Macroeconomics

COURSE 2024-2025.
Lesson 4 (Part 1) DEGREE IN
INTERNATIONAL
Openness in Goods BUSINESS
and Financial Markets
Outline
4.1 Openness in Goods Markets
4.2 Openness in Financial Markets
4.3 Conclusions and a Look Ahead

Reference: Chapter 18 in Macroeconomics, a European Perspective. 4th Edition

(Blanchard et al., 2021)

MACROECONOMICS. DEGREE IN INTERNATIONAL BUSINESS. COURSE 2024-2025 2

Figure 4.1. Growth in advanced and emerging economies since 2000

The 2008 crisis started

in the United States,
but it affected nearly
every country in the
world.

Source: IMF, World Economic Outlook, Oct. 2015. Used courtesy of IMF.

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Introduction
Openness has three distinct dimensions:
1. Openness in goods markets – the ability of consumers and firms to choose
between domestic and foreign goods. This choice is not free of restrictions:
tariffs (taxes on imported goods), quotas (restrictions on the quantity of goods
that can be imported) and administrative barriers.
◦ In most countries, average tariffs are low.
2. Openness in financial markets – the ability of financial investors to choose
between domestic assets and foreign assets. Countries may have capital
controls (restrictions on the foreign (domestic) assets that domestic residents
(foreigners) can hold).
◦ Capital controls are much more limited today.
3. Openness in factor markets – the ability of firms to choose where to locate
production and of workers to choose where to work.

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4.1. Openness in goods markets
Figure 4.2. EU exports and imports as ratios of GDP since 1970
60

55
How much Europe trades with the rest
50 of the world?
45
Over time, the EU economy became
40
more and more open.
35

30 Imports and exports have followed an

25
upward trend.
20

15
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
Exports goods & services (% of GDP) Imports goods & services (% of GDP)

Source: World Bank, World Development Indicators.

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 4.1. Openness in goods markets
Table 4.1. Ratios of exports to GDP for selected OECD countries, 2017

Source: World Bank database.

The main factors behind these differences are geography and size:
- Distance from other markets.
- The smaller the country, the more it must specialise in producing and exporting only a few
products and rely on imports for other products (for instance, the Netherlands cannot afford
to produce the same range of goods as the US).
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4.1. Openness in goods markets
Can exports exceed GDP?
That is… can a country have an export ratio (X/GDP) greater than 1?
The answer is yes: exports and imports include intermediate goods,
whereas GDP doesn’t.
This is the case for several small countries where most economic
activity is organized around import-export activities.
Example: the ratio of exports to GDP in Singapore was 173% in 2017.

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4.1. Openness in goods markets
The choice between domestic goods and foreign goods
In a closed economy, people face one spending decision: save or buy.
When goods markets are open, consumers face two spending
decisions: (1) save or buy and (2) buy domestic or foreign goods.
Central to this second decision is the price of domestic goods relative
to foreign goods: the real exchange rate.
The real exchange rate considers both the relative prices of
currencies (nominal exchange rates) and the relative price level.

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4.1. Openness in goods markets
Nominal exchange rates between two currencies can be quoted in two ways:
• As the price of the domestic currency in terms of the foreign currency.
• Example: if we look at the Euro area and the UK (the euro is the domestic currency
and the pound is the foreign currency), we can express the nominal exchange rate as
the price of a euro in terms of pounds. In September 2024, it was 0.84. One euro was
worth 0.84 pounds.
• As the price of the foreign currency in terms of the domestic currency.
• We can express the nominal exchange rate as the price of a pound in terms of euros.
In September 2024, one pound was worth 1.19 euros.
• We define the nominal exchange rate as the price of the domestic currency in
terms of foreign currency and denote it by E. That is, the price of a euro in terms
of pounds (or dollars, or any other foreign currency).

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4.1. Openness in goods markets
Exchange rates are determined in foreign exchange markets and change
every day. These changes are called appreciations or depreciations.
• 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 E, an appreciation means an increase in the exchange rate.
•A depreciation of the domestic currency is a decrease in the price of the
domestic currency in terms of a foreign currency. Given our definition of
E, a depreciation corresponds to a decrease in the exchange rate.

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4.1. Openness in goods markets
When countries operate under fixed exchange rates –a system in which
two or more countries maintain a constant nominal exchange rate
between their currencies-, movements in exchange rates are called
revaluations and devaluations.
• Increases in the exchange rate are called revaluations (rather than
appreciations).
• Decreases in the exchange rate are called devaluations (rather than
depreciations).

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4.1. Openness in goods markets
Figure 4.3. The ECB’s official euro exchange rates
1,8
The euro has appreciated relative to
1,6
the pound, but this appreciation has
1,4 come with large fluctuations in the
1,2 exchange rate.
1,0 The euro largely appreciated relative
0,8 to the dollar from 2000 to 2008.
0,6
The US$ gained strength following the
0,4 monetary policy reaction of the
Federal Reserve in March 2022.
jan 2000
jan 2001
jan 2002
jan 2003
jan 2004
jan 2005
jan 2006
jan 2007
jan 2008
jan 2009
jan 2010
jan 2011
jan 2012
jan 2013
jan 2014
jan 2015
jan 2016
jan 2017
jan 2018
jan 2019
jan 2020
jan 2021
jan 2022
jan 2023
jan 2024
euro/dollar euro/pound

Source: Banco de España

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4.1. Openness in goods markets
From nominal to real exchange rates
The nominal exchange rate is the price of the domestic currency in terms of the
foreign currency.
The real exchange rate is the relative price of domestic goods in terms of foreign
goods.
The real exchange rate (Ꜫ) between the euro area and the UK reflects the price
of European goods in terms of British goods. How can we construct Ꜫ?
• Suppose the Euro area produced only one good, a Ferrari; and the UK only one
good, a Jaguar. Constructing the real exchange rate is straightforward: the price
of EU goods (Ferrari) in terms of British goods (Jaguars).

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4.1. Openness in goods markets
How can we construct the real exchange rate (Ꜫ)?
•1st step: Take the price of a Ferrari in euros and convert it to a price in
pounds. If the price of a Ferrari is 200,000 euros and the euro is worth 0.9
pounds, the price of a Ferrari in pounds is €200,000 x 0.9= £180,000.
• 2nd step: compute the ratio of the price of the Ferrari in pounds to the
price of the Jaguar in pounds. The price of the Jaguar in pounds is
£30,000. What is the price of the Ferrari in terms of Jaguars? The real
exchange rate would be £180,000/£30,000=6
• A Ferrari would be six times more expensive than a Jaguar.

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4.1. Openness in goods markets

We need to generalize this example to construct a real exchange rate

that reflects the relative price of all the goods produced in the euro
area in terms of all the goods produced in the UK.
We must use a price index for all goods produced in the UK and a
price index for all goods produced in the euro area  the GDP
deflators!

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4.1. Openness in goods markets
Figure 4.4. The construction of the real exchange rate

euros

P is the GDP deflator for the euro area

P* is the GDP deflator for the UK
E is the euro-pound nominal exchange rate
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4.1. Openness in goods markets
• The real exchange rate is an index number: its level is uninformative. But
the rate of change is informative:
• 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.
• It may come either from a nominal appreciation or from domestic inflation
being higher than foreign inflation.
• 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.
• It may come either from a nominal depreciation or from domestic inflation
being lower than foreign inflation.

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4.1. Openness in goods markets
Figure 4.5. Real and nominal exchange rates between the euro area and the United Kingdom
since 1981
• The nominal and the real
exchange rates between the
euro and the pound have
moved largely together.
• This reflects that inflation
rates have been similar in
both countries.
• Movements in the real
exchange rate tend to be
driven largely by movements
in the nominal exchange
rate E.

Source: Eurostat.
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4.1. Openness in goods markets
From bilateral to multilateral exchange rates
The exchange rate between the euro area and the UK is a bilateral exchange
rate. But the UK is just one of many countries the euro area trades with.
Table 4.2. The country composition of euro area exports and imports, 2015

Source: European Central Bank.

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4.1. Openness in goods markets
The multilateral exchange rate is a weighted average of bilateral real exchange
rates.
Multilateral exchange rates are constructed so that they reflect the composition
of trade.
Each country is weighted according to:
- How much the country trades with the euro area.
- How much it competes with the euro area in other countries.
The multilateral exchange rate is also called the trade-weighted real exchange
rate or the effective real exchange rate.

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4.2. Openness in financial markets
• Openness in financial markets allows financial investors to hold both domestic
assets and foreign assets and to diversify their portfolios.
• Buying or selling foreign assets implies buying or selling foreign currency.
• A country’s openness in financial markets has an important implication: it
allows the country to run trade surpluses and trade deficits.
• A country running a trade deficit is buying more from the rest of the world
(RoW) than it is selling to the RoW.
• To pay for the difference between what it buys and what it sells, the country
must borrow from the RoW.

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4.2. Openness in financial markets
The relation between trade flows and financial flows.
• Balance of payments: A set of accounts that summarize a country’s
transactions with the RoW (including both trade flows and financial flows).

Table 4.3. The euro area balance of payments, 2019, in billions of euros

Source: European Central Bank.

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4.2. Openness in financial markets
• Current account: it records payments to and from the rest of the world.
◦ Exports and imports of goods and services (trade balance).
◦ Net income balance between income received from the rest of the world and
income paid to foreigners.
• Current account balance: The sum of net payments to and from the rest of the
world.
• Current account surplus: Positive net payments from the rest of the world.
• Current account deficit: Negative net payments from the rest of the world.
• Capital account — capital transfers between domestic and foreign residents
(official lending or government transfers and state aid).

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4.2. Openness in financial markets
Financial account: inward and outward direct investment, portfolio investment,
financial derivatives and others.
Net capital flows or financial account balance: it measures the increase or
decrease in a country’s ownership of international assets.
Financial account surplus: Positive net capital flows.
Financial account deficit: Negative net capital flows.
Statistical discrepancy: difference between financial account and current
account balance.

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4.2. Openness in financial markets
The difference between GDP and GNP
• GDP measures value added domestically.
• GNP (gross national product) measures the value added by domestic factors of
production.
• When the economy is closed, GDP = GNP.
• However, when the economy is open, they can differ: some of the income from
domestic production goes to foreigners; domestic residents receive some foreign
income.
• We have to add to GDP the net income payments from the rest of the world
(income received from RoW – income paid to the RoW):
GNP = GDP + NI
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4.2. Openness in financial markets
• Openness in financial markets implies a new financial decision: whether to hold
domestic interest-paying assets or foreign interest-paying assets.
• Consider the choice between German bonds and UK bonds.

Assessing the attractiveness of UK

vs German bonds.
- You cannot look just at the UK
and the German interest rate.
- You must also consider what will
happen to the euro/pound
exchange rate between this year
and the next.

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4.2. Openness in financial markets
• For every € you put in German bonds, you will get (1+it) euros next year.
• If you decide instead to hold UK bonds, you need to buy pounds first. For every euro, you get Et
pounds.
• Next year, you will have 𝐸𝐸𝑡𝑡 (1 + 𝑖𝑖𝑡𝑡∗ ) pounds. You will have then to convert your pounds back into
𝑒𝑒
euros. If you expect the nominal exchange rate next year to be 𝐸𝐸𝑡𝑡+1 , each pound will be worth
𝑒𝑒
(1/𝐸𝐸𝑡𝑡+1 ).

Then, what you can expect to have

next year for every euro you invest
now is 𝐸𝐸𝑡𝑡 (1 + 𝑖𝑖𝑡𝑡∗ )(1/𝐸𝐸𝑡𝑡+1
𝑒𝑒
)

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4.2. Openness in financial markets
Assume that you only care about the expected rate of return: you want to hold
the asset with the highest expected rate of return.
If an investor holds UK and German bonds, they must have the same expected
rate of return. Then, the following relation must hold:
 1 
*
(1+ it )= ( Et )(1+ i t ) e 
 E t +1 
Reorganising:
This is called the uncovered interest parity relation or
*  Et  the interest parity condition.
(1+ it )= (1+ i t ) e 
 E t +1  This arbitrage condition implies that the expected rates of
return of domestic and foreign bonds must be equal.
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4.2. Openness in financial markets
The assumption that financial investors will hold only the bonds with the highest
expected rate of return is too strong:
• It ignores transaction costs. Buying and selling foreign bonds involves a higher
transaction cost.
• It ignores risk. The exchange rate a year from now is uncertain.
• However, it is a good approximation for financial markets in rich countries:
• small changes in interest rates and rumors of appreciation or depreciation can
lead to movements of billions of euros within minutes.

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4.2. Openness in financial markets
The arbitrage relation between interest rates and exchange rates
The relation between the domestic nominal interest rate (i), the foreign nominal
interest rate (i*) and the expected rate of appreciation of the domestic currency
is given by: *
(1+ it )
(1+ it )=
[1+ ( Ete+1 − Et )/ Et )]

A good approximation of this equation is given by:

e
* E t +1 − Et
it ≈ i t −
Et

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4.2. Openness in financial markets
This interest parity condition implies that the domestic interest rate must be
equal to the foreign interest rate minus the expected appreciation rate of the
domestic currency.
e
* E t +1 − Et
it ≈ i t −
Et
Note that the expected appreciation rate of the domestic currency is also the
expected depreciation rate of the foreign currency.
𝑒𝑒
If 𝐸𝐸𝑡𝑡+1 = 𝐸𝐸𝑡𝑡 , then 𝑖𝑖𝑡𝑡 = 𝑖𝑖𝑡𝑡∗

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4.2. Openness in financial markets
Example. German bonds versus UK bonds
The one-year nominal interest rate on German bonds is 2%, and 5% in UK bonds.
Should you hold UK bonds or German bonds?
• It depends whether you expect the pound to depreciate relative to the euro by
more or less than the difference between i and i* (in this case, 3%=5%-2%).
E et +1 − Et
*
it ≈ i − t
Et
• If you expect the pound to depreciate by more than 3%  investing in UK bonds
is less attractive.
• If you expect the pound to depreciate by less than 3% (or to appreciate) 
investing in UK bonds is more attractive.

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4.2. Openness in financial markets
Example. German bonds versus UK bonds
Another way of looking at it: if the interest parity condition holds, and the
German one-year interest rate is 3% lower than the UK interest rate, it must be
that financial investors are expecting, on average, an appreciation of the euro
relative to the pound of about 3%.
• This is why they are willing to hold German bonds despite their lower interest
rate.

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4.2. Openness in financial markets
Example. Buying Brazilian bonds
In September 1993 Brazilian bonds were paying a monthly interest rate of 36.9%
while US bonds paid 0.2% monthly.
However, the Brazilian currency (cruzeiro) was depreciating rapidly. It fell 34.6%
in August 1993 versus the dollar.
(1+ it* ) 1,369
(1+ it )= e = = 1,017
[1+ ( Et +1 − Et )/ Et )] 1,346

When you factor in the currency movements the expected rate of return in
dollars from holding Brazilian bonds is only (1.017 – 1) = 1.7% per month.
While this return is higher you need to consider risk and transaction costs.

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4.3. Look ahead
We have now set the stage for the study of the open economy:
• Openness in goods markets allows people and firms to choose between
domestic goods and foreign goods. This choice depends primarily on the real
exchange rate.
• Openness in financial markets allows investors to choose between domestic
assets and foreign assets. This choice depends primarily on their relative rates of
return, and on the expected rate of appreciation of the domestic currency.

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