Chapter 6 Readings PDF

CHAPTER 6 The Open Economy No nation was ever ruined by trade. —Benjamin Franklin Even if you never leave your hometown, you are a participant in the global economy. When you go to the grocery store, you might choose between apples grown locally and grapes grown in Chile. When you ma...

CHAPTER 6 The Open Economy No nation was ever ruined by trade. —Benjamin Franklin Even if you never leave your hometown, you are a participant in the global economy. When you go to the grocery store, you might choose between apples grown locally and grapes grown in Chile. When you make a deposit into your local bank, the bank might lend those funds to your next-door neighbor or to a Japanese company building a factory outside Tokyo. Because economies around the world are integrated with one another, consumers have more goods and services from which to choose, and savers have more opportunities to invest their wealth. In previous chapters we simplified the analysis by assuming a closed economy. Yet most actual economies are open: they export goods and services abroad, they import goods and services from abroad, and they borrow and lend in world financial markets. Figure 6-1 gives some sense of the importance of these international interactions by showing imports and exports as a percentage of GDP for ten major countries. As the figure shows, exports from the United States are about 13 percent of GDP, and imports are about 15 percent. Trade is even more important for many other countries—imports and exports are about 20 percent of GDP in China, about 33 percent in Canada, and almost 50 percent in Germany. In these countries, international trade is central to analyzing economic developments and formulating economic policies. FIGURE 6-1 Imports and Exports as a Percentage of Output: 2015 While international trade is important for the United States, it is even more vital for other countries. Data from: World Bank. This chapter begins our study of open-economy macroeconomics. We begin in Section 6-1 with questions of measurement. To understand how an open economy works, we must understand the key macroeconomic variables that measure the interactions among countries. Accounting identities reveal a key insight: the flow of goods and services across national borders is always matched by an equivalent flow of funds to finance capital accumulation. In Section 6-2 we examine the determinants of these international flows. We develop a model of the small open economy that corresponds to our model of the closed economy in Chapter 3. The model shows the factors that determine whether a country is a borrower or a lender in world markets and how policies at home and abroad affect the flows of capital and goods. In Section 6-3 we extend the model to discuss the prices at which a country makes exchanges in world markets. We examine what determines the price of domestic goods relative to foreign goods. We also examine what determines the rate at which the domestic currency trades for foreign currencies. Our model shows how protectionist trade policies—policies designed to protect domestic industries from foreign competition— influence the amount of international trade and the exchange rate. 6-1 The International Flows of Capital and Goods The key macroeconomic difference between open and closed economies is that, in an open economy, a country’s spending in any given year need not equal its output of goods and services. A country can spend more than it produces by borrowing from abroad, or it can spend less than it produces and lend the difference to foreigners. To understand this more fully, let’s take another look at national income accounting, which we first discussed in Chapter 2. The Role of Net Exports Consider the expenditure on an economy’s output of goods and services, again denoted as Y. In a closed economy, all output is sold domestically, and expenditure is divided into three components: consumption C, investment I, and government purchases G. In an open economy, some output is sold domestically and some is exported to be sold abroad. In addition, some of the goods and services included in consumption, investment, and government purchases are produced abroad and imported. We can thus write the national income accounts identity as Y=C+I+G+X−IM where X represents exports and IM represents imports. Because spending on imports is included in domestic spending (C+I+G), and because goods and services imported from abroad are not part of a country’s output, this equation subtracts spending on imports. Defining net exports to be exports minus imports (NX=X−IM), we can write the identity as Y=C+I+G+NX. This equation states that expenditure on domestic output is the sum of consumption, investment, government purchases, and net exports. This form of the national income accounts identity should be familiar from Chapter 2.  The national income accounts identity shows how domestic output, domestic spending, and net exports are related. In particular, NX=Y−(C+I+G)Net Exports=Output−Domestic Spending. This equation shows that in an open economy, domestic spending need not equal the output of goods and services. If a country’s output exceeds its domestic spending, it exports the difference: net exports are positive. If a country’s output falls short of its domestic spending, it imports the difference: net exports are negative. International Capital Flows and the Trade Balance In an open economy, as in the closed economy we discussed in Chapter 3, financial markets and goods markets are closely related. To see the relationship, we must rewrite the national income accounts identity in terms of saving and investment. Begin with the identity Y=C+I+G+NX. Subtract C and G from both sides to obtain Y−C−G=I+NX. Recall from Chapter 3 that Y−C−G is national saving S, which equals the sum of private saving, Y−T−C, and public saving, T−G, where T stands for taxes. Therefore, S=I+NX. Subtracting I from both sides of the equation, we can write the national income accounts identity as S-I=NX. This form of the national income accounts identity shows that an economy’s net exports must always equal the difference between its saving and its investment. Let’s look more closely at each part of this identity. The right-hand side, NX, is net exports of goods and services. Another name for net exports is the trade balance, because it tells us how a country’s trade in goods and services departs from the benchmark of equal imports and exports. The left-hand side of the identity is the difference between domestic saving and domestic investment, S−I, which we’ll call net capital outflow. (It’s sometimes called net foreign investment.) Net capital outflow equals the amount that domestic residents are lending abroad minus the amount that foreigners are lending to us. If net capital outflow is positive, the economy’s saving exceeds its investment, and it is lending the excess to foreigners. If the net capital outflow is negative, the economy is experiencing a capital inflow: investment exceeds saving, and the economy is financing this extra investment by borrowing from abroad. Thus, net capital outflow reflects the international flow of funds to finance capital accumulation. The national income accounts identity shows that net capital outflow always equals the trade balance. That is, Net Capital Outflow=Trade BalanceS−I=NX. If S−I and NX are positive, a country has a trade surplus. In this case, it is a net lender in world financial markets, and it exports more than it imports. If S−I and NX are negative, a country has a trade deficit. In this case, it is a net borrower in world financial markets, and it imports more than it exports. If S−I and NX are exactly zero, a country is said to have balanced trade because its imports and exports are equal in value. The national income accounts identity shows that the international flow of funds to finance capital accumulation and the international flow of goods and services are two sides of the same coin. Suppose that, in the nation of Westeros, saving exceeds investment. In this case, the surplus saving of Westeros is used to make loans to foreigners. Foreigners require these loans because Westeros is providing them with more goods and services than they are providing Westeros. That is, Westeros is running a trade surplus. Conversely, suppose that, in the nation of Essos, investment exceeds saving. Then the extra investment in Essos must be financed by borrowing from abroad. These foreign loans enable Essos to import more goods and services than it exports. That is, Essos is running a trade deficit. Table 6-1 summarizes these lessons. TABLE 6-1 International Flows of Goods and Capital: Summary  This table shows the three outcomes that an open economy can experience. Trade Surplus Balanced Trade Trade Deficit Exports > Imports Exports = Imports Exports < Imports Net Exports>0 Net Exports=0 Net ExportsC+I+G Y=C+I+G Y Investment Saving = Investment Saving < Investment Net Capital Outflow>0 Net Capital Outflow=0 Net Capital Outflow