305 PPT WK12.2-Ch17 STUDENT F24

Openness in Financial Markets: Balance of Payments (BOP)

• Balance of Payments (BOP): A set of accounts that summarize a country’s transactions with the rest of the world.

  • Composed of two parts:

    • Current Account (CA)

    • Financial Account (FA)

  • Statistical discrepancy (SD) accounts for any errors, ensuring BOP = CA + FA + SD ≡ 0.

  • Openness in financial markets enables investors to hold both domestic and foreign assets, allowing for:

    • Portfolio diversification

    • Speculation on foreign interest rate and exchange rate movements.

  • Currency Transactions: Buying/selling foreign assets requires the purchase/sale of foreign currency.

The Current Account (CA)

• Current Account (CA): Records net payments to/from the rest of the world, consisting of transactions above the line.

  • Formula: CA = NX + NIB = Trade Balance + Net Income Balance

    • NX (Net Exports) = Exports (X) – Imports (IM)

    • NIB (Net Income Balance) = Income Received – Income Paid

  • Interpretation of CA:

    • CA > 0 (Surplus): Country lends to the Rest of the World (ROW).

    • CA < 0 (Deficit): Country borrows from the ROW.

The Financial Account (FA)

• Financial Account (FA): Records net foreign holdings of domestic assets, representing transactions below the line.

  • Formula: FA = ↑ in foreign holdings of US assets - ↑ in US holdings of foreign assets + Net Capital Transfers

  • FA balance indicates:

    • FA > 0: Positive net capital flows (inflows).

    • FA < 0: Negative net capital flows (outflows).

  • BOP balance requirement: BOP = CA + FA + SD = 0, where SD reconciles discrepancies.

  • Statistical discrepancy (SD) formula: SD = - (CA + FA).

US Balance of Payments (2018)

• Current Account (in billions):

  • Exports: $2,500

  • Imports: $3,122

  • Trade Balance: -$622 (deficit)

  • Income Received: $1,200

  • Income Paid: $1,067

  • Net Income: $133

  • Current Account Balance: -$489 (deficit)

• Financial Account:

  • Net Capital Transfers: (data missing)

  • Increase in foreign holdings of US assets: $811

  • Increase in US holdings of foreign assets: $301

  • Financial Account Balance: $519

  • Statistical Discrepancy: $30.

GDP vs. GNP

• GDP: Measures geographic production, value added domestically.

• GNP: Measures production by nationality.

  • Formula: GNP = GDP + NIB (Net Income Balance)

  • In nations with large CA surpluses and many foreign assets, GNP can exceed GDP.

Openness in Financial Markets: Uncovered Interest Parity (UIP)

• Investors can distribute wealth (W) between domestic and foreign assets (bonds).

  • The bond choice depends on the expected return.

  • All foreign variables are denoted with a *.

• Comparing Returns Example:

  • Exchange rate = 0.79 £/$, US interest rate i = 10%, UK interest rate i* = 12%.

  • Domestic Bond Return: $1(1+i) = $1.1.

  • Foreign Bond Return:

    • Step 1: Convert $1 into £: $1 (0.79) = £0.79

    • Step 2: Returns in £: £0.79 (1.12) = £0.88

    • Step 3: Convert back to $: £0.88 (1/0.79) = $1.047.

  • Conclusion: US bond provides better returns.

UIP: Uncovered Interest Parity

• Arbitrage must hold, making returns equal:

  • If UIP holds, investors are indifferent to bond choice.

  • Assumes perfect capital mobility and no capital flow limits.

UIP: Linear Approximation and Interest Rate Differentials

• Expected appreciation of domestic currency:

  • If expected appreciation > 0 → Domestic currency is expected to appreciate.

  • If expected appreciation < 0 → Domestic currency is expected to depreciate.

• Restatement: UIP can be expressed as:

  • E_t+1 / E_t = (i - i*).

  • If foreign rate > domestic rate, E_t+1 > E_t implies depreciation and vice versa.

Interest Rates Move Together

• Analysis of 3-Month Nominal Interest Rates in the US and UK since 1970 (data sourced from FRED).

Conclusions and Next Steps

• Openness in goods and financial markets impacts choices based on real exchange rates and relative rates of return.

• Integration into the IS-LM model:

  • IS: Y = C(Y-T) + I(Y, r + x) + G + NX(Y, Y*, ε)

  • LM: r = r

  • UIP: i* - i = E0 = (E_t+1 / E_t - E_t / E_t)

Discussion Questions

1. True or False: The nominal and real exchange rate always move in the same direction.

2. Given the definition of the nominal exchange rate, a nominal exchange rate of 0.75 means that 0.75 dollars is worth one euro.

3. If the dollar is expected to appreciate against the yen, uncovered interest parity implies that the US nominal interest rate must be greater than the Japanese nominal interest rate.