foreign trade in the next two lectures we will develop versions of the is-lm and ad-as models for an...
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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.
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.
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20000
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Millio
n A$
Exports Imports
Importance of external trade
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10
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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
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.
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.
Australian trade deficit
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-10000
-8000
-6000
-4000
-2000
0
2000
4000
Mil
lio
ns
A$
-24
-21
-18
-15
-12
-9
-6
-3
0
3
6
% o
f G
DP
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.
Price of the A$
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0.60
0.80
1.00
1.20
1.40
1.60
1960 1965 1970 1975 1980 1985 1990 1995 2000
US
$ p
er A
$
US$/A$
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.
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?
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$23.06 = 1.30.• But let’s say we want a real exchange rate for
the whole economy, not just for copies of Potter.
Real exchange rate
• We use the general price levels (or GDP deflators) in the two countries. Let P be the Australian price level, and P* be the US price level.
• Real exchange ratee = P / (P*/E)
e = EP/P*
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1960 1965 1970 1975 1980 1985 1990 1995 2000A
us
tra
lian
go
od
s in
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rms
of
US
go
od
s
Nominal exchange rate,
Real exchange rate, e
Real exchange rate
• The real exchange rate then expresses how average prices are moving in Australia with respect to other countries, such as the US.
• The nominal exchange rate of the A$, E, fell against the US$, but the real exchange rate did not fall as much. Why?
• Answer: Average inflation in Australia was higher than in the US, so P grew faster than P* balancing out the drop in E.
Multilateral exchange rates
• The higher is e, the cheaper US goods are compared to Australian goods.
• So far we have been considering only exchange rates between Australia and the US, but Australia trades with many countries. What if the A$ 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.
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.
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$)
Market for A$
• 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.
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.
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.
Interest parity
• For returns on the two assets to be the same, we will have:
1+ it = US$(1+ it*) Et / Et+1e
• Manipulating this and taking logs, it becomes the condition:
it = it* - [(Et+1e - Et)/ Et]
• The domestic interest rate must be equal to the foreign interest rate less the expected rate of appreciation.
• Or it - it* = Expected appreciation of A$.
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.
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1971 1976 1981 1986 1991 1996 2001
Per c
ent
Australian interest rate
U.S. interest rate
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) (+, -)
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
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.
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.
Paul Keating’s J curve
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1980 1985 1990 1995 2000
Rea
l exc
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995=
100)
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Rat
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f tra
de d
efic
it to
GD
P (p
erce
nt)
Trade deficit/GDP (scale at right)
Real exchange rate (scale at
left)