WEEK 7

CHAPTER 18

Openness in Goods and

Financial Markets
 KEY QUESTIONS
 What are the implications of openness?
 How do economies trade both goods and assets with the
rest of the word?
 How do households choose between domestic and
foreign goods?
 What is the exchange rate and how is it determined?
 How do households choose between domestic and
foreign assets?
 What is the Balance of Payments and why does it have a
high profile in political arguments over economic
policy?
STRUCTURE OF MATERIAL COVERED
 Quick overview of the open economy

 The implications of openness in the goods markets

 Nominal exchange rates and real exchange rates

 Bilateral and multilateral exchange rates

 The implications of openness in the financial markets

 The interest rate parity condition

QUICK OVERVIEW OF THE OPEN
ECONOMY
 Implication of openness: economies become linked
QUICK OVERVIEW OF THE OPEN
ECONOMY
 Openness has three distinct dimensions:

1. Openness in goods markets. The ability of agents to choose

btwn domestic and foreign goods.
 Free trade restrictions include tariffs and quotas.

2. Openness in financial markets. The ability of financial

investors to choose btwn domestic assets and foreign assets.
 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
QUICK OVERVIEW OF THE OPEN
ECONOMY
 In the SR and MR, openness in factor markets plays
much less of a role than openness in either goods and
financial markets

 Focus on openness in goods and financial markets

QUICK OVERVIEW OF THE OPEN
ECONOMY
 Structure:

 18.1. Openness in goods markets: determinants of the

choice between domestic and foreign goods  role of
real exchange rates (relative price of domestic goods in
terms of foreign goods)

 18.2. Openness in financial markets: determinants of the

choice between domestic and foreign assets  role of
interest rates and exchange rates
THE IMPLICATIONS OF OPENNESS IN
THE GOODS MARKETS

 Figure 18.2 South Africa’s exports and imports as ratios of

GDP since 1960
 Trend in the Imports/GDP and Exports/GDP
 Since 2004 Imports/GDP > Exports/GDP →SA has
consistently run a trade deficit
MEASURE OF OPENNESS
 Openness = average of the ratios of exports and imports to
GDP.

 The higher the ratio →more open an economy is.

 This measure is not necessarily the best because:

1. Exposure to foreign competition

2. Geography matters

3. Size matters
RATIOS OF EXPORTS TO GDP FOR
SELECTED OECD COUNTRIES, 2012

 Table 18.1 Ratios of exports to GDP for selected OECD

countries, 2012

 South Africa’s export ratio is 31%

SIZE MATTERS: EXAMPLE
 A country imports intermediate goods for R1billion
(R1000 million)
 Suppose it transforms them into final goods using labour
at a cost of R200million
 →Value of final goods = R1200million
 Assume that R1000million worth of final goods is
exported and R200million is consumed domestically.
 GDP = R200million
 Ratio of exports to GDP= R1000million / R200million =
5
OPENNESS IN GOODS MARKETS
 The choice between Domestic goods and foreign
goods:
 When goods markets are open, domestic consumers must
decide on
1. how much to consume and save
2. whether to buy domestic goods or to buy foreign
goods effects on domestic output

 Central to the second decision is the price of domestic

goods relative to foreign goods, or the real exchange rate
 not directly observable (nominal vs real)
OPENNESS IN GOODS MARKETS
 Exchange Rates
 a) Nominal exchange rate

 Definition: Its the price of one currency in terms of

another or the relative prices of currencies.
 Quote: Nominal exchange rates between two
currencies can be quoted in one of two ways:
A. Price of foreign currency in terms of the domestic
currency. Example: Dollar in terms of the Rand
(US$1=R14.49)
B. Price of domestic currency in terms of the foreign
currency. Example: Rand in terms of Dollars
(R1=US$0.07)
OPENNESS IN GOODS MARKETS
 Both definitions refer to the same:

 Definition A = 1/Definition B

 The important thing is to remain consistent.

 For this course, we shall adopt the second definition [ie

definition B (ER/$) ] and denote the currency by E.
OPENNESS IN GOODS MARKETS
 Movements in Nominal Exchange Rate
 The name for the nominal exrate changes depends on the
exchange rate system followed by a country:
 Flexible exchange rate system:
 a) Appreciation of the domestic currency--- is a rise in the exchange
rate (one Rand will get us more US$ E (From Example R1 –
US$0.07 to R1 – US$0.10) rand strengthens (USD weakens)
 b)Depreciation of the domestic currency--- is a fall in the exchange
rate (one Rand will get us less US$ E( From Example R1 – US$0.10
to R1 – US$0.07)  Rand weakens (USD strengthens)

 Because E expresses the value of one currency in terms of another,

when one currency appreciates the other must automatically depreciate.
OPENNESS IN GOODS MARKETS
 Fixed exchange rate system
 When countries operate under fixed exchange rates, that
is, maintain a constant exchange rate between them, the
terms used are:

 a) Revaluation is an increase in the exchange rate, E

(instead of appreciation)

 b) Devaluation is a decrease in the exchange rate, E

(instead of depreciation)
TREND IN R/US$
OPENNESS IN GOODS MARKETS
 b) Real exchange rate

 Definition: real exchange rate is the relative price of

domestic goods in terms of foreign goods

Measures the purchasing power of a currency

CONSTRUCTION OF RER

1. P = price of SA goods in Rands

2. P* = price of US goods in dollars

EP
 
P *
OPENNESS IN GOODS MARKETS
 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;
↑real exchange rate,   domestic goods become
relatively more expensive
 A decrease in the relative price of domestic goods in
terms of foreign goods is called a real depreciation,
↓real exchange rate,   domestic goods become
relatively cheaper
OPENNESS IN GOODS MARKETS
 ε changes for 2 reasons:
 Fluctuations in E
 Fluctuations in P/P*

 If inflation rates among the countries were equal, P/P*

would be constant  ε and E would move exactly
together.

 If inflation rates among countries differ over time  ε and

E would drift apart
OPENNESS IN GOODS MARKETS

Figure 18.5 Real and nominal exchange rates

between South Africa and the United States
since 1985
OPENNESS IN GOODS MARKETS
 From Bilateral to
Multilateral Exchange
rates:

 Country comparison of SA
trade, percentage of total:

• US is just one of the

countries SA trades with.

• Need of Multilateral
Exchange rates
OPENNESS IN GOODS MARKETS
 Bilateral exchange rates are exchange rates between
two countries. Multilateral exchange rates are
exchange rates between several countries.

How do we go from Bilateral to Multilateral?

 Multilateral/trade weighted/effective real exchange rate:

is a weighted average of exchange rates of domestic and
foreign currencies, where the weight for each foreign
country is equal to its share in trade
OPENNESS IN GOODS MARKETS

Figure 18.6 The South African multilateral real exchange rate since 1985
FOREIGN EXCHANGE INTERVENTION
 Discuss the following in class:

 How is it done?

 Define Currency Wars?

 Advantages and disadvantages of currency wars.

OPENNESS IN FINANCIAL MARKETS
 Openness in financial markets allows Financial
investors:
 to diversify their portfolios,
 to hold both domestic and foreign assets,
 to speculate on foreign interest rate movements, movements
in exchange rates and domestic interest rate.

 Openness in financial markets allows countries :

 torun trade surpluses and deficits. A country that buys
more than it sells (trade deficit) must pay for the difference
by using foreign reserves or borrowing from the RoW.

 How? By making it attractive for foreign financial

investors to increase their holdings of domestic assets
OPENNESS IN FINANCIAL MARKETS
The Balance of Payments (BoP)
 A systematic summary of all the transactions
that take place between one country’s residents
and the Rest of the World

Which are these transactions?

– imports and exports of goods and services
– tourist expenditures
– interest and dividends paid and received
– purchase or sale of financial assets
OPENNESS IN FINANCIAL MARKETS
How are the transactions recorded in the BoP?

 According to the payments or receipts that arise from

such transactions:
 transactions that lead to a receipt of payment from
the rest of the world  Credit

 transactions that lead to a payment to the rest of the

world  Debit

Balance = Credits (+) + Debits (-)

 COMPONENTS OF THE BOP
Current account Capital transfer account
relatively insignificant: includes debt
includes imports and exports of goods and forgiveness or government
services investment grants
income receipts or payments and Transfers
Financial account
International movements of ownership
of financial assets (purchase/sales)

Usually these two sides do not balance out

Most of the difference must be made up by using
foreign reserves (or gold) held at the SARB
Any remaining discrepancy is shown as an
unrecorded transaction (net errors and omissions)
SA BOP 2012
 THE CURRENT ACCOUNT
Main sections:

1. Merchandise exports and imports

2. Trade in services

3. Income receipts/payments

4. Current transfers
 THE CURRENT ACCOUNT
 Merchandise exports and imports:
 include payments and receipts in all tangible goods
 SA Imports require payments to foreign residents (in foreign currency) 
Registered as a debit
 SA exports require payments from foreign residents (in national currency) 
Registered as a Credit

 Trade in services
 Covers the transactions that do not involve a physical asset or commodity
 Includes:

 Shipping of goods and transport of passengers between countries,

 tourism
 financial and insurance services
 professional and technical services
 THE CURRENT ACCOUNT
• Income receipts/payments
– Employee compensation: wages, salaries and other benefits.
- SA resident being paid for working for non-residents  credit
- SA residents employing non-residents  debit
– Investment income includes dividends, interest, profits and other
income earned from the provision of financial capital
- SA residents receiving investment income from assets overseas
 credit
 Payments to non-resident owners of SA assets  debit

• Current transfers: money, goods or services that are transferred

without receiving anything tangible in return
– Ex. Government paying pension to a SA residing overseas,
Immigrants sending money back.
 THE CURRENT ACCOUNT
 If net payments from the RoW are positive  the
country is running a current account surplus

 If net payments from the RoW are negative  the

country is running a current account deficit
THE CAPITAL AND FINANCIAL
ACCOUNT

 The capital and financial account balance, also known as

net capital flows can be:
 positive if foreign holdings of SA assets are greater than
SA holdings of foreign assets.
 Negative if foreign holdings of SA assets are less than
SA holdings of foreign assets.

 Positive net capital flows lead to a capital account

surplus
 Negative net capital flows lead to a capital account
deficit.
THE INTEREST RATE PARITY
CONDITION
Understanding the Choice between Domestic and
Foreign Assets
Two new decisions:
1. Choice of holding domestic money vs foreign money
2. Choice of holding domestic interest-paying assets vs
foreign interest-paying assets

 People hold money to engage in transactions ~

Option 2 is the key issue
THE INTEREST RATE PARITY CONDITION
THE INTEREST RATE PARITY
CONDITION
 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.

 If both SA 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  it )  Et (1  i *t )( e )
Et 1
THE INTEREST RATE PARITY CONDITION

 The assumption that financial investors will hold only

the bonds with the highest expected rate of return is
obviously too strong, for two reasons:
 It ignores transaction costs.
 It ignores risk.
THE INTEREST RATE PARITY
CONDITION
 Getting a better sense of what the interest parity
condition implies:
THE INTEREST RATE PARITY
CONDITION
 A good approximation of the equation above is given by:

 This is the relation you must remember: domestic

interest rate must be (approximately) equal to the foreign
interest rate minus the expected appreciation rate of the
domestic currency.
EQUILIBRIUM IN FINANCIAL
MARKETS
Domestic Bonds versus Foreign Bonds – Examples:

1. Investors choosing between US and SA bonds:

 Suppose that the one-year bond interest rates are:
 SA = 5%
 US= 5%
 Suppose that current E = 100 and the expected E next year =
100

Which bond has the higher expected rate of return?

Both have the same expected return  investors indifferent 

interest parity condition holds
EQUILIBRIUM IN FINANCIAL
MARKETS
Domestic Bonds versus Foreign Bonds – Examples:

2. Investors choosing between US and SA bonds :

 Suppose that the one-year bond interest rates are:
 SA = 5%
 US= 5%
 Suppose that current E = 100 and the expected E next year = 110

Which bond has the higher expected rate of return?

Rand is expected to be worth 10% more than dollar in t+1 (stronger)

 return of US bonds = 5% (interest) – 10% (expected
appreciation of Rand Wrt Rand = -5% vs return of SA bonds = 5%
 SA bonds more attractive
EQUILIBRIUM IN FINANCIAL MARKETS
Domestic Bonds versus Foreign Bonds – Examples:

3. Investors choosing between US and SA bonds:

 Suppose that the one-year bond interest rates are:
 SA = 5%
 US= 6%
 Suppose that current E = 100 and the expected E next year = 120

Which bond has the higher expected rate of return?

Return of US bonds = 6% > SA bonds = 5%  but the expected

appreciation of the R eliminates part of the profit (120-100)/100
 SA bonds more attractive (5% vs -14%)
THE INTEREST RATE PARITY
CONDITION
Conclusion: Should you hold SA bonds or US bonds?
 It depends whether you expect the Rand to appreciate
 vis-à-vis the Dollar over the coming year by more or
 less than the difference between SA and US interest rates.

Assume the interest rates differ by 3%: (i = 2% and i*=5%)

 If you expect the Rand to appreciate over the coming
 year by more than 3.0%, then investing in US bonds
 is less attractive than investing in SA bonds despite
 the higher i*

WHY? you would get higher interest with a US bond
but when it comes to exchange the dollar for the Rand
in t+1, the R will be worth more and you would loose part of
your profit. This lost you need to consider before making the
decision.
THE INTEREST RATE PARITY
CONDITION
 If you expect the Rand to appreciate by less than 3.0% or
even to depreciate, then the US bonds are more attractive
than SA bonds (the expected appreciation or depreciation
is not enough to cover the interest rate differential)

 If the uncovered interest parity condition holds and SA

interest rate is 3% lower than the US (from example), it
must be true that financial investors are expecting, on
average, an appreciation of the Rand wrt the dollar over
the coming year of 3%.
 This is why they are willing to hold SA bonds despite
their lower interest rate.
 SUMMARY
We have set the stage for the study of an open
economy:

– 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
• the expected appreciation or depreciation of the domestic
currency.