Chapter 13 Open Economy and Exchange Rate

Measure of Openness: Ratio of exports to GDP. In USA, it is

11%.
Another measure of openness is the ratio of exports to tradable
goods. Tradable goods are goods like cars and computers that can
be traded and shipped in international trade. Tradable goods
excludes goods and services such as houses and haircuts. Sixty
percent of total GDP are tradable goods.
U.S. has the lowest export to GDP ratio among the industrialized
countries. Two reasons for this are distance from other countries
and the size of the economy.
Export Ratio of Industrialized Countries:
USA 11% UK 27%
Japan 11% Switzerland 45%
Germany 33% Netherland 76%
Chapter 13 Open Economy and Exchange Rate
Openness in Goods Markets: The ability of consumers to
choose between domestic and foreign goods. No country has a
completely open economy. Most countries resort to tariffs, quotas,
and other types of restrictions.

Openness in Financial Markets: The ability of investors to

choose between domestic assets and foreign assets. Most countries
are trying to eliminate capital controls and move towards open
capital markets.
Openness in Factor Markets: The ability of firms to choose
where to operate and the ability of workers to choose where to work.
Countries try to have free trade areas. However, movements of
plants and labor have resulted in heated political debates in most
countries.
 Chapter 13 Open Economy and Exchange Rate
Trade: Goods we buy from other countries are called imports.
Goods we sell to other countries are called exports. If imports >
exports, we have trade deficit. If imports < exports we have trade
surplus.
Goods We Trade Imports Exports Manufactured
Goods 60% 50% Industrial Materials
20% 17% Agricultural Products 3% 7%
Services 17% 26%

Trading Partners Imports Exports Canada

18% 21%
China 20% 8%
Japan 14% 10% European Union
32% 36% Latin America 22%
28%
Chapter 13 Open Economy and Exchange Rate
Trends in Trade: Net Export = Export – Import
1960 .5% 5% 4.5%
2001 -4% 11% 15% Increase in
imports has been due to oil price increases and purchase of
machinery.

Trade and Transfer of Assets: If NX < 0, we are borrowing from

foreigners or selling some of our assets to them.
If NX > 0, we are lending to foreigners or buying some of their
assets.

PPF and Trade: Production possibilities frontier (PPF) shows the

maximum amount of goods and services that an economy can
produce by using all of its available economic resources efficiently.
Given a two-goods PPF, the slope of the PPF shows the opportunity
cost of one good in terms of the other good.
Chapter 13 Open Economy and Exchange Rate
Take two countries, USA and Japan and two goods, food and fun.
Assume that a certain amount of economic resources can produce
food or fun in USA and Japan as given by the following table (assume
that the quality and productivity of resources are the same in both countries ).

Country Food Fun USA

10 5 Japan 5
10
 Chapter 13 Open Economy and Exchange Rate
Comparative Advantage and Trade: Fun is cheaper in Japan than in
USA, food is cheaper in USA than Japan. Here, Japan has absolute
and comparative advantage in fun and USA has absolute and
comparative advantage in food. A country has absolute advantage in
producing a good if the country can produces the good at a lower
cost than the other country. A country has comparative advantage in
producing a good if the country can produce the good at a lower
opportunity cost than the other country.
Gains from the Trade: If Japan makes fun and trades it with USA
and if USA makes food and trades it with Japan, both countries will
benefit from trade. Trade is a non-zero sum game, if trade is not
manipulated by trade restrictions and/or exchange rates.
Terms of Trade: The quantity of food that USA must pay Japan for
a unit of fun is USA’s term of trade with Japan. Since countries
trade in many goods, terms of trades are calculated as an index
number that averages the terms of trades over all items traded.
Terms of trade are decided by the international forces of demand and supply.
Chapter 13 Open Economy and Exchange Rate
Terms of Trade: USA’s import demand for fun is downward
sloping. The lower the price of fun in terms of food, the more fun US
will import from Japan. Japan’s export supply of fun is upward
sloping. International demand and supply decides the terms of trade
and US import quantity of fun from Japan.
Chapter 13 Open Economy and Exchange Rate
Production Possibilities/Consumption Possibilities: PPF shows the
limits of what a country can produce, not the limits of what it can
consume. A country that doesn’t trade has identical production and
consumption possibilities (CP). With trade, a country can have a
different consumption possibilities than its production possibilities.

Before Trade After Trade Import Export

Food Fun Food Fun Food Fun Food Fun
Prod.&Cons. Prod. Cons. Prod. Cons.

USA 6 2 10 5 0 5 0 5 5 0
Japan 2 6 0 5 10 5 5 0 0 5

Before trade, US terms of trade with Japan was 2 and Japan’s terms
of trade with US was .5. After trade, the terms of trade in both
countries will be the same, one unit of food traded for one unit of fun.
 Chapter 13 Open Economy and Exchange Rate
Pre-Trade & Post-Trade Production and Consumption Possibilities:
The graphs below show the pre-trade and post-trade production and
consumption possibilities for Japan and USA with a constant
opportunity cost PPF.
 Chapter 13 Open Economy and Exchange Rate
Trade Assuming Increasing Opportunity Cost PPF: The graphs
below show the pre-trade and post-trade production and
consumption (C) possibilities for Japan and USA with an increasing
opportunity cost PPF.
 Chapter 13 Open Economy and Exchange Rate
Before Trade After Trade Import Export
Food Fun Food Fun Food Fun Food Fun
Prod.&Cons. Prod. Cons. Prod. Cons.

USA 5 4 8 6 2.5 4.5 0 2 2 0

Japan 2.5 9 2.5 4.5 9 7 2 0 0 2
- Note that, with increasing opportunity cost PPF both countries produce both goods.

- Prod. stands for production, Cons. Stands for consumption

Gains form Trade: Trade allows consumers in US to buy fun at a
cheaper price than if there were no international trade. Consumers
in Japan also gain from trade by buying food at a cheaper price than
if there were no trade.
- With international trade, production of food will increase in USA
and farmers will receive higher prices for their products than if
there were no trade.
 Chapter 13 Open Economy and Exchange Rate
- Japan’s fun industry will produce more fun goods and will receive
higher prices than what they could earn with no trade.
- In US producers of fun products will reduce their production due
to the lower prices of fun and more of the economic resources will be
allocated for production of food.
- The slope of the consumption possibilities line (the terms of trade)
will be the same in both countries.

Trade in Similar Goods: Why do countries trade in similar goods?

The two main reasons are diversity of tastes and economies of scale.

Trade Restrictions: Tariffs and Non-tariff restrictions.

Tariffs: A tax imposed by importing country on foreign goods.
Non-Tariff Restrictions: Quotas, licensing, and voluntary export
restraint.
 Chapter 13 Open Economy and Exchange Rate
Trade Restrictions Many countries use trade restrictions to keep
domestic prices higher than the world level to protect the domestic
industries. These restrictions are Tariffs and quotas.
With a free trade, domestic price
is equal to the world price (Pw).
Total consumed would be Qd,
domestic supply would be Qs,
and imports would be QdQs.
When trade is restricted, price
rises to Pe, the gain to producer
is a. The loss to consumers is a +
b + c and the net economic loss
or dead-weight loss is -(b + c).
Area c under demand curve is
called Consumption Effect and
area b under supply curve is
called Production Effect of tariff.
 Chapter 13 Open Economy and Exchange Rate
U.S. Tariffs: 1930- 2000: The highest tariff in the US was in 1930,
during great depression, with one third of imported goods subject to
60% tariff. Today, the average tariff is below 5% and decreasing.
 Chapter 13 Open Economy and Exchange Rate
The Effect of Tariffs on Imports: A one dollar U.S. tariff on import
of fun from Japan reduces the quantity imported from 5 units to 2.
 Chapter 13 Open Economy and Exchange Rate
Tariffs: Tariffs are taxes on imported goods.
With tariffs, domestic
price rises to Pd. The
gain to domestic
producers is a. The
loss to consumers is a +
b + c + d. The
government earns an
import tax of c.
Therefore, the net loss
to the economy or the
dead-weight loss is b +
d. Area b is called the
production effect of
tariff and area d is
called the consumption
effect of tariff.
 Chapter 13 Open Economy and Exchange Rate
The Effects of a Tariff: A tariff on the import of fun from Japan to
the USA will:
 Decrease supply of fun in USA.
 Increase price of fun in USA.
 Decrease export of food from USA to Japan.

 Decrease price of food in USA.

 Generate income for the government.

 Results in misallocation of economic resources in the USA.

 The value of imports changes as much as the values of exports and
trade remains balanced.
 Chapter 13 Open Economy and Exchange Rate
The Effect of Quotas: A quota of 2 units on quantity imported of
fun goods to the USA increases the price of fun in USA and
generates more profit to the producers of the fun goods in USA.
 Chapter 13 Open Economy and Exchange Rate
Quotas: Import quotas limit the quantities of goods that can be
imported.

With quotas, domestic

price rises to Pd. The
gain to domestic produces
is a. The loss to
consumers is a + b + c +
d. The net loss to the
economy is b + d.
Chapter 13 Open Economy and Exchange Rate
The Effects of a Quota: A quota on the import of fun from Japan to
the USA will have the same effects on the price and the quantity
supplied of fun as with the a tariff. The main difference is that, a
tariff generate income for the government of the importing country.
A quota generates income for the domestic industries of the
importing country.
Voluntary Export Restraint: A voluntary export restraint works like
a quota, except this type of quota is established by the government of
the exporting country, with the consent of the importing country.
The government of the exporting country allocates the export
quantity and the revenue from the restriction among the producers
in the exporting country.
The Case Against Free Trade: National Security, infant-industry,
dumping, and saving jobs. None of these are a valid argument for
trade restrictions.
 Chapter 13 Open Economy and Exchange Rate
Trade and GDP - Exports: Since exports are independent of
domestic income (GDP), an increase in exports will shift aggregate
demand curve (AD) to higher level, resulting in an increase in GDP
from Y1 to Y2, at the amount equal to X times spending multiplier.
 Chapter 13 Open Economy and Exchange Rate
Trade and GDP - Imports: Since imports depend on the
domestic income (GDP), an increase in imports will rotate aggregate
demand curve (AD) downward, resulting in a decrease in GDP from
Y1 to Y2, at the amount equal to M times spending multiplier. With
imports, the simple spending multiplier changes to 1/(1-MPC+m),
where m is marginal propensity to import.
 Chapter 13 Open Economy and Exchange Rate
The Total Effect of Trade On GDP: At lower levels of income
(recessions) the economy usually ends up with more exports than
imports, resulting in trade surplus. As income increases, imports
increases. At higher levels on income, the economy usually ends up
with a trade deficit.
Chapter 13 Open Economy and Exchange Rate
Foreign Exchange Rate: The price of one country’s currency in
terms of another country’s.
Internal perspective quote: $1.00 = 125.11 yen.
External perspective quote: 1 yen = $ 0.008 .
Both definitions are used in practice and are interchangeable.
Exchange Market: Like any other market, demand for and supply
of dollar decide the international value of the dollar (exchange rate).
Spot Market: Purchase and sale of foreign currency for immediate
delivery.
Forward Markets: Purchase and sale of foreign currency to be
delivered in the future.
Demand for Dollar: Demand for dollar is the result of trade with
other countries (exports). As trade in goods and services or capital
transactions with other countries take place, the payments are
settled by trading the currencies of the trading countries.
Chapter 13 Open Economy and Exchange Rate
Demand for Imports: Demand for imports is a function of income
(GDP) and exchange rate: M = f(Y, E)
+
+ where, M is imports, Y is GDP or income,
and E is the real exchange rate. A higher value of dollar makes foreign goods
relatively cheaper, leading to increase in imports.
Demand for Exports: Demand for exports is a function of income or
GDP of foreign countries and exchange rate: X = f(YF , E)

+ - where,
X is exports, YF is the GDP or income of the foreign country, and E is the real
exchange rate. A higher exchange rate makes domestic goods relatively more
expensive, leading to a decrease in exports.
Note: Here we define exchange rate as the price of dollar in terms of foreign
currency. Increase in the exchange rate implies appreciation of dollar and
decrease in exchange rate implies depreciation of dollar. In other words, strong
dollar means higher E and weaker dollar means smaller E.
Chapter 13 Open Economy and Exchange Rate
Demand for Dollars: Quantity Demanded for dollar is inversely
related with the international value of dollar relative to other
currencies (exchange rate). As dollar depreciates from 125 yen/$ to
110 yen/$, quantity demanded for dollar increases from $10 billion to
$12 billion.
Chapter 13 Open Economy and Exchange Rate
Exports and Demand for Dollar: As the export of goods and services
to other countries increases, or the sale of domestic capital and
securities to other countries increases, demand for dollars by foreign
countries increases. This will shift demand curve for U.S. dollars to
the right, from D$1 to D$2.
Dollar Appreciation/Depreciation: A rise in the value of dollar
relative to other currencies is the appreciation of dollar. As the
Japanese yen changes from 125 yen/$ to 110 yen/$, U.S. dollar is
depreciating and the Japanese yen is appreciating.

Appreciation/Depreciation and Trade: An appreciation of U.S.

dollar will result is U.S. goods to be relatively more expensive in
other countries, hurting the exporting industries. As U.S. dollar
depreciates, U.S. goods become relatively cheaper in other countries,
resulting in more exports to other countries and less imports.
Chapter 13 Open Economy and Exchange Rate
Imports and Supply of Dollars: The supply of American dollars in
the international money markets is in response to imports of goods
and services and the demand for foreign currencies by American
companies. As the dollar appreciates from 110 yen/$ to 125 yen/$,
quantity supplied of dollar in international markets will increase
from $11 billion to $14 billion. An increase in imports or purchase of
foreign securities and assets shifts supply of dollar from S1 to S2.
Chapter 13 Open Economy and Exchange Rate
Trade and Exchange Market: The exchange market is the mirror
image of the international trade and capital movements. An increase
in imports or an increase in purchase of capital from foreign
countries by U.S citizens increases supply of U.S. dollars in
international markets, resulting in depreciation of U.S. dollar
relative to other currencies. The reverse happens with exports.
Chapter 13 Open Economy and Exchange Rate
Trade Deficit and the Value of the Dollar: Assume a trade balance
between U.S. and Japan, with the given initial equilibrium in
exchange market, yen/$1 and Q1. Now, suppose that U.S. purchase
of goods and services from Japan results in trade deficit. The trade
deficit will increase supply of U.S. dollars in international money
markets and will shift supply of dollars to S2. At the new
equilibrium the exchange rate will be yen/$2 (depreciation of dollar).
Chapter 13 Open Economy and Exchange Rate
Trade Surplus and the Value of the Dollar: Assume a trade balance
between U.S. and Japan, with the given initial equilibrium in
exchange market, yen/$1 and Q1. Now, suppose that U.S. sales of
goods and services to Japan results in trade surplus. The trade
surplus will increase demand for U.S. dollars in international money
markets and will shift demand for dollars to D2. At the new
equilibrium the exchange rate will be yen/$2 (appreciation of dollar).
Chapter 13 Open Economy and Exchange Rate
Types of Exchange Rate Systems: Gold standard, fixed exchange
rate, freely floating or flexible exchange rate, and managed floating.
Gold Standard: At one time, almost all international payments were
made in gold or currencies denominated in gold. Since the supply of
gold did not keep up with rapidly growing international trade,
countries abandoned the gold standard.
Depreciation /Appreciation: Depreciation is when the international
value of a currency decreases gradually relative to the value of other
currencies. When the exchange rate between yen and US dollar
changes from .0087 to .0079, yen has depreciated and US dollar has
appreciated.
Devaluation/Revaluation: Devaluation is when the government or
central bank of a country reduces the international value of the
currency relative to the currencies of the other countries.
Devaluation and revaluation were a common practice during the
fixed exchange era.
Chapter 13 Open Economy and Exchange Rate
The Balance of International Payments: Records all economic
transactions between domestic residents and residents of foreign
countries over a given period of time.
The Balance of Payments is divided into:
Current Account: Covers transactions involving purchase and sale
of goods and services, plus some transfers.
Capital Account: Covers changes in holdings of financial claims.
Capital Inflows: Arises when domestic country “borrows” from
foreigners, or when domestic country liquidate claims against
foreigners. Capital inflows lead to an increase in the supply of
foreign exchange in the international money market.
Capital Outflows: Arises when domestic country “lends” to
foreigners, or when foreigners liquidate claims against domestic
country. Capital outflows lead to an increase in demand for foreign
currencies.
Chapter 13 Open Economy and Exchange Rate
Distinction Between Short Term and Long Term Capital Flows:
Short-term flows involve debt instruments with term to maturity of
less than one year and highly liquid.
Long-term flows involve debt instruments with term to maturity of
more than one year and less liquid, such as direct Investment.
The Balance of Payments Must Always Balance: Set up on the basis
of double entry bookkeeping, the current account balance must be
offset ( financed) by the capital flows in capital account and official
monetary movements.
Balance of Payments Equilibrium: If a country is operating on a
true flexible exchange rate system, exchange rate will always move
to bring quantity of foreign exchange being supplied in the market
and the quantity being demanded into equilibrium.
It is when we are on a fixed exchange rate system that we can have
Balance of Payments disequilibrium.
Chapter 13 Open Economy and Exchange Rate
The Balance of Payments and Exchange Rate: An American surplus
of dollars leads to a deficit in the US balance of payments. Japanese
will experience a balance of payments surplus.
Chapter 13 Open Economy and Exchange Rate
Fixed Exchange Rate: The international monetary system under the
Bretton Woods agreement used fixed exchange rates until 1970s.
Inflationary pressures of the Vietnam era and emergence of other
strong currencies, such as yen and DM led to the downfall of the
fixed exchange rate system.
With fixed exchange rate, the balance of payments deficit can persist
until the deficit country take an action such as devaluation of
currency or some other arrangement for payments.

Flexible Exchange Rate and Balance of Payments: If exchange rates

are flexible, a surplus of dollars will cause the dollar to depreciate
until the surplus is closed. In Japan, the yen will appreciate until
equilibrium is reached. Overtime, American balance of payments
deficit and Japanese balance of payments surplus will be eliminated.
Chapter 13 Open Economy and Exchange Rate
Why Do We have Balance of Payments Deficit: Japanese policy of
holding and hoarding U.S. dollars in effect is the same as a tariff by
Japanese on their import of goods from the United States and a
subsidy on their exports to the USA.
How Could U.S. hold a Balance of Payments Deficit:
 U.S. dollar has been viewed as international medium of exchange.
 Dollar holdings have been viewed as “insurance” in politically
unstable countries.
 Japan, China and Germany have supported the dollar at
artificially high rates in order to boost American demand for their
goods. These policies have increased employment and economic
growth in these countries.
 Japanese and Chinese policy of holding and hoarding U.S. dollars
in effect is the same as a tariff by Japanese on their import of
goods from the United States and a subsidy on their exports to the
Chapter 13 Open Economy and Exchange Rate
Fixed Exchange Rate and Disequilibrium: If at the Official
Exchange Rate, the quantity of foreign exchange supplied to the
market is persistently less than the quantity demanded, then we have
a balance of payments deficit. To maintain the exchange rate, the
gap must be filled by drawing upon Official Reserves. Balance of
payments surplus is simply the reverse.
Managed Floating: Government authorities sometimes intervene in
the foreign exchange market. Possible reasons for intervention are to
smooth out or calm the exchange rate fluctuations.
Appreciation and Depreciation of Currencies:
March 3, 2003:
$1.00 = 118.69 yen
1 yen = $0.0084
March 3, 2004: U.S. dollar has appreciated relative to March 3, 2003.
$1.00 = 125.11 yen
1 yen = $0.0079
 Chapter 13 Open Economy and Exchange Rate
Elasticity Approach: How much a depreciation or devaluation of a currency can
improve a country’s trade deficit depends on the elasticity of imports (ε me) and
elasticity of exports (εxe) with respect to exchange rate. The condition under which
trade improves is called Marshall-Lerner condition. One version of the condition,
under the assumption of equilibrium (X = M) states that: εxe + |εme| > 1. If this
condition is satisfied, a devaluation or depreciation of currency will improve the
trade balance. Another version of the Marshall Lerner condition is:

ωxεx + ωm(εm - 1) > 0

Where, ωx and ωm are the weight of export and import in total trade (X + M),
respectively. εx and εm are the price elasticities of foreign demand for domestic
country’s export and domestic country’s demand for imports, respectively.

The condition above indicates that more elastic demand, for either import or
export, makes it more likely that the trade balance will improve. If the demand
for imports are elastic (εm>1), then the trade balance will definitely improve.
Chapter 13 Open Economy and Exchange Rate
Arbitrage and Exchange Rate: If exchange rates are inconsistent
with each other in different markets, then arbitragers will buy one
currency in one market and sell it in another market to make profit.
The arbitrage will continue until the two currencies exchange rates
are consistent in both markets.
Law of One Price: The assurance of consistency of exchange rates
between and among foreign exchange markets gives us the law of
one price. The law of one price states that in competitive markets,
with zero transportation costs and an absence of official barriers to
trade, e.g. tariffs, identical goods sold in different countries must sell
at the same price, when their prices are expressed in the same
currency (the same term of trade for trading partners).

Purchasing Power Parity (PPP): The most commonly accepted

theory designed to explain the determination of exchange rates in
the spot market in the long run is the Purchasing Power Parity
Chapter 13 Open Economy and Exchange Rate
PPP states that, in the long run, exchange rates in the spot market
are determined by Current Account flows. The Absolute version of
the PPP Theory says that the exchange rate between the Japanese
yen and the US dollars must be such that the following equation
holds:
PJ = E * P US

Where, PJ is the price in Japan, E is the exchange rate and PUS is the
price in U.S.
The theory states that the equilibrium exchange rate results in
having the same purchasing power in the US, as it does in Japan.

Real Exchange Rate:

The Real Exchange Rate =
Chapter 13 Open Economy and Exchange Rate
The Choice Between Domestic and Foreign Investment:
The choice between the domestic and the foreign investment depends
on the difference between the yield on domestic investment, idt and
the yield on foreign investment, ift at time t, adjusted for expected
changes in exchange rate at time t. That is:
Chapter 13 Open Economy and Exchange Rate