305 PPT WK12.2-Ch17 STUDENT F24

Openness in Financial Markets

Balance of Payments (BOP)

• Definition: A summary of a country’s transactions with the rest of the world.

• Composition: Includes two main parts:

  • Current Account (CA)

  • Financial Account (FA)

• Statistical Discrepancy (SD): Balances out errors to ensure BOP = 0.

• Equation: BOP = CA + FA + SD ≡ 0

• Importance of Openness: Enables investment in domestic and foreign assets (bonds, equity). Facilitates portfolio diversification and speculation on foreign interest rates and foreign exchange (FX) movements.

• Foreign Currency Transactions: Involves buying/selling foreign assets which implies trading foreign currencies.

Current Account (CA)

• Definition: Records net payments to/from the rest of the world (transactions above the line).

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

  • Net Exports (NX): Exports (X) - Imports (IM)

  • Net Income Balance (NIB): Income received - Income paid

• CA Surplus: CA > 0, indicating the country is lending to the rest of the world.

• CA Deficit: CA < 0, indicating borrowing from the rest of the world.

Financial Account (FA)

• Definition: Records net foreign holdings of domestic assets (transactions below the line).

• Equation: FA = Increase in foreign holdings of US assets - Increase in US holdings of foreign assets + Net Capital Transfers

• Net Capital Flows:

  • FA Balance = Net capital flows which indicates an increase in net foreign indebtedness.

• FA Surplus: FA > 0 indicates positive net capital inflows.

• FA Deficit: FA < 0 indicates negative net capital outflows.

• BOP Balancing Equation: The financial account must equal the overall balance so that BOP = CA + FA + SD = 0.

• Statistical Discrepancy (SD): It measures the gap between current and financial account transactions; expressed as SD = - (CA + FA).

2018 US Balance of Payments Overview

• Current Account:

  • Exports = $2,500 billion

  • Imports = $3,122 billion

  • Trade Balance (Deficit) = -$622 billion

  • Income Received = $1,200 billion

  • Income Paid = $1,067 billion

  • Net Income = $133 billion

  • Current Account Balance = -$489 billion

• Financial Account:

  • Net Capital Transfers = Unknown

  • Increase in Foreign Holdings of US Assets = $811 billion

  • Increase in US Holdings of Foreign Assets = $301 billion

  • Calculated Financial Account Balance = $519 billion

  • Statistical Discrepancy = Financial Account - Current Account Balance = $30 billion.

GDP vs. GNP

• GDP: Measures the value added domestically – a geographic production measure.

• GNP: Measures value added by domestic factors of production – a production measure by nationality.

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

• Significance: For countries with large current account surpluses, GNP can exceed GDP due to substantial foreign asset accumulation.

Uncovered Interest Parity (UIP)

• Investment Decisions: In an open economy, investors allocate their fixed wealth across money and bonds (domestic or foreign).

• Choice of Bonds: Depends solely on expected rates of return irrespective of risks/transaction costs.

• Illustrative Example:

  • Investors compare returns on US bonds vs. UK bonds, considering exchange rates and interest rates.

Comparing Returns Example (referencing exchange rate E)

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

• Domestic Bond Return Calculation:

  • $1 (1 + i) = $1 (1.10) = $1.10.

• Foreign Bond Calculation Steps:

  1. Convert $1 to pounds: $1 * E = £0.79.

  2. Return on the UK bond in pounds: £0.79 * (1 + i*) = £0.88.

  3. Convert back to $: £0.88 * (exchange rate) = $1.047.

• Conclusion: The US bond has a better return than the UK bond.

UIP and Interest Rate Differentials

• Concept: In equilibrium, returns must be equal in an arbitrage scenario. This manifests in the Uncovered Interest Parity (UIP) principle.

• Equations:

  • UIP states that the difference in expected returns must match the difference in interest rates; all investors will seek the best returns disregarding transaction costs.

• Expected Currency Movements:

  • If i* > i, then the domestic currency is expected to appreciate.

  • The reverse holds true if i* < i.

• Fixed Exchange Rate Dynamics: Under fixed rates, UIP holds under certain credibility conditions to limit inflation and preserve monetary policy independence.

Conclusions and Discussion

• Openness impacts choice between domestic/foreign goods and assets based on relative rates of return and expected currency appreciation.

• IS-LM Model Integration:

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

  • LM: r = r5

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

Discussion Questions:

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

2. True/False: A nominal exchange rate of 0.75 implies 0.75 dollars exchange for one euro.

3. True/False: If the dollar appreciates against the yen, UIP suggests US nominal rates must exceed Japanese rates.