Prof.

Fei DING
The Hong Kong University of Science and Technology

ECON 2123: Macroeconomics

OPEN MARKETS
PREVIOUSLY …

Ch5: Goods and Financial Markets:

The IS-LM Model

LEARNING OBJECTIVES
 Explain and derive the IS relation and the LM relation.
 Define and derive the “grand” equilibrium using the IS-LM Model.
 Apply the IS-LM model to predict and explain effects of fiscal and monetary
policy, both separately and together.

2
Outline of the Course:
PART I: OVERVIEW (CH1-2)
PART II: SHORT-RUN MODEL (CH3-5)
PART III: OPEN ECONOMY (CH18-20)
PART IV: MEDIUM-RUN MODEL (CH6&7)

3
Ch18: Openness in Goods and Financial Markets

LEARNING OBJECTIVES
 Explain how people choose between domestic and foreign goods in terms of
nominal and real exchange rates.
 Understand the role and components of balance of payments.
 Explain how people choose between domestic and foreign assets, and derive the
relation between interest rates and exchange rates.

4
QUOTE OF THE DAY

5
DISCUSSION: THE WORLD IMPACT OF
 Increase in domestic demand results in an increase
in Y, but also leads to a deterioration of the trade
balance.
 Increase in foreign demand leads to an increase in Y
and an improvement in the trade balance.
 Implications:

 Positive.
 Negative.
 It depends.
6
TRADE – EXPORT AND IMPORT

 Up to now we assumed “closed” economy.

 All demand and supply are contained within the
same group of participants.
 New issues arise in open economy as we buy
from and sell to foreigners.
 Balance of payment; exchange rate; trade
restrictions/barriers; etc.
 Will fiscal and monetary policy have different
impacts in open economies?
7
US – EXPORTS AND IMPORTS
Figure 17-2 U.S. Exports and Imports as Ratios of GDP since 1960

Since 1960, exports

and imports have more
than tripled in relation
to GDP. The United
States has become a
much more open
economy.

8
EXPORT RATIOS
Table 17-1 Ratios of Exports to GDP for Selected OECD Countries, 2014

http://data.worldbank.org/indicator/NE.EXP.GNFS.ZS/coun
tries/1W-CN-US?display=graph

9
Can Exports Exceed GDP?

Countries can have export ratios larger than the value

of their GDP because exports and imports may include
exports and imports of intermediate goods.

Singapore’s exports to GDP ratio was 211% in 2010.

What about Hong Kong?

https://www.tid.gov.hk/english/aboutus/publications/tradestat/trad
estat_maincontent.html

10
TRADE – FACTS

 Tradable goods: some goods are more likely to

be traded.
 What are non-tradable goods?
 How to choose between domestic vs. foreign
goods?
 The price of domestic goods relative to foreign
goods  real exchange rate

11
TRADE – EXCHANGE RATE

 What is the (nominal) exchange rate?

 Conversion ratio (price) between two currencies.
 Example: 1 USD = 7.8 HKD
 We can compare the price of the same good in
HK and in US with the exchange rate.
 But the exchange rate is very volatile.
 Huge trading volume and price fluctuations in the
FOREX market.

12
TRADE – EXCHANGE RATE
Figure 17-3 The Nominal Exchange Rate between the Dollar and the
Pound since 1971

Although the dollar has

appreciated
relative to the pound
over the past four
decades, this
appreciation has come
with large swings in the
nominal exchange rate
between the two
currencies.

13
TRADE – EXCHANGE RATE

 Flexible vs. fixed exchange rate

 Flexible: conversion ratio is determined by demand
and supply in the market.
 Fixed: price is maintained at certain level (range) by
certain method.
 Examples
 USD to GBP? USD to HKD?
 How about RMB (Chinese Yuan)?

14
TRADE – EXCHANGE RATE
 Nominal vs. real exchange rate
 Goods can be generally more expensive in one country after
currency conversions.
 Real exchange rate gives us the relative price of goods in
different regions.
𝐸𝑃 𝑃
 Real exchange rate: 𝜖 = or 𝜖 = 𝐸 ∗
𝑃∗ 𝑃
 E: nominal exchange rate (price of home currency in terms
of foreign currency)
 1-unit home currency = E-unit foreign currency
 P: home price level; P*: foreign price level
15
TRADE – EXCHANGE RATE
Figure 18 - 3 The Construction of the Real Exchange Rate

EP
 
P *

16
EXAMPLE: WHAT’S YOUR FAVORITE BAG?

LV Montaigne MM (M41056)

 HK$ 21,800

 US$ 2640 E~0.13 ~1.07

 GBP 1840 E~0.10 ~1.18
 EUR 1980 E~0.11 ~1.21

17
TRADE – EXCHANGE RATE
Figure 17-5 Real and Nominal Exchange Rates between the United
States and the United Kingdom since 1971

18
TRADE – EXCHANGE RATE
 How to interpret the “gap” between nominal and real
exchange rates in the 70s?
 Nominal appreciation of USD in early 1970s: E ↑
 P/P* decreased and more than offset the increase in E 
inflation was higher in the UK than in the US.
 Real exchange rate dropped ( ↓).

 Since the 1990s, nominal and real exchange rates

have moved closely together  US and UK have
similar inflation rates.
19
TRADE – EXCHANGE RATE
 So nominal and real exchange rates can move in
different directions.
 Appreciation (E ↑) vs. depreciation (E ↓) of currency
 For fixed regime, “revaluation” vs. “devaluation”
 Real appreciation ( ↑) vs. real depreciation ( ↓)

EP
 
P *

20
TRADE – EXCHANGE RATE
 Bilateral exchange rates: between two countries
 Multilateral exchange rates: between several countries
 To measure the average price of US goods relative to
the average price of goods of US trading partners, we
use the US share of import and export trade with each
country as the weight for that country  the
multilateral real US exchange rate, or the US real
exchange rate for short.

21
REFRESH
1. A real appreciation means that domestic goods become
less expensive relative to foreign goods after currency
conversions. (True, false, or uncertain?)

2. When the dollar appreciates relative to the pound, the

pound price of the dollar
A) increases.
B) decreases.
C) does not change.
D) increases or decreases, depending on the amount of the
depreciation.
E) changes in the next period.
22
REFRESH
Suppose there is a real depreciation of the dollar. Which
of the following may have occurred?
A) foreign currency has become more expensive in dollars.
B) foreign goods have become more expensive to Americans.
C) the foreign price level has increased relative to the U.S.
price level.
D) all of the above
E) none of the above

23
OPENNESS IN FINANCIAL MARKETS

 Foreign currencies are needed for the trading

of goods and services.
 Trade surplus: exports > imports
 Trade deficit: exports < imports
 People can also invest in domestic and foreign
assets. Trading of global assets also involves
foreign currencies.
 What is the link/relation between the two?
24
BALANCE OF PAYMENTS (BOP)
Table 17-3 The U.S. Balance of Payments, 2014, in Billions of
U.S. Dollars

25
BALANCE OF PAYMENTS (BOP)
 Current account balance + Capital account balance =
0 (in principle; statistical discrepancy in reality)
 Current account balance: sum of net payments to and
from the rest of the world.
 When current account is in deficit, what does it mean?
 Have to borrow from the rest of the world! But how?
 Sell financial assets to the world (money inflow today, but
obligated to return in the future)
 So, Current account deficit = Capital account surplus

26
BALANCE OF PAYMENTS – PECULIARITY
 In principle, a country’s BoP should be zero.
 But the capital accounts for some countries are closed
or controlled.
 For example: China
 “Double surplus” until recently
 The degree of control/restriction is being reduced.
 http://www.simontaylorsblog.com/2012/09/18/chinas-
balance-of-payments-current-and-capital-accounts-now-
pulling-in-different-directions/
 What’s going to happen to RMB exchange rate?
27
DOMESTIC VS. FOREIGN ASSETS

 How to make the choice? Risk and return!

 To diversify (reduce risk), maybe you don’t want to
hold all in domestic assets.
 To get higher return, you also don’t want to hold all
in cash.
 Choose  domestic vs. foreign currency and
domestic vs. foreign (interest-paying) assets.
 Focus on domestic vs. foreign assets.

28
DOMESTIC VS. FOREIGN ASSETS
Expected Returns from Holding One-Year U.S. Bonds or One-Year U.K. Bonds

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.

29
DOMESTIC VS. FOREIGN ASSETS
 If both foreign (with a *) and home bonds are to be
held, they must offer the same expected rate of return.
 1 
(1 + i )  ( E )(1 + i )  
*

t e

E 
t t

t 1

 Uncovered interest parity: you have to “expect” the

future exchange rate – your risk is not “covered”.
 E 
(1 + i )  (1 + i ) 
*


t
e

E 
t t

t 1

30
DOMESTIC VS. FOREIGN ASSETS
Rewrite . Then,

 E  (1 + i ) *

(1 + i )  (1 + i )  (1 + i ) =
*


t t

[1 + ( E  E ) / E )]
e

E 
t t
t e
t 1
t 1 t t

If interest rates and exchange rate changes are small (no more than 10%),
we can use (1+x)(1+y) ≈ 1 + x + y approximation to obtain:

E
e

i i  E
*
t 1 t

t t
E t

31
DOMESTIC VS. FOREIGN ASSETS

E
e

i i  E
*
t 1 t

t t
E t

 LHS: differences between foreign and domestic bond

interest rates
 RHS: expected appreciation rate of domestic currency
You are willing to hold domestic bonds at a lower interest
rate than foreign bonds only because you expect home
currency to appreciate relative to that foreign currency.

If E e
t 1  Et , then it  i
*
t
32
DOMESTIC VS. FOREIGN ASSETS

 If either i or E deviates from the Uncovered

Interest Parity relation, we can trade and earn
profits.
 If US i = 2%, UK i = 5%, expect 4% USD
appreciation relative to GBP. Should we invest
in US or UK bonds?

E
e

i i 
* E t 1 t

t t
E t

33
DOMESTIC VS. FOREIGN ASSETS
Figure 17-8 Three-Month Nominal Interest Rates in the United
States and in the United Kingdom since 1970

U.S. and U.K.

nominal interest
rates have largely
moved together
over the last 40
years.

34
IMPLICATIONS AND CAVEAT
 If we want the exchange rate between two currencies
to stay stable, domestic and foreign interest rates
must move very closely together.
 Example: Hong Kong and the US
 What about the EURO Zone?
 The assumption that investors only hold bonds with
the highest expected return is too strong.
 It ignores transaction costs.
 It ignores risk.
35
Buying Brazilian Bonds

 Back in Sep. 1993, Brazilian bonds were paying a monthly interest

rate of 36.9%, compared to 0.2% monthly rate for US bonds!

 Should we buy Brazilian bonds?

 What’s the depreciation rate of Brazilian currency relative to the USD?

VERY BIG!

 Taking into account the rate of deprecation, monthly return dropped to

1.6%.

 Think about the transaction costs and the risk, was it worth it?

(1 + i ) *

(1 + i ) = t

[1 + ( E  E ) / E )]
t e

t 1 t t

36
REFRESH
1. If there are no statistical discrepancies, countries with current
account deficits must receive net capital inflows. (?)
2. Uncovered interest parity implies that interest rates must be
the same across countries. (?)
3. Which of the following will cause a real appreciation, holding
everything else constant?
A) a reduction in E
B) a decrease in P
C) an increase in P*
D) none of the above

37
REFRESH
Assume that the uncovered interest parity condition
holds. Also assume that the U.S. interest rate is less
than the U.K. interest rate. Given this information, we
know that investors expect
A) the pound to depreciate.
B) the pound to appreciate.
C) the dollar-pound exchange rate to remain fixed.
D) the U.S. interest rate to fall.
E) none of the above

38
SEE YOU NEXT TIME 

 Assigned reading:
 Textbook Chap. 18
 Textbook Chap. 19 (for next time)
 PS3 will be release soon. Please start early.

39