Open-Economy Macroeconomics

Open-Economy Macroeconomics

• Open-economy macroeconomics is an economic approach that takes into account the interaction between a country's economy and the rest of the world

The Flow of Goods and Services

• Trade balance is the the measure of a nation’s exports minus the value of its imports and is also called net exports
• Trade surplus occurs when a country's exports exceed its imports
• Trade deficit is when a country's imports are greater than its exports
• Balanced trade refers to the situation in which a country's exports are equal to its imports

Influences on Exports, Imports, and Net Exports

• The tastes of consumers for domestic and foreign goods
• The prices of goods at home and abroad
• The exchange rates for domestic currency to buy foreign currencies
• The need by firms for raw materials and resources for use in production
• The incomes of consumers both at home and abroad
• The cost of transporting goods from country to country
• The policies of the government towards international trade

The Flow of Financial Resources

• Net capital outflow is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners

The Equality of Net Exports and Net Capital Outflow

• Net exports measures an imbalance between a country's exports and its imports in the goods market
• Net capital outflow measures an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners
• NCO = NX

International Flows of Goods and Capital

• Trade deficit: Exports < Imports, Net exports < 0, Y < C + I + G, Saving < Investment, Net capital outflow < 0
• Balanced trade: Exports = Imports, Net exports = 0, Y = C + I + G, Saving = Investment, Net capital outflow = 0
• Trade surplus: Exports > Imports, Net exports > 0, Y > C + I + G, Saving > Investment, Net capital outflow > 0

Balance of Payments

• The balance of payments is the official account of international payments for the import and export of goods, services, and capital
• It consists of three elements: The Current Account, The Financial Account and the Capital Account

Purchasing Power Parity (PPP)

• PPP is a theory of exchange rates which states a unit of any given currency should be able to buy the same quantity of goods in all countries
• Arbitrage is the process of buying a good in one market at a low price and selling it in another market at a higher price in order to profit from the price difference

Market for Loanable Funds

• Interest rate in an open economy determined by the supply and demand for loanable funds
• National saving is the source of the supply of loanable funds
• Domestic investment and net capital outflow are the sources of the demand for loanable funds
• At the equilibrium interest rate, the amount that people want to save exactly balances the amount that people want to borrow for the purpose of buying domestic capital and foreign assets

Market for Foreign Currency Exchange

• Real exchange rate is determined by the supply and demand for foreign currency exchange
• Supply of domestic currency for exchange comes from net capital outflow
• Demand for domestic currency comes from net exports
• At the equilibrium real exchange rate, the number of domestic currency people supply to buy foreign assets exactly balances the number of domestic currency people demand to buy net exports

Government Budget Deficit Effects

• A government budget deficit reduces the supply of loanable funds
• This increases the real interest rate, reduces net capital outflow, reduces the supply of domestic currency, and appreciates the real exchange rate

Import Quota Effects

• An import quota increases net exports and demand for domestic currency
• It also appreciates the real exchange rate, offsetting the effect on the trade balance

Capital Flight Effects

• Capital flight increases net capital outflow and raises domestic real interest rate
• It also increases the supply of domestic currency, causing it to depreciate