International Financial Market and Korean Economy ISLM framework for an open economy

Openness in Goods and Financial Markets  Openness has three distinct dimensions: 1. Openness in goods markets. Free trade restrictions include tariffsand quotas. 2. Openness in financial markets. Capital controlsplace restrictions on the ownership of foreign assets. 3. Openness in factor markets. The ability of firms to choose where to locate production, and workers to choose where to work. The North American Free Trade Agreement (NAFTA)is an example of this.

International Financial market and Korean Economy

Prepared by Seok-Kyun HUR

IS-LM Framework for an Open Economy Based on Blanchard’s Chapter18~20

Openness in Goods and Financial Markets

 Openness has three distinct dimensions:

1. Openness in goods markets Free trade restrictions

include tariffs and quotas.

2. Openness in financial markets Capital controls place

restrictions on the ownership of foreign assets

3. Openness in factor markets The ability of firms to

choose where to locate production, and workers to

choose where to work The North American Free

Trade Agreement (NAFTA) is an example of this.

Exports and Imports

Since 1960, exports and

imports have more than

doubled in relation to GDP.

U.S Exports and Imports as Ratios of GDP since 1960

 The behavior of exports and imports in the United States

long periods of time, generating sustained trade

surpluses and trade deficits

Exports and Imports

 The main factors behind differences in export ratios are geography and country size:

- Distance from other markets.

- Size also matters: The smaller the country, the more it must

specialize in producing and exporting only a few products and rely on imports for other products.

Table 18-1 Ratios of Exports to GDP for Selected OECD Countries, 2006 Country Export Ratio (%) Country Export Ratio (%)

 When goods markets are open, domestic consumers

must decide not only how much to consume and save, but also whether to buy domestic goods or to buy foreign

 Nominal exchange rates between two currencies can be quoted in one of two ways:

 As the price of the domestic currency in terms of the foreign currency

 As the price of the foreign currency in terms of the domestic currency

Nominal Exchange Rates

 The nominal exchange rate is the price of the foreign

currency in terms of the domestic currency.

 An appreciation of the domestic currency is an

increase in the price of the domestic currency in

terms of the foreign currency, which corresponds

to a increase in the exchange rate.

 A depreciation of the domestic currency is a decrease

in the price of the domestic currency in terms of the foreign currency, or a decrease in the exchange rate

Nominal Exchange Rates

 When countries operate under fixed exchange rates, that is, maintain a constant exchange rate between them, two other terms used are:

 Revaluations, rather than appreciations, which are

decreases in the exchange rate, and

 Devaluations, rather than depreciations, which are

increases in the exchange rate

Nominal Exchange Rates

Let’s look at the real exchange rate between the United States and the UK.

 If the price of a Cadillac in the US is $40,000, and a dollar is

worth 0.50 pounds, then the price of a Cadillac in pounds is

$40,000 X 0.50 = £20,000.

 If the price of a Jaguar in the UK is £30,000, then the price of a

Cadillac in terms of Jaguars would be £20,000/ £30,000 = 0.66.

To generalize this example to all of the goods in the economy, we use a

price index for the economy, or the GDP deflator.

From Nominal to Real Exchange Rates

1 P = price of U.S goods in dollars

2 P* = price of British goods in pounds

*

EP

P

From Nominal to Real Exchange Rates

The Construction of the

Real Exchange Rate

Like nominal exchange rates, real exchange rates move over time:

 An increase in the relative price of domestic goods in

terms of foreign goods is called a real appreciation,

which corresponds to a decrease in the real exchange rate, ε

 A decrease in the relative price of domestic goods in

terms of foreign goods is called a real depreciation,

which corresponds to an increase in the real exchange rate, ε

From Nominal to Real Exchange Rates

From Nominal to Real Exchange Rates

 Except for the difference in trend reflecting higher average inflation in the United Kingdom than in the United States, the nominal and the real exchange rates have moved largely together since 1970.

Real and Nominal Exchange

Rates between the United

States and the United

Kingdom since 1970

 The purchase and sale of foreign assets implies buying or selling foreign currency—sometimes called foreign

exchange

 Openness in financial markets allows:

(1) Financial investors to diversify—to hold both domestic and foreign assets and speculate on foreign interest rate

movements

(2) Countries to run trade surpluses and deficits A country that buys more than it sells must pay for the difference by borrowing from the rest of the world

Openness in Financial Markets

 The decision whether to invest abroad or at home

depends not only on interest rate differences, but also on your expectation of what will happen to the nominal

exchange rate

The Choice between Domestic and Foreign Assets

Expected Returns from

Holding One-Year U.S

Bonds or One-Year U.K

Bonds

 If both U.K bonds and U.S bonds are to be held, they must have the same expected rate of return, so that the following arbitrage relation must hold:

*

1

( 1 + ) ( 1 + ) t

e t

Rearranging the equation, we obtain the uncovered interest

parity relation, or interest parity condition:

Uncovered Interest Parity

 The relation between the domestic nominal interest rate,

the foreign nominal interest rate, and the expected rate of depreciation

of the domestic currency is stated as:

E + − E E

A good approximation of the equation above is given by:

Interest Rates and Exchange Rates

 The balance of payments account summarizes a country’s transactions with the rest of the world.

 Transactions above the line are current account transactions Transactions below the line are capital account transactions

 The current account balance and the capital account balance should be equal, but because of data gathering errors they

don’t For this reason, the account shows a statistical

discrepancy

The Balance of Payments

Table 18-3 The U.S Balance of Payments, 2006 (in billions of U.S dollars)

Investment income paid 629

Net investment income (2) -9 Net transfers received (3) -84 Current account balance (deficit = -) (1) + (2) + (3) -856

Capital Account

Increase in foreign holdings of U.S assets (4) 1,764

Increase in U.S holdings of foreign assets (5) 1,049

Capital account balance (deficit = -) (4) − (5) 715 Statistical discrepancy 141

The Balance of Payments

We define market openness in the goods market and the

financial markets(Money and bonds market)

 The choice between domestic goods and foreign goods

depends primarily on the real exchange rate.

 The choice between domestic assets and foreign assets

depends primarily on their relative rates of return, which depend on domestic interest rates and foreign interest rates, and on the expected depreciation of the domestic currency.Summing up

 Now we must be able to distinguish between the domestic

demand for goods and the demand for domestic goods.

Some domestic demand falls on foreign goods, and some

of the demand for domestic goods comes from foreigners

Goods Market in an Open Economy

 In an open economy, the demand for domestic goods is given by:

 The first three terms—consumption, C, investment, I, and

government spending, G—constitute the domestic demand for

goods.

 Until now, we have only looked at C + I + G But now

we have to make two adjustments:

 First, we must subtract imports

 Second, we must add exports

/

Z ≡ + + − C I G IM ε + X

The Demand for Domestic Goods

 Domestic Demand:

( + ) (+,-)

 The real exchange rate affects the composition

of consumption and investment, but not the overall

level of these aggregates

The Determinants of C, I, and G

 A higher real exchange rate leads to higher imports,

thus:

 An increase in domestic income, Y, leads to an

increase in imports

 An increase in the real exchange rate, , leads to

an increase in imports, IM

 Let Y* denote foreign income, thus for exports we

Putting the Components Together

The domestic demand for

subtracting the value of

imports from domestic

demand, and then adding

exports (Panel b)

The Demand for Domestic

Goods and Net Exports

Putting the Components Together

The demand for domestic

goods is obtained by

subtracting the value of

imports from domestic

demand, and then adding

exports (Panel c)

The trade balance is a

decreasing function of

output (Panel d)

The Demand for Domestic

Goods and Net Exports

 We can establish two facts about line AA, which will be

useful later in the chapter:

domestic demand for domestic goods increases less than total domestic demand

 As long as some of the additional demand falls on

domestic goods, AA has a positive slope

 Y TB is the value of output that corresponds to a trade balance.

Putting the Components Together

Equilibrium Output and the Trade Balance

 The goods market is in equilibrium when domestic

output equals the demand – both domestic and foreign – for domestic goods:

 Collecting the relations we derived for the components of

the demand for domestic goods, Z, we get:

Y = Z

Equilibrium Output and the Trade Balance

The goods market is in

equilibrium when

domestic output is equal

to the demand for

domestic goods At the

equilibrium level of

output, the trade balance

may show a deficit or a

surplus

Equilibrium Output

and Net Exports

Increases in Domestic Demand

 There are two important difference you should

note between open and closed economies:

 There is now an effect on the trade balance The

increase in output from Y to Y’ leads to a trade

deficit equal to BC Imports go up, and exports

do not change

 Government spending on output is smaller than it would be in a closed economy This means the

multiplier is smaller in the open economy.

Increases in Domestic Demand

Increases in Foreign Demand

The direct effect of the increase in foreign output is

an increase in U.S exports by some amount, which

We have derived two basic results so far:

 An increase in domestic demand leads to an

increase in domestic output, but leads also to a

deterioration of the trade balance

 An increase in foreign demand leads to an increase

in domestic output and an improvement in the trade balance

Fiscal Policy Revisited

Recall that the real exchange rate is given by :

In words, the real exchange rate, , is equal to the

nominal exchange rate, E, times the domestic price level,

P, divided by the foreign price level, P*.

*

EP P

ε ≡

ε

Depreciation, the Trade Balance, and Output

As the real exchange rate ε enters the right side of the

equation in three places, this makes it clear that the real

depreciation affects the trade balance through three separate channels:

goods, 1/e, increases.

( , ) ( , ) /

Depreciation and the Trade Balance:

The Marshall–Lerner Condition

 The Marshall-Lerner condition is the condition under which a real depreciation (a decrease in ε) leads to an increase in net exports.

 Then, What is the condition?

Depreciation and the Trade Balance:

The Marshall–Lerner Condition

The J-Curve Effect

A real depreciation leads

initially to a deterioration and

then to an improvement of the

trade balance

The J-Curve

 A depreciation may lead to an initial deterioration of the trade balance; ε increases, but

neither X nor IM adjusts very much initially

 Eventually, exports and imports respond, and depreciation leads to an improvement of the trade balance.

The J-Curve Effect

The real appreciation and

depreciation of the dollar in

the 1980s were reflected in

increasing and then

decreasing trade deficits

There were, however,

substantial lags in the effects

of the real exchange rate on

the trade balance

The Real Exchange Rate

and the Ratio of the Trade

Deficit to GDP: United

States, 1980 to 1990

Combining Exchange Rate and Fiscal Policies

To reduce the trade deficit

without changing output, the

government must both

achieve a depreciation and

decrease government

spending

Reducing the Trade Deficit

without Changing output

Exchange-Rate and Fiscal Policy Combinations

Initial Conditions Trade Surplus Trade Deficit

Low output ε? G↑ ε ↓ G?

High output ε↑ G? ε? G↓

 If the government wants to eliminate the trade deficit

without changing output, it must do two things:

 It must achieve a depreciation sufficient to eliminate the trade deficit at the initial level of output

 The government must reduce government spending

Combining Exchange Rate and Fiscal Policies

 The alternative way of looking at equilibrium from the condition that investment equals saving has an important meaning:

 Subtract C + T from both sides and use the fact that private saving is given by S = Y – C – T to get

 Use the definition of net exports, , and reorganize, to get:

 From the equation above, we conclude:

 An increase in investment must be reflected in either

an increase in private saving or public saving, or in a deterioration of the trade balance

 An increase in the budget deficit must be reflected in an increase in either private saving, or a decrease in

investment,

or a deterioration of the trade balance

 A country with a high saving rate must have either a

high investment rate or a large trade surplus

Saving, Investment, and the Trade Balance

NX = + S T − G − I

Output, the Interest Rate, and the Exchange Rate

 The model developed in this chapter is an extension of

the open economy IS-LM model, known as the

Mundell-Fleming model

 The main questions we try to solve are:

 What determines the exchange rate?

 How can policy makers affect exchange rates?

45

 Equilibrium in the goods market can be

described by the following equations:

 Consumption, C, depends positively on disposable

income, Y - T.

 Investment, I, depends positively on output Y, and negatively

on the real interest rate, r

 Government spending, G, is taken as given.

 The quantity of imports, IM, depends positively on both

output, Y, and the real exchange rate

 Exports, X, depend positively on foreign output Y*, and

negatively on the real exchange rate

εε

Equilibrium in the Goods Market

47 of 31

The main implication of this equation is that both the real

interest rate and the real exchange rate affect demand and,

in turn, equilibrium output:

 An increase in the real interest rate leads to a decrease in

investment spending, and to a decrease in the demand for domestic goods

 An increase in the real exchange rate leads to a shift in

demand toward foreign goods, and to a decrease in net

 For Simplifications, let’s assume the following.

Then, the equilibrium condition becomes:

 Now that we look at a financially open economy, we

must also take into account the fact that people have a

choice between domestic bonds and foreign bonds

 We wrote the condition that the supply of money

be equal to the demand for money as:

 Then, we can use this equation to think about the

determination of the nominal interest rate in an open economy

M

P = YL i ( ) Equilibrium in Financial Markets

50

 What combination of domestic and foreign

bonds should financial investors choose in order

to maximize expected returns?

1 + 𝑖𝑖𝑡𝑡 = 1 + 𝑖𝑖𝑡𝑡∗ 𝐸𝐸𝐸𝐸𝑡𝑡

𝑡𝑡+1𝑒𝑒

 The left side gives the return, in terms of domestic

currency The right side gives the expected return,

also in terms of domestic currency In equilibrium,

the two expected returns must be equal

Domestic Bonds versus Foreign Bonds

51 of 31