Openness in goods and financial markets• Goods markets: frictions to free trade through tariffs and quotas.• Financial markets: frictions to free trade through capital controls.• Factor markets – in long run, labor and capital are also potentially mobile across countries.U.S Imports and exports:• Grown steadily in last 50 years.• 1930 Smoot-Hawley act – sharp reduction in trade volume.• Surpluses and deficits:– 1940’s post-war period.– Mid-1980’s – links to strong dollar and budget deficits.– Current period.Determinants of openness:• Tradeable goods share better measure of degree of openness (extent to which U.S producers subject to world competitive pressures).• Openness depends on:– Size (Belgium vs U.S)– Proximity to trading partners (Iceland vsBelgium).84Belgium27United KingdomNetherlandsAustriaSwitzerlandCountryGermanyJapanUnited StatesRatios of Exports to GDP for Selected OECD Countries, 2000Table 18-1743348104511Export Ratio (%)Export Ratio (%)CountryReal vs nominal exchange rates• Open economy: decision whether to purchase domestic or foreign goods depends on the real exchange rate –the price of foreign goods relative to domestic good.• The nominal exchange rate – the price of a foreign currency in terms of a domestic currency is what we observe.• Let E denote the amount of dollars it takes to buy one unit of foreign currency. Ex: 1.2$ to buy one Euro.– An appreciation of the U.S. dollar implies that it takes less dollars to buy a unit of foreign currency: E falls.– A depreciation of the U.S. dollar implies that it take more dollars to buy a unit of foreign currency: E rises.Real exchange rates: an example• If the price of a Jaguar is £30,000, and a pound is worth 1.5 dollars, then the price of the Jaguar in dollars is £30,000 x $1.5 = $45,000.• If a Cadillac is $40,000, then the relative price of a Jaguar in terms of Cadillacs is $45,000/$40,000 = 1.12• To generalize this example to all of the goods in the economy, we use a price index for the economy, or the GDP deflator.Real exchange rates• Let P = domestic price level, P* foreign price level then the real exchange rate is defined as•Example: ε≡EPP*PP* = price of British goods in pounds* = price of British goods in poundsEE= price of pounds in terms of dollars= price of pounds in terms of dollarsEPEP* = price of British goods in dollars* = price of British goods in dollarsReal appreciations vs depreciations• An increase in the relative price of domestic goods in terms of foreign goods is called a real appreciation, which corresponds to a decrease in the real exchange rate, ε.• A decrease in the relative price of domestic goods in terms of foreign goods is called a real depreciation, which corresponds to an increase in the real exchange rate, ε.Trade weighted exchange rates:• To obtain a multi-lateral real exchange rate (the price of foreign traded goods relative to U.S traded goods) we take a weighted average of bilateral exchange rates.• Weights depend on share of trade between countries.• Example: Canada receives high weight in U.S. multi-lateral exchange rate.* Not including Japan.OPEC: Organization of Petroleum Exporting Countries.78315116Others342320OPEC12146864Japan111361186Mexico2834017130Asia*Imports fromExports to1002019Percent1222243232$ BillionsTable 18-2 The Country Composition of U.S. Merchandise Trade, 2000100773Total23178Western Europe23179CanadaPercent$ BillionsCountriesTrade weighted U.S real exchange
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