Chapter 18. Openness in Goods andFinancial MarketsWe have assumed until now that the economy was closed—that it did notinteract with the rest of the world. We had to start this way, to keep thingssimple and build up your intuition for the basic macroeconomic mechanisms.We are now ready to relax this assumption. Understanding the macroeconomicimplications of openness will occupy us for this and the next three chapters.“Openness” has three distinct dimensions:1. Openness in goods markets—the ability of consumers and firmsto choose between domestic goods and foreign goods. In no countryis this choice completely free of restrictions: Even the countries mostcommitted to free trade have tariffs—taxes on imported goods—andquotas—restrictions on the quantity of goods that can be imported—on at least some foreign goods. At the same time, in most countries,average tariffs are low and getting lower.2. Openness in financial markets—the ability of financial investorsto choose between domestic assets and foreign assets. Until recentlyeven some of the richest countries, such as France and Italy, had cap-ital controls—restrictions on the foreign assets their domestic res-idents could hold and on the domestic assets foreigners could hold.These restrictions are rapidly disappearing. As a result, world financialmarkets are becoming more and more closely integrated.13. Openness in factor markets—the ability of firms to choose whereto locate production, and of workers to choose where to work. Herealso trends are clear. Multinational companies operate plants in manycountries and move their operations around the world to take advantageof low costs. Much of the debate about the North American FreeTrade Agreement (NAFTA) signed in 1993 by the United States,Canada, and Mexico centered on its implications for the relocationof U.S. firms to Mexico. Similar fears now center around China. Andimmigration from low-wage countries is a hot political issue in countriesfrom Germany to the United States.In the short run and in the medium run—the focus of this and the next threechapters—openness in factor markets plays much less of a role than opennessin either goods markets or financial markets. Thus, I shall ignore openness infactor markets, and focus on the implications of the first two dimensions ofopenness here.Section 18–1 looks at openness in the goods market, the determinants of thechoice between domestic goods and foreign go ods, and the role of the realexchange rate.Section 18–2 looks at openness in financial markets, the determinants of thechoice b etween domestic assets and foreign assets, and the role of interestrates and exchange rates.Section 18–3 gives the map to the next three chapters.18–1. Openness in Goods MarketsLet’s start by looking at how much the U.S. sells to and buys from therest of the world. Then, we shall be better able to think about the choicebetween domestic go ods and foreign goods, and the role of the relativeprice of domestic goods in terms of foreign goods—the real exchange rate.2Exports and ImportsFigure 18–1 plots the evolution of U.S. exports and U.S. imports, as ratiosto GDP, since 1960 (“U.S. exports” means exports from the United States;“U.S. imports” means imports to the United States.) The figure suggeststwo main conclusions.Figure 18–1. U.S. Exports and Imports as Ratios of GDP; 1960–2003. (Cap-tion. Exports and imports, which were equal to 5% of GDP in the 1960s,are now equal to about 12% of GDP.• The U.S. economy is becoming more open over time. Exports andimports, which were equal to 5% of GDP during the 1960s, now areequal to about 12% of GDP (10% for exports, 14% for imp orts).In other words, the United States trades more than twice as much(relative to its GDP) with the rest of the world as it did just 40years ago.• Although imports and exports have followed broadly the same up-ward trend, they have also diverged for long periods of time, gen-erating sustained trade surpluses and trade deficits.1Two episodesstand out:First, the large trade deficits of the mid–1980s: The ratio of thetrade deficit to GDP reached 3% in 1986, before decreasing to 1%in the early 1990s.Second, the large and increasing trade deficits since the mid–1990s.The ratio of the trade deficit to GDP reached 4.5% in 2003, a his-torical record.1. From Chapter 3: The trade balance is the difference between exports and imports:Exp orts > imports: Trade surplus (equivalently, positive trade balance)Exp orts < imports: Trade deficit (equivalently, negative trade balance)3Understanding the sources and implications of these trade deficits isa central issue in macroeconomics today, and one to which we shallreturn later.Given all the talk in the media about globalization, a volume of trade(measured by the average of the ratios of exports and imports to GDP)around 12% of GDP may strike you as small. However, the volume oftrade is not necessarily a go od measure of openness. Many sectors canbe exposed to foreign competition without the effects of this competitionshowing up in large imports: By being competitive and keeping their priceslow enough, these sectors can retain their domestic market share and keepimports out. This suggests that a better index of openness than export orimport ratios is the proportion of aggregate output composed of tradablegoods—goods that compete with foreign go ods in either domestic marketsor foreign markets.2Estimates are that tradable goods represent around60% of aggregate output in the United States today.It remains true that, with exports around 10% of GDP, the United Stateshas one of the smallest ratios of exports to GDP among the rich countriesof the world. Table 18–1 gives ratios for a number of OECD countries.3Table 18–1. Ratios of Exports to GDP for Selected OECD Countries, 2003.Country Export Ratio Country Export RatioUnited States 10% Switzerland 42%Japan 12% Austria 51%Germany 36% Netherlands 62%United Kingdom 25% Belgium 79%2. Tradable goods: Cars, computers... Non tradable goods: Housing, most medical ser-vices, haircuts...3. For more on the OECD and for the list of member countries, see Chapter 1.4Source : OECD Economic Outlook.The United States and Japan are at the low end of the range of exportratios. The large European countries, such as Germany and the UnitedKingdom, have ratios that are two to three times larger. And the smallerEuropean countries have even larger ratios, from 42% in Switzerland
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