Open Economy Concepts and Capital Flows

Open Economy Concepts

• Open Economy: An economy that interacts with other economies globally, allowing for trade in goods and services and financial assets.
• Closed Economy: An economy that does not interact with other economies.
• Exports: Domestically produced goods and services sold abroad.
• Imports: Foreign-produced goods and services sold domestically.
• Net Exports (Trade Balance): Value of exports minus imports; can be positive (surplus) or negative (deficit).
• Balanced Trade: Exports equal imports.

Capital Flows and Net Capital Outflow

• Net Capital Outflow (NCO): Purchases of foreign assets by domestic residents less purchases of domestic assets by foreigners (also called Net Foreign Investment).
• Foreign Direct Investment: Foreign ownership with active management of the asset.
• Foreign Portfolio Investment: Foreign ownership with a more passive role.
• Relationship between Net Exports and NCO: Net exports (NX) always equal net capital outflow (NCO), meaning NX = NCO. This arises from the exchange occurring in every transaction. For example, selling oil (exports) generates foreign currency, which is an acquisition of a foreign asset.

National Accounting in an Open Economy

• National Saving (S): Portion of national income remaining after consumption and government spending.
• National Income Identity: Y = C + I + G + NX, where Y is national income, C is consumption, I is investment, G is government spending, and NX is net exports.
• Saving-Investment Relationship: S = I + NX, implying national saving can finance domestic investment or investment abroad.

Exchange Rates

• Nominal Exchange Rate: Rate at which one currency can be exchanged for another.
  • Appreciation: Increase in currency value, measured by the amount of foreign currency it can buy.
  • Depreciation: Decrease in currency value.
• Real Exchange Rate: Rate at which goods and services of one country can be exchanged for goods and services of another. RealExchangeRate = (Nominal Exchange Rate × Domestic Price) / Foreign Price.
• Example Calculation: A real exchange rate calculation can determine how many units of foreign beer can be bought with one unit of domestic beer.
• Calculating Real Exchange Rate: Computation involves a basket of goods and prices in each country. The formula (real exchange rate) = (e × P) / P*, where e is the nominal exchange rate, P is the domestic price, and P* is the foreign price, establishes the relationship.

Purchasing Power Parity (PPP)

• Purchasing Power Parity (PPP): A theory where a unit of currency should buy the same quantity of goods in all countries
• Law of One Price: Underlying principle that goods should sell for the same price everywhere, theoretically enabling arbitrage when prices differ.
• Factors Affecting PPP: Real exchange rate is affected by the relative prices of goods in different countries.
• Reasons PPP Doesn't Always Hold: Non-traded goods, imperfect substitutes for traded goods, and government policies.

Small Open Economy and Perfect Capital Mobility

• Small Open Economy: An economy whose actions have negligible impact on global prices and interest rates.
• Perfect Capital Mobility: Implies equal real interest rates in the domestic economy and the world.

Interest Rate Parity

• Interest Rate Parity: Theory stating that real interest rates on comparable assets should be the same in all economies with full access to world financial markets. Different interest rates for similar assets could lead to arbitrage opportunities, requiring rates to converge.
• Factors Impacting Interest Rate Parity: Differences in risk levels and tax treatment of returns can affect the observed interest rates.