

1. The CPI in the US and Britain are different bundles of goods

2. The CPI in the US and Britain are benchmarked by different base years

A better method is to look at changes rather than levels


England

Inflation = 2.4%

(12 months)

USA

Inflation = 3.4%

(12 months)

*% e4.24.3

%1The dollar should depreciate by 1% against the pound

12 months ago, the British pound was trading at $1.904

$1.904 ( 1.01) = $1.923

$1.786 – $1.923$1.923

X 100 = -7.1%Now, it looks like the British pound is undervalued

The real exchange rate is the price level adjusted exchange rate. Its meant to capture the relative value of goods and services across countries

P

PeRER

*

Nominal Exchange Rate

Domestic CPI

Foreign CPI

By definition, the PPP explanation of exchange rates assumes that the real exchange rate is constant (and equal to one)

50

100

150

200

250

300

Jan-85 Jan-89 Jan-93 Jan-97

Yen/$ Real

Empirically, real exchange rates are clearly not constant. In fact, the correlation between real and nominal exchange rates is nearly one. This casts some serious doubt on PPP.

One difficulty with PPP is that it requires arbitrage of goods, which can be costly (shipping costs, tariffs, taxes, etc). Arbitrage with assets is relatively costless.

i = 6% i = 4%

Suppose we have the following interest rates in the US and England. The current exchange rate is $1.25/L and the brtish pound is expected to appreciate by 10% to $1.375/L over the next year.

1Buy Pounds at $1.25 (you will get L800) and buy British bonds

2Short $1,000 in T-Bills (You will owe $1,060 in one year)

On maturity, your British bonds pay L832 (4%)3

Convert to dollars at $1.375 (You will have $1,144) and pay off loan

4

Interest Rate Parity is an arbitrage condition for assets. It states that assets with similar risk characteristics should produce the same common currency yield.

i = 3.20%

(March 2005)

i = 4.59%

(March 2005)

Interest Parity

*% iie 59.42.3

1.39%The dollar should appreciate by 1.39% against the pound

12 months ago, the British pound was trading at $1.904

$1.904 ( .986) = $1.877

$1.786 – $1.877$1.877

X 100 = -4.8%

Interest parity fails just as miserably as PPP does for predicting exchange rate movements…actually, if you look closely, they are actually the same condition.

*% iie Interest Parity Condition

The nominal interest rate equals the real interest rate plus inflation

**% rreIntegrated world capital markets insure that the real return is equalized across countries

*rr *% e Purchasing Power Parity

So, if both interest parity and purchasing power parity fail, then how are we supposed to predict movements in exchange rates?

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