foreign trade

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Foreign trade In the next two lectures we will develop versions of the IS-LM and AD-AS models for an open economy. An open economy can have several meanings: Goods market: trades goods and services Financial market: allow the flow of investment capital Factor market: allows the free movement of companies and people In this class we will focus on the first two: openness in goods and financial markets.

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Foreign trade. In the next two lectures we will develop versions of the IS-LM and AD-AS models for an open economy. An open economy can have several meanings: Goods market: trades goods and services Financial market: allow the flow of investment capital - PowerPoint PPT Presentation

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Page 1: Foreign trade

Foreign trade

• In the next two lectures we will develop versions of the IS-LM and AD-AS models for an open economy.

• An open economy can have several meanings:– Goods market: trades goods and services– Financial market: allow the flow of investment capital– Factor market: allows the free movement of

companies and people

• In this class we will focus on the first two: openness in goods and financial markets.

Page 2: Foreign trade

How open is the Australian economy?

• You could measure the size of imports or exports (why not both?) in the Australian economy.

• But this would lead to the same problems as measuring GDP in nominal terms.

0

20000

40000

60000

80000

100000

120000

Millio

n A$

Exports Imports

Page 3: Foreign trade

Importance of external trade

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5

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15

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35

40

1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001

Rat

io t

o G

DP

(pe

rcen

t) Imports/GDP

Exports/GDP

Page 4: Foreign trade

Globalization?

• Much is made of the “new” impact of globalization in the world economy.

• But from the previous graph, the Australian economy is as dependent (even less) on the rest of the world as it was one century ago.

• “Globalization” must be referring to something else instead- the free flow of people and ideas across the world- rather than goods and services.

Page 5: Foreign trade

Trade balance

• We define a term “net exports”, which is just exports minus imports, X – M.

• If X>M, we say we are in a “trade surplus” and if X<M, we say we are in a “trade deficit”.

• The trade deficit in Australia has grown large in nominal terms in the last twenty years, but as a percentage of GDP, it has stayed constant (or even fallen).

• Later, we will explore what an Australian trade deficit means.

Page 6: Foreign trade

Australian trade deficit

-12000

-10000

-8000

-6000

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-2000

0

2000

4000

Mil

lio

ns

A$

-24

-21

-18

-15

-12

-9

-6

-3

0

3

6

% o

f G

DP

Page 7: Foreign trade

Nominal exchange rates

• When we talk of “exchange rates”, we have to be cautious, as there are many types of “exchange rates” that are used.

• The “nominal exchange rate” is the rate at which the Australian dollar (A$) trades for other currencies- the “price of the Australian dollar”.

• Example: If the Australian dollar trades for $0.80, we mean that A$1 is worth US$0.80.

• Note that there will be as many nominal exchange rates as there are other currencies.

• For Australia, the reference currencies are usually US$ and the Japanese Yen.

Page 8: Foreign trade

Price of the A$

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1.60

1960 1965 1970 1975 1980 1985 1990 1995 2000

US

$ p

er A

$

US$/A$

Page 9: Foreign trade

Appreciation and depreciation

• When we talk of an “appreciation of the A$”, we mean that the price of the A$ in terms of another currency has increased, so the A$ was appreciating in 1973.

• When we talk of a “depreciation of the A$”, we mean that the price of the A$ in terms of another currency has decreased, so the A$ has generally depreciated against the US$ since the mid 1970s.

• But these are nominal terms, and don’t signify much in reality.

Page 10: Foreign trade

Real exchange rate

• We would like to have an exchange rate that got rid of the effects of prices and concentrated on “real” effects, just as we do with real GDP.

• We would like instead to talk simply in terms of how Australian goods trade for American goods.

• Example: Harry Potter and the Half-Blood Prince sells for US$17.99 at www.amazon.com, while at www.dymocks.com.au it sells for A$29.95.

• What is the real exchange rate between Potter in Australia and Potter in the US?

Page 11: Foreign trade

Real exchange rate

• We need to translate the prices into a common currency, so we will use the Australian $. The nominal exchange rate, E, is US$0.78/$A1.

• One US Potter goes for US$17.99, which is US$17.99/E

US$17.99/(US$0.78/A$1) = A$23.06• The real exchange rate is

A$29.95/A$23.06 = 1.30.• But let’s say we want a real exchange rate for

the whole economy, not just for copies of Potter.

Page 12: Foreign trade

Real exchange rate

• We use the general price levels (or GDP deflators) in the two countries. Let P be the Australian price level, and P* be the US price level.

• Real exchange ratee = P / (P*/E)

e = EP/P*

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1960 1965 1970 1975 1980 1985 1990 1995 2000A

us

tra

lian

go

od

s in

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rms

of

US

go

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s

Nominal exchange rate,

Real exchange rate, e

Page 13: Foreign trade

Real exchange rate

• The real exchange rate then expresses how average prices are moving in Australia with respect to other countries, such as the US.

• The nominal exchange rate of the A$, E, fell against the US$, but the real exchange rate did not fall as much. Why?

• Answer: Average inflation in Australia was higher than in the US, so P grew faster than P* balancing out the drop in E.

Page 14: Foreign trade

Multilateral exchange rates

• The higher is e, the cheaper US goods are compared to Australian goods.

• So far we have been considering only exchange rates between Australia and the US, but Australia trades with many countries. What if the A$ falls against the US$, but rises against the Japanese Yen?

• Multilateral exchange rates show the price of the A$ compared to a weighted average of the currencies of our trading partners, where the weight of a currency depends on the percentage of our trade it composes.

Page 15: Foreign trade

What determines E?

• The nominal exchange rate (say US$/A$) is determined in a market for A$, where you have both supply and demand for A$. E is the price in this market.

• Who demands A$?– Exporters who buy Australian goods to sell overseas.– Foreign investors who buy Australian assets.

• Who supplies A$?– Importers who want to buy overseas goods.– Australian investors who buy foreign assets.

Page 16: Foreign trade

Market for A$

Amount of A$

Demand for A$

•Foreign investors

•Exporters

Supply of A$

•Domestic investors

•Importers

Exchange rate

(cost of 1 A$ in

terms of US$)

Page 17: Foreign trade

Market for A$

• The nominal exchange rate is then affected both by changes in the goods market and also the financial markets.

• But the volume of A$ traded on the world financial markets was A$75 billion per day in 2001, while the volume of goods trade was A$0.7 per day in 2001. Goods trade was only 1% of financial trading in the A$.

• In the short-term, the price of the A$ is determined by changes in financial markets.

Page 18: Foreign trade

Financial market openness

• Openness in financial markets means that investors are free to put their money where they wish.

• Australian investors are free to invest overseas, and foreign investors are free to invest in Australia.

• In this case, investors will put their money where they think it will earn the highest returns.

• In equilibrium that means that expected asset returns must be the same in Australia as overseas.

Page 19: Foreign trade

Domestic and foreign assets

• Return on A$1 invested in Australia for a year:

1+ it• Return on A$1 invested in the US:

A$1 becomes US$Et

US$Et becomes US$(1+ it*)Et

US$(1+ it*)Et becomes US$(1+ it*)Et / Et+1e

• As you have to buy a US asset, earn the US interest rate, i*, and then turn the US$ back into A$ in a year.

Page 20: Foreign trade

Interest parity

• For returns on the two assets to be the same, we will have:

1+ it = US$(1+ it*) Et / Et+1e

• Manipulating this and taking logs, it becomes the condition:

it = it* - [(Et+1e - Et)/ Et]

• The domestic interest rate must be equal to the foreign interest rate less the expected rate of appreciation.

• Or it - it* = Expected appreciation of A$.

Page 21: Foreign trade

Interest parity

• Another way of thinking about this is to remember that you earn money on foreign assets either because of foreign interest rates or because of exchange rate movements.

• If I expect my currency to depreciate, I will need a high interest rate to keep my money in the country.

2.0

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1971 1976 1981 1986 1991 1996 2001

Per c

ent

Australian interest rate

U.S. interest rate

Page 22: Foreign trade

Imports and exports

• We assume that Australian consumers will consume more imports as their income rises and as imports become cheaper (e rises):

IM = IM(Y, e) (+ , +)• We assume that foreign consumers will

consume more Australian exports as foreign income rises and as exports become cheaper (e falls):

X = X(Y*, e) (+, -)

Page 23: Foreign trade

The new IS equation

• Exports are measured in Australian goods, but imports are foreign goods, so we have to translate into Australian good through the real exchange rate, e, so net exports are:

NX = X(Y*, e) – IM(Y, e)/e• This becomes a component of our AD, so

equilibrium in the goods market requires:

Y = C(Y-T) + I(Y, r) + G + NX

Y = C(Y-T) + I(Y, r) + G + X(Y*, e) – IM(Y, e)/e

Page 24: Foreign trade

The new IS equation

• We have a new IS curve which depends on Y and r, and has G, T, Y* and e as parameters.

• An increase in Y* will shift the IS curve to the right, as export demand rises, but what happens when e rises?

• When e rises, perhaps because E rises, X falls and IM rises, as Australian goods are now more expensive. But what happens to IM/e- the value of imports? It is ambiguous.

• Marshall-Lerner condition: A rise in e will lead to a drop in NX.

Page 25: Foreign trade

The J curve

• Typically prices move much faster than goods supply and demand- ie. firms order goods in advance.

• In this case, X and IM will not move when e falls. But that means that NX will initially fall if e falls, even if the Marshall-Lerner condition is satisfied. Eventually however the X and IM will react and NX will rise.

• We saw this in the early 80s in Australia.

Page 26: Foreign trade

Paul Keating’s J curve

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1980 1985 1990 1995 2000

Rea

l exc

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te (1

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P (p

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Trade deficit/GDP (scale at right)

Real exchange rate (scale at

left)