CHAPTER 18. OPENNESS IN GOODS AND FINANCIAL MARKETS 1. Openness in Goods Markets Openness in goods markets means that domestic residents are able to buy foreign goods and sell domestic goods abroad. Goods sold to foreigners are called exports. Goods bought from foreigners are called imports. The difference between exports and imports is the trade balance. A negative trade balance is called a trade deficit, and a positive one a trade surplus. In the closed economy model developed earlier in the book, domestic residents made only one decision—how much to spend. In an open economy, domestic residents make two decisions—how much to spend and how much to spend on domestic (as opposed to foreign) goods. The latter decision depends on the real exchange rate, the relative price of foreign goods in terms of home goods. The real exchange rate depends on the nominal exchange rate (E), the foreign price level (P*), and the home price level (P). The nominal exchange rate is defined as the home currency price of foreign currency. So, for example, if the United States were the home country, and one dollar traded for 100 yen, the nominal exchange rate would be 0.01 dollars/yen. Given this definition, an increase in the exchange rate means that the home currency loses value (i.e., one unit of the foreign currency is worth more units of the home currency). A currency is said to depreciate when it loses value and to appreciate when it gains value. Thus, a depreciation (appreciation) of the home currency means an increase (decrease) in E. Suppose Japan, the foreign country, produces only one good, cars. If a car were to sell for P* in Japan, its price in dollars would be EP*. Note that E is in units of dollars/yen and P* in units of yen per car, so EP* is in units of dollars/car. Now assume that the United States, the home country, also produces only one good, computer games. One could compare the dollar price P of computer games produced in the United States to the dollar price of cars produced in Japan. This motivates the definition of the real exchange rate (ε): ε=EP*/P. (18.1) In this one-good-per-country example, the real exchange rate would have units of home goods per foreign good (in this case, computer games per car). The nominal exchange rate has units of home currency per foreign currency. Since in fact there are many goods, in practice the real exchange rate is defined over baskets of goods, and P and P* refer to price indices. As such, the real exchange rate is also an index: its level is arbitrary (since one can choose any base year for the price indices), but its rate of change is well defined. In terms of price indices, the real exchange rate measures the price of a basket of goods in the foreign country in terms of baskets of goods in the home country. So, for example, if the real exchange rate is 2, the price of a foreign basket of goods is two home baskets of goods. Which basket depends upon which price index is used. If P refers to the GDP deflator, as in the text, then the real exchange rate measures the price of goods produced in the foreign country in terms of goods produced in the home country. An increase in the relative price of foreign goods is a real depreciation (an increase in ε). An increase in the relative price of home goods is a real appreciation (a decrease in ε). Since a country has many trading partners, the bilateral real exchange rate defined above is often replaced by a multilateral real exchange rate, which is a weighted average of the real exchangerate against each of the country’s trading partners. The weights are the shares of total home country trade with each country. 2. Openness in Financial Markets Openness in financial markets means that domestic residents are able to exchange assets (stocks, bonds, and money) with residents of other countries. There is link between trade in assets and trade in goods. Trade in assets allows countries to borrow from one another. Thus, countries that run trade deficits can finance them by borrowing from countries that run trade surpluses.1 The balance of payments summarizes the transactions of one country with the rest of the world. It has two components. The first, the current account, is the sum of the trade balance, net investment income received from abroad, and transfers. As such, the current account is a record of net income received from the rest of the world. The second component of the balance of payments, the capital account, measures the purchase and sale of foreign assets. The capital account is defined as the net decrease in foreign assets (i.e., the increase in home assets held by foreigners minus the increase in foreign assets held by home country residents). Apart from a statistical discrepancy, the current account and the capital account sum to zero by construction. The intuition behind balance of payments accounting is simple. Think of a country as a single person. A country with a negative current account balance (a deficit) spends more than its income. To finance the deficit, it can either sell some of its existing assets to foreigners or borrow from foreigners (sell bonds to foreigners). By definition, these transactions have a positive sign in the capital account. Likewise, a country with a positive current account balance (a surplus) spends less than its income. It can dispose of the extra income by purchasing foreign assets or making loans to foreigners (buying foreign bonds). By definition, these transactions have a negative sign in the capital account. The capital account measures a country’s aggregate financial transactions with the rest of the world. Individual investment decisions are governed by the relative returns on home and foreign assets. The text assumes that domestic residents do not use foreign currency to purchase goods. Thus, there is no transactions motive for domestic residents to hold foreign currency. In addition, the text continues to assume that stocks and bonds are perfect substitutes, so it limits attention to home and foreign bonds. How does one choose between home and foreign bonds? Suppose a U.S. resident has a dollar to invest. Let i be the interest rate on U.S. bonds and i* the interest rate on Japanese bonds. Consider the choice between U.S. and Japanese bonds. Option 1: Buy U.S. bonds The return on one dollar equals 1+ it dollars. Option 2: Buy Japanese
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