Chapter 18.

Openness in Goods and

Financial Markets

We have assumed until now that the economy was closedthat it did not
interact with the rest of the world. We had to start this way, to keep things
simple and build up your intuition for the basic macroeconomic mechanisms.
We are now ready to relax this assumption. Understanding the macroeconomic
implications of openness will occupy us for this and the next three chapters.
Openness has three distinct dimensions:
1.

Openness in goods marketsthe ability of consumers and firms

to choose between domestic goods and foreign goods. In no country
is this choice completely free of restrictions: Even the countries most
committed to free trade have tariffstaxes on imported goodsand
quotasrestrictions 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 marketsthe ability of financial investors

to choose between domestic assets and foreign assets. Until recently
even some of the richest countries, such as France and Italy, had capital controlsrestrictions on the foreign assets their domestic residents could hold and on the domestic assets foreigners could hold.
These restrictions are rapidly disappearing. As a result, world financial
markets are becoming more and more closely integrated.
1

3.

Openness in factor marketsthe ability of firms to choose where

to locate production, and of workers to choose where to work. Here
also trends are clear. Multinational companies operate plants in many
countries and move their operations around the world to take advantage
of low costs. Much of the debate about the North American Free
Trade Agreement (NAFTA) signed in 1993 by the United States,
Canada, and Mexico centered on its implications for the relocation
of U.S. firms to Mexico. Similar fears now center around China. And
immigration from low-wage countries is a hot political issue in countries
from Germany to the United States.

In the short run and in the medium runthe focus of this and the next three
chaptersopenness in factor markets plays much less of a role than openness
in either goods markets or financial markets. Thus, I shall ignore openness in
factor markets, and focus on the implications of the first two dimensions of
openness here.
Section 181 looks at openness in the goods market, the determinants of the
choice between domestic goods and foreign goods, and the role of the real
exchange rate.
Section 182 looks at openness in financial markets, the determinants of the
choice between domestic assets and foreign assets, and the role of interest
rates and exchange rates.
Section 183 gives the map to the next three chapters.

181. Openness in Goods Markets

Lets start by looking at how much the U.S. sells to and buys from the
rest of the world. Then, we shall be better able to think about the choice
between domestic goods and foreign goods, and the role of the relative
price of domestic goods in terms of foreign goodsthe real exchange rate.
2

Exports and Imports

Figure 181 plots the evolution of U.S. exports and U.S. imports, as ratios
to GDP, since 1960 (U.S. exports means exports from the United States;
U.S. imports means imports to the United States.) The figure suggests
two main conclusions.
Figure 181. U.S. Exports and Imports as Ratios of GDP; 19602003. (Caption. 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 and
imports, which were equal to 5% of GDP during the 1960s, now are
equal to about 12% of GDP (10% for exports, 14% for imports).
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 40
years ago.

Although imports and exports have followed broadly the same upward trend, they have also diverged for long periods of time, generating sustained trade surpluses and trade deficits.1 Two episodes
stand out:
First, the large trade deficits of the mid1980s: The ratio of the
trade deficit to GDP reached 3% in 1986, before decreasing to 1%
in the early 1990s.
Second, the large and increasing trade deficits since the mid1990s.
The ratio of the trade deficit to GDP reached 4.5% in 2003, a historical record.

1.

From Chapter 3: The trade balance is the difference between exports and imports:
Exports > imports: Trade surplus (equivalently, positive trade balance)
Exports < imports: Trade deficit (equivalently, negative trade balance)

Understanding the sources and implications of these trade deficits is

a central issue in macroeconomics today, and one to which we shall
return 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 of
trade is not necessarily a good measure of openness. Many sectors can
be exposed to foreign competition without the effects of this competition
showing up in large imports: By being competitive and keeping their prices
low enough, these sectors can retain their domestic market share and keep
imports out. This suggests that a better index of openness than export or
import ratios is the proportion of aggregate output composed of tradable
goodsgoods that compete with foreign goods in either domestic markets
or foreign markets.2 Estimates are that tradable goods represent around
60% of aggregate output in the United States today.
It remains true that, with exports around 10% of GDP, the United States
has one of the smallest ratios of exports to GDP among the rich countries
of the world. Table 181 gives ratios for a number of OECD countries.3
Table 181. Ratios of Exports to GDP for Selected OECD Countries, 2003.

Country
United States
Japan
Germany
United Kingdom

Export Ratio
10%
12%
36%
25%

Country
Switzerland
Austria
Netherlands
Belgium

Export Ratio
42%
51%
62%
79%

2. Tradable goods: Cars, computers... Non tradable goods: Housing, most medical services, haircuts...
3. For more on the OECD and for the list of member countries, see Chapter 1.

Source : OECD Economic Outlook.

The United States and Japan are at the low end of the range of export
ratios. The large European countries, such as Germany and the United
Kingdom, have ratios that are two to three times larger. And the smaller
European countries have even larger ratios, from 42% in Switzerland to
79% in Belgium. (Belgiums 79% ratio of exports to GDP raises an odd
possibility: Could a country have exports larger than its GDP, an export
ratio greater than one? The answer is: Yes. The reason why is given in the
Focus box Can Exports Exceed GDP?)
Do these numbers indicate that the United States has more trade barriers
than, say, the United Kingdom or Belgium? No. The main factors behind
these differences are geography and size. Distance from other markets explains a good part of the low Japanese ratio. Size also matters: The smaller
the country, the more it must specialize in only a few products, producing
and exporting them, and relying on imports for the others. Belgium can
hardly afford to produce the range of goods produced by the United States,
a country roughly 40 times its economic size.4

Focus. Can Exports Exceed GDP?

Can a country have exports larger than its GDPi.e. have an export ratio
greater than one?
It would seem that the answer must be no. Countries cannot export more
than they produce, so that the export ratio must be less than one. Not so.
The key to the answer is to realize that exports and imports may include
exports and imports of intermediate goods.
4. Iceland is both isolated and small. What would you expect its export ratio to be?
(Answer: 37%)

Take for example a country that imports intermediate goods for $1 billion.
Suppose it transforms them into final goods using only labor. Say that total
wages equal $200 million and there are no profits. The value of these final
goods is thus equal to $1,200 million. Assume that $1 billion worth of final
goods is exported and the rest, $200 million, is consumed domestically.
Exports and imports therefore both equal $1 billion. What is GDP in this
economy? Remember that GDP is value added in the economy (see Chapter
2). So, in this example, GDP equals $200 million, and the ratio of exports
to GDP equals $1000/$200 = 5.
Hence, exports can exceed GDP. This is actually the case for a number of
small countries where most economic activity is organized around a harbor
and importexport activities. This is even the case for small countries where
manufacturing plays an important role, such as Singapore. In 2002, the
ratio of exports to GDP in Singapore was 145%.

The Choice Between Domestic Goods and Foreign Goods

How does openness in goods markets force us to rethink the way we look
at equilibrium in the goods market?
Until now, when we were thinking about consumers decisions in the goods
market, we focused on their decision to save or to consume. When goods
markets are open, domestic consumers face a second decision: whether to
buy domestic goods or to buy foreign goods.5 Indeed, all buyersother
domestic buyers such as firms or the government, and foreign buyersface
5.

In a closed economy, people face one decision:

Save, or Buy (consume)
In an open economy, they face two decisions:
Save, or Buy
Buy domestic, or Buy foreign

the same decision. This decision has a direct effect on domestic output: If
buyers decide to buy more domestic goods, the demand for domestic goods
increases, and so does domestic output. If they decide to buy more foreign
goods, then foreign output increases instead of domestic output.
Central to this second decision (to buy domestic goods or foreign goods) is
the price of domestic goods relative to foreign goods. We call this relative
price the real exchange rate. The real exchange rate is not directly observable, and you will not find it in the newspapers. What you will find in
newspapers are nominal exchange rates, the relative prices of currencies.
So, in the rest of this section, we start by looking at nominal exchange
rates, and then see how we can use them to construct real exchange rates.

Nominal Exchange Rates

Nominal exchange rates between two currencies can be quoted in one of
two ways:

As the price of the domestic currency in terms of the foreign currency. If for example, we look at the United States and the United
Kingdom, and think of the dollar as the domestic currency and the
pound as the foreign currency, we can express the nominal exchange
rate as the price of a dollar in terms of pounds. In August 2004, the
exchange rate defined this way was 0.55 (1 dollar was worth 0.55
pounds.)

As the price of the foreign currency in terms of the domestic currency. Continuing with the same example, we can express the nominal exchange rate as the price of a pound in terms of dollars. In
August 2004, the exchange rate defined this way was 1.8 (1 pound
was worth 1.8 dollars.)

Either definition is fine; the important thing is to remain consistent. In

this book, I shall adopt the first definition: I shall define the nominal
7

exchange rate as the price of the domestic currency in terms of foreign

currency, and denote it by E.6 When looking for example at the exchange
rate between the United States and the United Kingdom (from the viewpoint of the United States, so the dollar is the domestic currency), E will
denote the price of a dollar in terms of pounds (so, for example, 0.55 in
August 2004.

Exchange rates between the dollar and most foreign currencies change every
day, every minute of the day. These changes are called nominal appreciations or nominal depreciationsappreciations or depreciations for short.

An appreciation of the domestic currency is an increase in the

price of the domestic currency in terms of a foreign currency. Given
our definition of the exchange rate, an appreciation corresponds to
an increase in the exchange rate.8

A depreciation of the domestic currency is a decrease in the price

of the domestic currency in terms of a foreign currency. So, given
our definition of the exchange rate, a depreciation of the domestic
currency corresponds to a decrease in the exchange rate, E.9

You may have encountered two other words to denote movements in exchange rates: revaluations and devaluations. These two terms are used
when countries operate under fixed exchange ratesa system in which
two or more countries maintain a constant exchange rate between their
currencies. Under such a system, increases in the exchange ratewhich
6. Warning. There is no agreed upon rule among economists or among newspapers as
to which of the two definitions to use. You will encounter both. Always check which
definition is used.
7. E: Nominal exchange ratePrice of domestic currency in terms of foreign currency.
(From the point of view of the U.S. looking at the United Kingdom, the price of a dollar
in terms of pounds.)
8. Appreciation of the domestic currency Increase in the price of the domestic currency in terms of foreign currency Increase in the exchange rate
9. Depreciation of the domestic currency Decrease in the price of the domestic
currency in terms of foreign currency Decrease in the exchange rate

are infrequent by definitionare called revaluations (rather than appreciations). Decreases in the exchange rate are called devaluations (rather
than depreciations).10
Figure 182 plots the nominal exchange rate between the dollar and the
pound since 1970. Note the two main characteristics of the figure:

The trend increase in the exchange rate. In 1970, a dollar was worth
only 0.41 pounds. In 2003, a dollar was worth 0.59 pounds. Put
another way, there was an appreciation of the dollar vis`avis the
pound over the period.

The large fluctuations in the exchange rate. In the space of less than
ten years in the 1980s, the value of the dollar increased from 0.42
pounds in 1981 to 0.82 pounds in 1985, only to go back down to
0.54 pounds by early 1988. Put another way, there was a very large
appreciation of the dollar in the first half of the 1980s, followed by
a large depreciation later in the decade.

Figure 182. The Nominal Exchange Rate Between the Dollar and the
Pound, 19702003 (Caption. While the dollar has appreciated visavis
the pound over the past 33 years, this appreciation has come with large
swings in the nominal exchange rate between the two currencies, especially
in the 1980s.)
If we are interested however in the choice between domestic goods and
foreign goods, the nominal exchange rate gives us only part of the information we need. Figure 182 for example tells us only about movements
in the relative price of the two currencies, the dollar and the pound. To
U.S. tourists thinking of visiting the United Kingdom, the question is not
only how many pounds they will get in exchange for their dollars, but how
10. We shall discuss fixed exchange rates in Chapter 20.

much goods will cost in the United Kingdom, relative to how much they
cost in the United States. This takes us to our next stepthe construction
of real exchange rates.

From Nominal to Real Exchange Rates

How can we construct the real exchange rate between the United States and
the United Kingdomthe price of U.S. goods in terms of British goods?
Suppose the United States produced only one good, a Cadillac Seville Luxury Sedan, and the United Kingdom also produced only one good, a Jaguar
S-type Luxury Sedan (This is one of those Suppose statements that run
completely against the facts, but we shall become more realistic shortly.)
Constructing the real exchange rate, the price of the U.S. goods (Cadillacs)
in terms of British goods (Jaguars), would be straightforward. We would
express both goods in terms of the same currency, and then compute their
relative price.
Suppose for example we expressed both goods in terms of pounds.11 Then:

The first step would be to take the price of a Cadillac in dollars and
convert it to a price in pounds. The price of a Cadillac in the United
States is $ 40,000. A dollar is worth 0.55 pounds, so the price of a
Cadillac in pounds is 40,000 dollars x 0.55 = 22,000.

The second step would be to compute the ratio of the price of the
Cadillac in pounds to the price of the Jaguar in pounds. The price of
a Jaguar in the United Kingdom is 30,000. So the price of a Cadillac in terms of Jaguarsthat is, the real exchange rate between the
United States and the United Kingdomwould be $22,000/$30,000
= 0.73.

11. Check that, if we expressed both in terms of dollars instead, we would get the same
result for the real exchange rate.

10

The example is straightforward, but how do we generalize it? The United

States and the United Kingdom produce more than Cadillacs and Jaguars,
and we want to construct a real exchange rate that reflects the relative
price of all the goods produced in the United States in terms of all the
goods produced in the United Kingdom.
The computation we just went through tells us how to proceed. Rather
than using the price of a Jaguar and the price of a Cadillac, we must use
a price index for all goods produced in the United Kingdom and a price
index for all goods produced in the United States. This is exactly what the
GDP deflators we introduced in Chapter 2 do: They are by definition price
indexes for the set of final goods and services produced in the economy.
Figure 183. The Construction of the Real Exchange Rate
So let P be the GDP deflator for the United States, P be the GDP deflator
for the United Kingdom (as a rule, I shall denote foreign variables by a
star), and E be the dollar-pound nominal exchange rate. Figure 183 goes
through the steps needed to construct the real exchange rate.

The price of U.S. goods in dollars is P . Multiplying it by the exchange rate, Ethe price of dollars in terms of poundsgives us
the price of U.S. goods in pounds, EP .

The price of British goods in pounds is P . The real exchange rate,

the price of U.S. goods in terms of British goods, which we shall call
(the greek lowercase epsilon), is thus given by12
=

EP
P

(18.1)

12. : Real exchange ratePrice of domestic goods in terms of foreign goods (For example, from the point of view of the U.S. looking at the United Kingdom, the price of
U.S. goods in terms of British goods)

11

The real exchange rate is constructed by multiplying the domestic price

level by the nominal exchange rate, and then dividing by the foreign price
levela straightforward extension of the computation we made in our
Cadillac/Jaguar example.
Note, however, an important difference between our Cadillac/Jaguar example and this more general computation:
Unlike the price of Cadillacs in terms of Jaguars, the real exchange rate is
an index number: That is, its level is arbitrary, and so, uninformative. It is
uninformative because the GDP deflators used in the construction of the
real exchange rate are themselves index numbers; as we saw in Chapter 2,
they are equal to 1 (or 100) in whatever year is chosen as the base year. But
all is not lost. Although the level of the real exchange rate is uninformative,
the rate of change of the real exchange rate is informative: If for example,
the real exchange rate between the United States and the United Kingdom
increases by 10%, this 10% increase tells us U.S. goods are now 10% more
expensive relative to British goods than they were before.
Like nominal exchange rates, real exchange rates move over time. These
changes are called real appreciations or real depreciations:

An increase in the real exchange rate, i.e. an increase in the relative

price of domestic goods in terms of foreign goods, is called a real
appreciation.13

A decrease in the real exchange rate, i.e. a decrease in the relative

price of domestic goods in terms of foreign goods, is called a real
depreciation.14

Figure 184 plots the evolution of the real exchange rate between the
United States and the United Kingdom from 1970 to 2003, constructed
13. Real appreciation Increase in the price of the domestic goods in terms of foreign
goods Increase in the real exchange rate
14. Real depreciation Decrease in the price of the domestic goods in terms of foreign
goods Decrease in the real exchange rate

12

using equation (18.1). For convenience, it also reproduces the evolution of

the nominal exchange rate from Figure 182. The GDP deflators have both
been set equal to 1 in the first quarter of 2000, so the nominal exchange
rate and the real exchange rate are equal in that quarter by construction.
Figure 184. Real and Nominal Exchange Rates between the United States
and the United Kingdom, 19702003. (Caption. Except for the difference
in trend reflecting higher average inflation in the United Kingdom than in
the United States, the nominal and the real exchange rates have moved
largely together since 1970.)
Note the two main characteristics of Figure 184:

While the nominal exchange rate went up during the period, the
real exchange rate went down: In 1970, the real exchange rate was
equal to 1.04; in 2003, it was down to 0.60.
How do we reconcile the fact that there was both a nominal appreciation (of the dollar vis a vis the pound) and a real depreciation (of
U.S. goods vis a vis British goods) during the period? To see why,
return to the definition of the real exchange rate:
=E

P
P

Two things have happened since 1970:

First, E has increased: The dollar has gone up in terms of pounds
this is the nominal appreciation we saw earlier.
Second, P/P has decreased. The price level has increased less in the
United States than in the United Kingdom. Put another way, over
the period, average inflation has been lower in the United States
than in the United Kingdom.
The resulting decrease in P/P has been larger than the increase in
E, leading to a decrease in , a real depreciation.
13

To get a better intuition for what happened, lets go back to our

U.S tourists thinking of visiting the United Kingdom. They find that
they can buy more pounds per dollar than in 1970 (E has increased).
Does this imply their trip will be cheaper? No: When they arrive
in the United Kingdom, they will discover that the prices of goods
in the United Kingdom have increased much more than the prices
of goods in the United States (P has increased more than P , so
P/P has declined), and this more than cancels the increase in the
value of the dollar in terms of pounds. They will find that their trip
will actually be more expensive (in terms of U.S. goods) than it was
in 1970. In other words, they will find that there has been a real
depreciation.
There is a general lesson here. Over long periods of time, differences
in inflation rates across countries can lead to very different movements in nominal exchange rates and real exchange rates.15 We shall
return to this issue in Chapter 20.

The large fluctuations in the nominal exchange rate we saw in Figure

182 also show up in the real exchange rate.
The is not surprising: Yeartoyear movements in the price ratio
P/P are typically small compared to the often sharp movements
in the nominal exchange rate, E. Thus, from year to year, or even
over a few years, movements in the real exchange rate () tend to
be driven mostly by movements in the nominal exchange rate E.
Note that since the early 1990s, the nominal exchange rate and the
real exchange rate have moved nearly together. This reflects the fact
that, since the mid1980s, inflation rates have been very similar in
both countries.16

15. Can there be a real appreciation with no nominal appreciation?

Can there be a nominal appreciation with no real appreciation?
(The answers to both questions: Yes.)
16. If inflation rates were exactly equal, P /P would be constant, and and E would
move exactly together.

14

From Bilateral to Multilateral Exchange Rates

We need to take one last step. We have so far concentrated on the exchange
rate between the United States and the United Kingdom. But the United
Kingdom is just one of many countries the United States trades with. Table
182 gives the geographic composition of U.S. trade for both exports and
imports (The numbers refer only to merchandise tradeexports and
imports of goods. They do not include exports and imports of services, such
as travel services and tourism, for which the decomposition by country is
not available.)
The main message of the table is that the United States does most of
its trade with three sets of countries. The first includes its neighbors to
the North and to the South, Canada and Mexico: Trade with Canada and
Mexico accounts for 36% of U.S. exports and 29% of U.S. imports. The
second includes the countries of Western Europe, which account for 23%
of U.S. exports and 21% of U.S. imports. The third includes the Asian
countries, including Japan and China, which, together, account for 25% of
U.S. exports and 39% of U.S. imports.
Table 182. The Country Composition of U.S. Merchandise Trade, 2003

Canada
Mexico
Western Europe
China
Japan
Rest of Asia *
Others

Proportion of
Exports to
23
13
23
4
7
14
11

Proportion of
Imports from
18
11
21
13
9
17
6

Source: Survey of Current Business, April 2004. *: Asia, excluding Japan

15

and China. OPEC: Organization of Petroleum Exporting Countries.

How do we go from bilateral exchange rates, such as the real exchange
rate between the United States and the United Kingdom we focused on
earlier to multilateral exchange rates which reflect this composition of
trade?17 The answer is straightforward. If we want to measure the average
price of U.S goods relative to the average price of goods of U.S. trading
partners, we should use the U.S. share of trade with each country as the
weight for that country. Using export shares we can construct an export
real exchange rate, and using import shares we can construct an import
real exchange rate. Because economists usually do not want to keep track
of two different exchange rates, they typically use an exchange rate that
takes an average of export and import shares. This is the variable we shall
think of when talking about the multilateral real U.S. exchange rate,
or the U.S. real exchange rate for short.18
Figure 185. The U.S. Multilateral Real Exchange Rate, 19732003. (Caption. The large real appreciation of U.S. goods in the first half of the 1980s
was followed by a large real depreciation in the second half of the 1980s.
This large swing in the 1980s is sometimes called the dance of the dollar.)
Figure 185 shows the evolution of this multilateral real exchange rate, the
price of U.S goods in terms of foreign goods, from 1973 to 2003.19 Like
the bilateral real exchange rates we saw a few pages earlier, it is an index
17. Bi means two. Multi means many.
18. These are all equivalent names for the relative price of U.S.goods in terms of foreign
goods:
The real multilateral U.S. exchange rate
The U.S. trade weighted real exchange rate
The U.S. effective real exchange rate.
19. The figure starts in 1973 because this multilateral real exchange rate, which is constructed by the Federal Reserve Board, is available only from 1973 on.

16

number. So its level is also arbitrary; here it is set equal to 1 in the first
quarter of 2000.
The most striking aspect of the figure is something we already saw when
looking at the bilateral exchange rate between the United States and the
United Kingdom in Figure 184, the large swing in the real exchange rate
in the 1980s. U.S. goods were about 40% more expensive relative to foreign
goods in the mid1980s than they were either at the beginning or at the
end of the decade. In other words, there was a large real appreciation in
the first half of the 1980s, followed by an even larger real depreciation in
the second half. This large swing, which as we have seen has its origins in
the movement of the nominal exchange rate, is so striking that it has been
given various names, from the dollar cycle to the more graphic dance of
the dollar. Note the similar, but smaller movements of the dollar from the
mid 1990s on, with an increase of 25% from 1995 to 2001, and a decrease
since then. Many economists wonder whether we are in the middle of a
second large swing, a second dollar cycle. In the coming chapters, we shall
return to these swings, look at where they come from, and what effects
they have on the trade deficit and economic activity.

182. Openness in Financial Markets

Openness in financial markets allows financial investors to hold both domestic assets and foreign assets, to diversify their portfolios, to speculate
on movements in foreign interest rates versus domestic interest rates, on
movements in exchange rates, and so on.
Diversify and speculate they do. Given that buying or selling foreign assets implies buying or selling foreign currencysometimes called foreign
exchangethe volume of transactions in foreignexchange markets gives
a sense of the importance of international financial transactions. In 2001
17

the recorded daily volume of foreignexchange transactions in the world

was $2.6 trillion, of which 90%about $2.4 trillioninvolved dollars on
one side of the transaction.20
To get a sense of the magnitude of these numbers, the sum of U.S. exports
and imports in 2001 totalled $2.5 trillion for the year, or about $7 billion a
day. Suppose the only dollar transactions in foreignexchange markets had
been, on one side, by U.S. exporters selling their foreign currency earnings,
and on the other side by U.S. importers buying the foreign currency they
needed to buy foreign goods. Then, the volume of transactions would have
been $7 billion a day, or about 0.3% of the actual daily volume of dollar
transactions ($2.4 trillion) involving dollars in foreign exchange markets.21
This computation tells us that most of the transactions are associated not
with trade, but with purchases and sales of financial assets. The volume of
transactions in foreign exchange markets is not only high but also rapidly
increasing. The volume of foreignexchange transactions in New York is
now about 25 times what it was in 1980. Again, this activity reflects mostly
an increase in financial transactions rather than an increase in trade over
the last 15 years.
For a country as a whole, openness in financial markets has another important implication. It allows the country to run trade surpluses and trade
deficits. Recall, a country running a trade deficit is buying more from the
rest of the world than it is selling to the rest of the world. In order to pay
for the difference between what it buys and what it sells, the country must
borrow from the rest of the world. It borrows by making it attractive for
foreign financial investors to increase their holdings of domestic assetsin
effect, to lend to the country.
20. The year 2001 is the latest year for which these numbers are available.
21. Daily volume of foreign exchange transactions with dollars in one side of the transaction: $ 2.4 trillion.
Daily volume of trade of the United States with the rest of the world: $7 billion (0.3%
of the volume of foreign exchange transactions.)

18

Lets start by looking more closely at the relation between trade flows and
financial flows. When this is done, we shall look at the determinants of
these financial flows.

The Balance of Payments

A countrys transactions with the rest of the world, including both trade
flows and financial flows, are summarized by a set of accounts called the
balance of payments. Table 183 presents the U.S. balance of payments
for 2003. The table has two parts, separated by a line. Transactions are
referred to either as above the line or below the line.
The current account. The transactions above the line record payments
to and from the rest of the world. They are called current account transactions.

The first two lines record the exports and imports of goods and services. Exports lead to payments from the rest of the world, imports
to payments to the rest of the world. In 2003, imports exceeded exports, leading to a U.S. trade deficit of $490 billionroughly 4.5%
of U.S. GDP.

Exports and imports are not the only sources of payments to and
from the rest of the world. U.S. residents receive investment income on their holdings of foreign assets, and foreign residents receive investment income on their holdings of U.S. assets. In 2003,
investment income received from the rest of the world was $275 billion, and investment income paid to foreigners was $258 billion, for
a net balance of $17 billion.

Finally, countries give and receive foreign aid; the net value of these
payments is recorded as net transfers received. These net transfers amounted in 2003 to $68 billion. This negative amount reflects

19

the fact that, in 2003, the United States wasas it has traditionally
beena net donor of foreign aid.
The sum of net payments to and from the rest of the world is called the
current account balance. If net payments from the rest of the world are
positive, the country is running a current account surplus; if they are
negative, the country is running a current account deficit. Adding all
payments to and from the rest of the world, net payments from the United
States to the rest of the world were equal in 2003 to $490 +$17 $68 =
$541 billion. Put another way, in 2003, the United States ran a current
account deficit of $541 billionroughly 5.0% of its GDP.22
Table 183. The U.S. Balance of Payments, 2003, in billions of U.S. dollars
Current Account
Exports
Imports
Trade balance (deficit= ) (1)
Investment income received
Investment income paid
Net investment income (2)
Net transfers received (3)
Current account balance (deficit=) (1)+(2)+(3)
Capital account
Increase in foreign holdings of U.S. assets (4)
Increase in U.S. holdings of foreign assets (5)
Capital account balance (deficit=) (4)-(5)
Statistical discrepancy

1018
1508
490
275
258
17
68
541

856
277
579
-38

22. Can a country have:

A trade deficit and no current account deficit?
A current account deficit and no trade deficit?
(The answers to both questions: Yes.)

20

Source: Survey of Current Business, April 2004. All numbers in billions of

dollars.
The capital account. The fact that the United States had a current
account deficit of $541 billion in 2003 implies that it had to borrow $541
billion from the rest of the worldor, equivalently, that net foreign holdings
of U.S. assets had to increase by $541 billion. The numbers below the
line describe how this was achieved. Transactions below the line are called
capital account transactions.
The increase in foreign holdings of U.S. assets was $856 billion. But there
was also an increase in U.S. holdings of foreign assets of $277 billion, so
the net increase in U.S foreign indebtedness, (the increase in foreign holdings of U.S. assets, minus the increase in U.S. holdings of foreign assets),
also called net capital flows to the United States, was $856 $277 =
$579 billion. Another name for net capital flows is the capital account
balance: Positive net capital flows are called a capital account surplus;
negative net capital flows are called a capital account deficit. So, put
another way, in 2003, the United States ran a capital account surplus of
$579 billion.23
Shouldnt net capital flows (equivalently the capital account surplus) be
exactly equal to the current account deficit (which we saw from above was
equal to $541 billion in 2003)?
In principle, yes. In practice, no.
The numbers for current and capital account transactions are constructed
using different sources; although they should give the same answers, they
typically do not. In 2003, the difference between the twothe statistical
discrepancywas $38 billion, about 7% of the current account balance.
23. A country that runs a current account deficit must finance it through positive net
capital flows. Equivalently, it must run a capital account surplus.

21

This is yet another reminder that, even for a rich country such as the United
States, economic data are far from perfect. (This problem of measurement
manifests itself in another way as well. The sum of the current account
deficits of all the countries in the world should be equal to zero: One countrys deficit should show up as a surplus for the other countries taken as a
whole. However, this is not the case in the data: If we just add the published
current account deficits of all the countries in the world, it would appear
that the world is running a large current account deficit! Some economists
speculate that the explanation is unrecorded trade with the Martians. Most
others believe that mismeasurement is the explanation.)
Now that we have looked at the current account, we can return to an issue
we touched on in Chapter 2, the difference between GDP, the measure
of output we have used so far, and GNP, another measure of aggregate
output. This is done in the Focus box GDP versus GNP: The Example of
Kuwait.

Focus. GDP versus GNP: The Example of Kuwait

Should value added in an open economy be defined as

The value added domestically (that is, within the country), or

The value added by domestically owned factors of production ?

The two definitions are not the same: Some domestic output may be produced by capital owned by foreigners, while some foreign output may be
produced by capital owned by domestic residents.
The answer is that either definition is fine, and economists use both. Gross
domestic product (GDP), the measure we have used so far, corresponds
to value added domestically. Gross national product (GNP) corresponds to the value added by domestically owned factors of production.
22

GNP is equal to GDP plus net factor payments from the rest of the world
(factor payments from the rest of the world minus factor payments to
the rest of the world). While GDP is now the measure most commonly
mentioned, GNP was widely used until the early 1990s, and you will still
encounter it in newspapers and academic publications.
For most countries, the difference between GNP and GDP is typically small,
because factor payments to and from the rest of the world roughly cancel.
For the United States in 2003, the difference between GDP and GNP was
$43 billionabout 0.4% of GDP (This is an unusually small number, by
historical standards. But, for the United States, the difference between the
two has never exceeded 1% of GDP.)
There are a few exceptions. Among them is Kuwait. When oil was discovered in Kuwait, Kuwaits government decided that a portion of oil revenues
would be saved and invested abroad rather than spent, so as to provide future Kuwaiti generations with investment income when oil revenues came
to an end. Kuwait ran a large current account surplus, steadily accumulating large foreign assets. As a result, it now has large holdings of foreign
assets, and receives substantial investment income from the rest of the
world. Table 1 gives GDP, GNP, and net factor payments for Kuwait, from
1989 to 1994.
Table 1. GDP, GNP, and Net Factor Payments in Kuwait, 19891994
Year
1989
1990
1991
1992
1993
1994

GDP
7143
5328
3131
5826
7231
7380

GNP
9616
7560
4669
7364
8386
8321

Net Factor Payments

2473
2232
1538
1538
1151
941

23

Source: International Financial Statistics, IMF All numbers are in millions

of Kuwaiti dinars. 1 dinar=$3.3 (2003).
Note how much larger GNP is compared to GDP throughout the period.
But note also how net factor payments decreased after 1989. This is because
Kuwait had to pay its allies for part of the cost of the 19901991 Gulf
War and to pay for reconstruction after the war. It did so by running
a current account deficitequivalently, by decreasing its net holdings of
foreign assets. This in turn led to a decrease in the income from foreign
assets, and by implication, a decrease in net factor payments.

The Choice between Domestic and Foreign Assets

Openness in financial markets implies that financial investors face a new
financial decision, holding domestic versus holding foreign assets.
It would seem that we actually have to think about at least two new decisions, the choice of holding domestic money versus foreign money, and the
choice of holding domestic interestpaying assets versus foreign interest
paying assets. But remember why people hold money: to engage in transactions. For somebody who lives in the United States, and whose transactions are mostly or fully in dollars, there is little point in holding foreign
currency: Foreign currency cannot be used for transactions in the United
States, and if the goal is to hold foreign assets, holding foreign currency
is clearly less desirable than holding foreign bonds, which pay interest.24
This leaves us with only one new choice to think about, the choice between
domestic interestpaying assets and foreign interestpaying assets.
24. Two qualifications:
Foreigners involved in illegal activities often hold dollars, because dollars can be exchanged easily and cannot be traced.
In times of very high inflation, people sometimes switch to a foreign currency, often the
dollar, for use even in some domestic transactions.

24

Lets think of these assets for now as domestic oneyear bonds and foreign
oneyear bonds. To continue with our focus on the United States and the
United Kingdom, consider for example the choice between U.S. oneyear
bonds and U.K. oneyear bonds, from the point of view of a U.S. investor.

Suppose you decide to hold U.S. bonds.

Let it be the oneyear U.S. nominal interest rate. Then, as Figure
186 shows, for every dollar you put in U.S. bonds, you will get
(1 + it ) dollars next year. (This is represented by the arrow pointing
to the right at the top of the figure.)

Suppose you decide instead to hold U.K. bonds.

To buy U.K. bonds, you must first buy pounds. Let Et be the nominal exchange rate between the dollar and the pound. For every dollar, you get Et pounds. (This is represented by the arrow pointing
downward in the figure).
Let it denote the oneyear nominal interest rate on U.K. bonds (in
pounds). When next year comes, you will have Et (1 + it ) pounds.
(This is represented by the arrow pointing right at the bottom of
the figure.)
You will then have to convert your pounds back into dollars. If
e , each
you expect the nominal exchange rate next year to be Et+1
e ) dollars. So you can expect to have
pound will be worth (1/Et+1
e ) dollars next year for every dollar you invest now.
Et (1 + it )(1/Et+1

(This is represented by the arrow pointing upward in the figure.)

We shall look at the expression we just derived in more detail soon.
But note its basic implication already: In assessing the attractiveness
of U.K. versus U.S. bonds, you cannot look just at the U.K. interest
rate and the U.S. interest rate; you must also assess what you think
will happen to the dollar/pound exchange rate between this year
and next.25
25. The decision whether to invest abroad or at home depends on more than interest
rates. It also depends on the expected movements in the exchange rate in the future.

25

Figure 186. Expected Returns from Holding OneYear U.S. Bonds or OneYear U.K. Bonds
Lets now make the same assumption we made in Chapter 14 when discussing the choice between shortterm bonds and longterm bonds, or between bonds and stocks. Lets assume that you and other financial investors
care only about the expected rate of return and therefore want to hold only
the asset with the highest expected rate of return. In that case, if both U.K.
bonds and U.S. bonds are to be held, they must have the same expected
rate of return, so that the following arbitrage relation must hold
(1 + it ) = (Et )(1 + it )(

1
e )
Et+1

Reorganizing
(1 + it ) = (1 + it )(

Et
e )
Et+1

(18.2)

Equation (18.2) is called the uncovered interest parity relation, or simply the interest parity condition.26
The assumption that financial investors will hold only the bonds with the
highest expected rate of return is obviously too strong, for two reasons:

It ignores transaction costs: Going in and out of U.K. bonds requires

three separate transactions, each with a transaction cost.

26. The word uncovered is to distinguish this relation from another relation called the
covered interest parity condition. The covered interest parity condition is derived by
looking at the following choice:
Buy and hold U.S. bonds for one year. Or buy pounds today, buy one-year U.K. bonds
with the proceeds, and agree to sell the pounds for dollars a year ahead at a predetermined price, called the forward exchange rate.
The rate of return to these two alternatives, which can both be realized at no risk today,
must be the same. The covered interest parity condition is a riskless arbitrage condition.

26

It ignores risk: The exchange rate a year from now is uncertain; that
means that holding U.K. bonds is more risky, in terms of dollars,
than holding U.S. bonds.27

But as a characterization of capital movements among the major world

financial markets (New York, Frankfurt, London, and Tokyo), the assumption is not far off. Small changes in interest rates and rumors of impending
appreciation or depreciation can lead to movements of billions of dollars
within minutes. For the rich countries of the world, the arbitrage assumption in equation (18.2) is a good approximation of reality. Other countries
whose capital markets are smaller and less developed, or countries that
have various forms of capital controls, have more leeway in choosing their
domestic interest rate than is implied by equation (18.2). We shall return
to this issue at the end of Chapter 20.
Interest Rates and Exchange Rates
Lets get a better sense of what the interest parity condition implies. First
e
e
rewrite Et /Et+1
as 1/(1 + (Et+1
Et )/Et . Replacing in equation (18.2)

gives
(1 + it ) =

(1 + it )
e
[1 + (Et+1
Et )/Et )]

(18.3)

This gives us a relation between the domestic nominal interest rate, it , the
foreign nominal interest rate, it , and the expected rate of appreciation of
e
the domestic currency, (Et+1
Et )/Et . As long as interest rates or the

expected rate of depreciation are not too largesay below 20% a yeara
good approximation to this equation is given by28
27. Whether holding U.K. bonds or U.S. bonds is more risky actually depends on which
investors we are looking at. Holding U.K. bonds is more risky from the point of view
of U.S. investors. Holding U.S. bonds is more risky from the point of view of British
investors. (Why?)
28. This follows from Proposition 3 in Appendix 2 at the end of the book.

27

it it

e
Et+1
Et
Et

(18.4)

This is the form of the interest parity condition you must remember: Arbitrage implies that the domestic interest rate must be equal to the foreign
interest rate minus the expected appreciation rate of the domestic currency.
Note that the expected appreciation rate of the domestic currency is also
the expected depreciation rate of the foreign currency.29 So equation (18.4)
can be equivalently stated as saying that the domestic interest rate must
be equal to the foreign interest rate minus the expected depreciation rate
of the foreign currency.
Lets apply this equation to U.S. bonds versus U.K. bonds. Suppose the
oneyear nominal interest rate is 2.0% in the United States, 5.0% in the
United Kingdom. Should you hold U.K. bonds or U.S. bonds? The answer:

It depends whether you expect the pound to depreciate vis`avis

the dollar over the coming year by more or less than the difference
between the U.S. interest rate and the U.K. interest rate, 5.0%
2.0% =3.0%.

If you expect the pound to depreciate by more than 3.0%, then, despite the fact that the interest rate is higher in the United Kingtom
than in the United States, investing in U.K. bonds is less attractive
than investing in U.S. bonds. By holding U.K. bonds, you will get
higher interest payments next year, but the pound will be worth less
in terms of dollars next year, making investing in U.K. bonds less
attractive than investing in U.S. bonds.

If you expect the pound to depreciate by less than 3.0% or even to

appreciate, then the reverse holds, and U.K bonds are more attractive than U.S. bonds.

29. If the dollar is expected to appreciate by 3% vis a vis the pound, then the pound is
expected to depreciate by 3% vis a vis the dollar.

28

Looking at it another way: If the uncovered interest parity condition holds,

and the U.S. one-year interest rate is 3% lower than the U.K. interest rate,
it must be that financial investors are expecting on average an appreciation
of the dollar vis a vis the pound over the coming year of about 3%, and this
is why they are willing to hold U.S. bonds despite their lower interest rate.
(Another application of the uncovered interest parity condition is provided
in the Focus box Buying Brazilian Bonds).

Focus. Buying Brazilian Bonds

Go back to September 1993 (the very high interest rate in Brazil at the time
helps make the point I want to get across here). Brazilian bonds are paying
a monthly interest rate of 36.9%. This seems very attractive compared to
the annual rate of 3% on U.S. bondscorresponding to a monthly interest
rate of about 0.2%. Shouldnt you buy Brazilian bonds?
The discussion in this chapter tells you that, to decide, you need one more
crucial element, the expected rate of depreciation of the cruzeiro (the name
of the Brazilian currency at the time; the currency is now called the real)
in terms of dollars.
You need this information because, as we saw in equation 183, the return
in dollars from investing in Brazilian bonds for a month is equal to one
plus the Brazilian interest rate, divided by one plus the expected rate of
depreciation of the cruzeiro relative to the dollar:
1 + it
e
[1 + (Et+1
Et )/Et ]
What rate of depreciation of the cruzeiro should you expect over the coming
month? A reasonable assumption is to expect the rate of depreciation over
29

the coming month to be equal to the rate of depreciation over the last
month. The dollar was worth 100,000 cruzeiros at the end of July 1993,
and worth 134,600 cruzeiros at the end of August 1993, so the rate of
appreciation of the dollar vis a vis the cruzeiroequivalently the rate of
depreciation of the cruzeiro vis a vis the dollarin August was 34.6%. If
depreciation is expected to continue at the same rate in September as it
did in August, the expected return from investing in Brazilian bonds for a
month is

1.369
= 1.017
1.346

The expected rate of return in dollars from holding Brazilian bonds is only
(1.017 1) = 1.6% per month, not the 36.9% per month that looked so
attractive. Note that 1.6% per month is still much higher than the monthly
interest rate on U.S. bonds (about 0.2%). But think of the risk and the
transaction costsall the elements we ignored when we wrote the arbitrage
condition. When these are taken into account, you may well decide to keep
your funds out of Brazil.

The arbitrage relation between interest rates and exchange rates (either
in the form of equation (18.2) or equation (18.4)) will play a central role
in the following chapters. It suggests that, unless countries are willing to
tolerate large movements in their exchange rate, domestic and foreign interest rates are likely to move very much together. Take the extreme case
of two countries that commit to maintaining their bilateral exchange rates
at a fixed value. If markets have faith in this commitment, they will expect
the exchange rate to remain constant, and the expected depreciation will
be equal to zero. In that case, the arbitrage condition implies that interest
rates in the two countries will have to move exactly together.30 Most of
the time, as we shall see, governments do not make such absolute commite
30. If Et+1
= Et , then the interest parity condition implies it = it .

30

ments to maintain the exchange rate, but they often do try to avoid large
movements in the exchange rate. This puts sharp limits on how much they
can allow their interest rate to deviate from interest rates elsewhere in the
world.
How much do nominal interest rates actually move together in major countries? Figure 187 plots the threemonth nominal interest rate in the
United States and the threemonth nominal interest rate in the United
Kingdom (both expressed at annual rates), since 1970. The impression from
the figure is of related but not identical movements. Interest rates were very
high in both countries in the early 1980s, and high againalthough much
more so in the United Kingdom than in the United Statesin the late
1980s. Both have been low since the early to mid 1990s. At the same time,
differences between the two have sometimes been quite large: In 1990, for
example, the U.K. interest rate was nearly 7% above the U.S. interest rate.
In the coming chapters, we shall return to why such differences emerge,
and what their implications may be.31
Figure 187 ThreeMonth Nominal Interest Rates in the United States
and in the United Kingdom, 19702003 (Caption. U.S. and U.K. nominal
interest rates have largely moved together over the last 33 years.)

183. Conclusions and a Look Ahead

We have now set the stage for the study of the open economy:
31. Meanwhile, do the following: Look at the back pages of a recent issue of the
Economist for short-term interest rates in different countries relative to the United States.
Which are the currencies against which the dollar is expected to depreciate?

31

Openness in goods markets allows a choice between domestic goods

and foreign goods. This choice depends primarily on the real exchange ratethe relative price of domestic goods in terms of foreign
goods.

Openness in financial markets allows a choice between domestic assets and foreign assets. This choice depends primarily on their relative rates of return, which depend on domestic interest rates and
foreign interest rates, and on the expected rate of appreciation of
the domestic currency.

In the next chapter, Chapter 19, we look at the implications of openness

in goods markets. Chapter 20 brings in openness in financial markets. In
Chapter 21, we discuss the pros and cons of different exchange rate regimes.

Summary

Openness in goods markets allows people and firms to choose between domestic goods and foreign goods. Openness in financial markets allows financial investors to hold domestic financial assets or
foreign financial assets.

The nominal exchange rate is the price of the domestic currency in

terms of foreign currency. From the viewpoint of the United States,
the nominal exchange rate between the United States and the United
Kingdom is the price of a dollar in terms of pounds.

A nominal appreciation (an appreciation, for short) is an increase

in the price of the domestic currency in terms of foreign currency,
i.e. an increase in the exchange rate. A nominal depreciation (a
depreciation, for short) is a decrease in the price of the domestic
currency in terms of foreign currency, i.e. a decrease in the exchange
rate.

32

The real exchange rate is the relative price of domestic goods in

terms of foreign goods. It is equal to the nominal exchange rate
times the domestic price level divided by the foreign price level.

A real appreciation is an increase in the relative price of domestic

goods in terms of foreign goods, i.e. an increase in the real exchange
rate. A real depreciation is a decrease in the relative price of domestic goods in terms of foreign goods, i.e. a decrease in the real
exchange rate.

The multilateral real exchange rate, or real exchange rate for short,
is a weighted average of bilateral real exchange rates, with the weight
for each foreign country equal to its share in trade.

The balance of payments records a countrys transactions with the

rest of the world. The current account balance is equal to the sum of
the trade balance, net investment income, and net transfers received
from the rest of the world. The capital account balance is equal to
capital flows from the rest of the world minus capital flows to the
rest of the world.

The current account and the capital account are mirror images of
each other. Leaving aside statistical problems, the current account
plus the capital account must sum to zero. A current account deficit
is financed by net capital flows from the rest of the world, thus
by a capital account surplus. Similarly, a current account surplus
corresponds to a capital account deficit.

Uncovered interest parity, or interest parity for short, is an arbitrage

condition stating that the expected rates of return in terms of domestic currency on domestic bonds and foreign bonds must be equal.
Interest parity implies that the domestic interest rate approximately
equals the foreign interest rate minus the expected appreciation rate
of the domestic currency.

33

Key terms

openness in goods markets

tariffs

quotas

openness in financial markets

capital controls

openness in factor markets

North American Free Trade Agreement (NAFTA)

tradable goods

real exchange rate

nominal exchange rate

appreciation (nominal, real)

depreciation (nominal, real)

fixed exchange rates

revaluation

devaluation

merchandise trade

bilateral exchange rate

multilateral exchange rate

multilateral real U.S. exchange rate

tradeweighted real exchange rate

effective real exchange rate

foreign exchange

balance of payments

above the line, below the line

current account

capital account

investment income

net transfers received

current account balance

34

current account surplus, deficit

net capital flows

capital account balance

capital account surplus, deficit

statistical discrepancy

gross domestic product (GDP) versus gross national product (GNP)

uncovered interest parity relation, or interest parity condition

Further Readings
If you want to learn more about international trade and international economics, a very good textbook is by Paul Krugman and Maurice Obstfeld,
International Economics, Theory and Policy, 6th ed. (New York: Pearson
Addison Wesley, 2002).
If you want to know current exchange rates between nearly any pair of currencies in the world, look at the currency converter on http://www.oanda.com.

35

17.5

Figure 18-7. U.S. and U.K. Three-Month Nominal Interest Rates, 1970-2003
IUS
IUK

15.0

12.5

Percent

10.0

7.5

5.0

2.5

0.0
1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

Figure 18-6. Expected Returns from Holding One-Year

U.S. or U.K. Bonds
Year t:

Year t+1:

$1

$(1+it )

$1

$ Et (1+i*t) (1/Eet+1)

Et

Et (1+i*t)

Holding:
U.S. bonds

U.K. bonds

Figure 18-5. The U.S. Effective Real Exchange Rate, 1973-2003

1.25

1.20

1.15

Index (2000:1 =1.0)

1.10

1.05

1.00

0.95

0.90

0.85

0.80
1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

Figure 18-4. Real and Nominal Exchange rates between the U.S. and the the U.K., 1970-2003

2.0

1.8

U.S. goods in terms of U.K. goods

1.6

1.4

1.2

1.0

0.8

EXCN
REXCN

0.6
1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

Figure 18-3. The Construction of the Real Exchange Rate

Price of U.S. goods

in dollars
P

Price of U.S. goods

in pounds
EP

Price of U.K. goods

in pounds
P*

Price of U.S. goods

in terms of U.K goods
= E P/P*

0.90

Figure 18-2. The Nominal Exchange Rate between the dollar and the pound, 1970-2003

0.84

0.78

Dollars in terms of pounds

0.72

0.66

0.60

0.54

0.48

0.42

0.36
1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

Figure 18-1. U.S. Exports and Imports as Ratios of GDP, 1960-2003

0.16

0.14

0.12

Percentage of GDP

0.10

0.08

0.06

0.04

0.02

EXPORTS_GDP
IMPORTS_GDP

0.00
1960

1965

1970

1975

1980

1985

1990

1995

2000