Economic Concepts Overview

An economy that engages in international trade in goods and services with the rest of the world.

A country's exports can be expressed by subtracting consumption of domestic goods and services, investment of domestic goods and services, and government purchases of domestic goods and services from GDP.

Net exports are equal to the difference between a country's GDP and its domestic spending on all goods and services.

If domestic expenditure is higher than production, imports compensate for the difference, resulting in negative net exports.

The value of net exports is equal to the difference between national saving and domestic investment.

If net capital outflow is positive, it means that a country is investing more abroad than foreign investors are investing in the country, resulting in a trade surplus.

Net capital outflow is determined by subtracting domestic investment from national saving.

Net capital outflow corresponds to the amount that domestic investors lend abroad, minus the amount that foreign investors lend to the domestic country.

When domestic saving surpasses domestic investment, it leads to positive net exports and positive net capital outflows, which means the country invests more abroad than it receives from foreign investors.

A small open economy is one whose domestic interest rate aligns with the world interest rate. This implies that the country significantly impacts global financial markets, making it a price taker for lending and borrowing rates.

The world interest rate is the prevailing interest rate observed in global financial markets.

In a small open economy with perfect capital mobility, the real interest rate is always equal to the world real interest rate. This ensures that capital flows freely across borders, driven by the pursuit of the highest return, making the domestic interest rate match the global interest rate.

A small open economy, characterized by perfect capital mobility, allows for unrestricted international borrowing and lending, meaning that the government can lend money abroad or borrow from overseas investors without any constraints.

A model built on the assumption of a small open economy is useful because it simplifies the analysis of open economy macroeconomics. It simplifies the dynamics of international trade and capital flows, allowing us to understand the core principles of this complex area.

In a small open economy, if the world real interest rate is above the rate at which national saving equals domestic investment, the country generates a trade surplus and experiences positive net capital outflow. This means the country invests more capital abroad than it receives from foreign investors.

An increase in the trade deficit of a small open economy can result from an increase in government spending. When government expenditure rises, it reduces national saving, leading to a lower supply of loanable funds. This pushes up domestic interest rates, attracting foreign capital and creating a need for imported goods to meet the increased demand.

An increase in the world interest rate can lead to an increase in the trade surplus of a small open economy. When the world interest rate rises, it attracts more foreign capital to the domestic economy. This increased inflow of capital strengthens the domestic currency, making exports more competitive and imports less attractive, leading to a trade surplus.

In a small open economy, if the government boosts domestic government purchases, it has the effect of creating a tendency toward a trade deficit and negative net capital outflow. This is attributed to the increased spending consuming the country’s resources, raising expenditure above production, leading to more imports and less capital outflow.

In a small open economy, starting from a position of balanced trade, an increase in the income tax generates a tendency toward a trade surplus and positive net capital outflow. Higher taxes reduce disposable income, leading to lower consumption and higher national saving. As a result, the supply of loanable funds increases. This forces interest rates down leading to a reduction in investment. The decline in investment leads to an increase in net capital outflow and the consequent trade surplus.

In a small open economy with perfect capital mobility, if the world interest rate falls, then the amount of domestic investment will increase, and net exports will fall. The fall in interest rates lowers the cost of borrowing, making investment more appealing and thus raising domestic investment. However, as domestic investment rises, it demands more loanable funds, leading to a decrease in net capital outflow and a resulting decline in net exports as domestic spending outweighs domestic production.

A trade deficit can be financed through borrowing from foreigners, selling assets to foreigners, or, perhaps surprisingly, selling foreign assets owned by domestic residents to foreigners. However, it cannot be financed by borrowing from domestic lenders.

The nominal exchange rate represents how much of one currency you can obtain for one unit of another currency.

The real exchange rate is calculated by multiplying the nominal exchange rate by the ratio of the foreign price level to the domestic price level. It reflects the relative price of goods and services in two economies.

If the number of dollars per yen rises, it implies an appreciation of the dollar. This means that one dollar buys more yen, indicating that the dollar has become stronger relative to the yen.

The real exchange rate measures the relative cost of goods and services between two countries. If the real exchange rate is high, foreign goods are relatively cheap compared to domestic goods.

If the real exchange rate depreciates, foreign goods become relatively more expensive, and domestic goods are relatively less expensive to foreign buyers. Consequently, U.S. exports tend to decrease, while imports increase.

In a small open economy with perfect capital mobility, national saving is fixed, and investment is determined by the investment function and the world interest rate. This means that national saving sets the overall level of lending, while investment is influenced by the world interest rate, which makes borrowing costs consistent across countries.

In a large open economy, the real interest rate is determined by the interaction of national saving, the domestic investment function, and the net capital outflow function. This means that the real interest rate balances the demand for loanable funds (from domestic investment and net capital outflow) with the supply of loanable funds (from national saving).