Open-Economy Macroeconomics (Ch 31 & 32) – Detailed Study Notes

Open-Economy Macroeconomics – Core Ideas (Chapter 31)

Closed vs. Open Economies

• Closed economy: No exports, no imports, no cross-border asset trade.
• Open economy: Interacts through
  • World product markets ⇒ buys/sells goods & services.
  • World financial markets ⇒ buys/sells capital assets.

Flow of Goods

• Exports ($X$): Domestically produced, sold abroad.
• Imports ($M$): Produced abroad, sold domestically.
• Net Exports (Trade Balance): $NX = X - M$
  • Trade deficit: NX < 0 \; (X < M).
  • Trade surplus: NX > 0 \; (X > M).
  • Balanced trade: $NX \approx 0$.
• Determinants of $NX$:
  • Consumer tastes (domestic vs. foreign goods).
  • Relative price levels at home/abroad.
  • Exchange rate ($e$) movements.
  • Domestic & foreign incomes.
  • Transportation costs.
  • Government trade policies (tariffs, quotas, FTAs – e.g.
    WTO, NAFTA, other FTAs).
• U.S. trend: Rising export & import shares of GDP since 1950 due to
  1. Cheaper transportation.
  2. Advances in telecommunications.
  3. Technological progress (lighter, easier-to-ship output).
  4. Progressive trade agreements lowering barriers.

Flow of Financial Resources

• Net Capital Outflow (NCO): NCO = \text{Domestic purchases of foreign assets}
  • \text{Foreign purchases of domestic assets}.
  • Example ↑ $NCO$: U.S. resident buys SK Telecom stock.
  • Example ↓ $NCO$: Korean resident buys U.S. Treasury bond.
• Drivers of $NCO$:
  • Real return on foreign assets ($r_f$).
  • Real return on domestic assets ($r_d$).
  • Perceived political/economic risk abroad.
  • Government regulations on foreign ownership, capital controls, etc.

Fundamental Accounting Identity

• Every international transaction exchanges goods for assets ⇒ $NX = NCO$.
  • Trade surplus (sell goods) → acquire foreign assets ⇒ NCO > 0.
  • Trade deficit (buy goods) → issue/sell domestic assets ⇒ NCO < 0.

Saving, Investment & International Flows

• GDP identity: $Y = C + I + G + NX$.
• National saving: $S = Y - C - G$.
• Combining: $S = I + NX = I + NCO$ ⇒
  • Domestic saving funds either
  • Domestic investment ($I$), or
  • Foreign investment ($NCO$).
• U.S. data: Persistent gap between domestic saving & investment mirrors $NCO/NX$ patterns.

Prices Relevant for International Transactions

• Nominal exchange rate ($e$): Foreign currency per unit of domestic currency (quantity quotation). Reverse quotation possible.
  • Appreciation: $e \uparrow$ ⇒ home currency buys more foreign currency.
  • Depreciation: $e \downarrow$ ⇒ home currency buys less foreign currency.
• Real exchange rate ($E$): Relative price of goods baskets. $E = \dfrac{eP}{P^*}$.
  • $P$: Domestic price level; $P^*$: Foreign price level.
  • $E \downarrow$ (real depreciation) ⇒ domestic goods cheaper → $X \uparrow$, $M \downarrow$ ⇒ $NX \uparrow$.
  • $E \uparrow$ (real appreciation) has opposite effects.

Purchasing-Power Parity (PPP) – First Theory of $e$

• Law of One Price ⇒ Arbitrage equalises prices; single currency should buy same quantity everywhere.
• If PPP holds: $1/P = e/P^* \;\Rightarrow\; e = P^*/P$ ⇒ real rate $E=1$.
• Implications
  • Nominal exchange rate mirrors relative price levels.
  • Excess money creation (hyper-inflation) lowers a currency’s value in both goods & FX markets.
• German hyperinflation (1921-1924): Money supply ↑ ⇒ Price level ↑ ⇒ Mark depreciates (cent/Mark graph shows cointegration).
• Limitations
  1. Non-traded goods (haircuts, housing).
  2. Imperfect substitutes / product differentiation (German vs. U.S. beer).

A Macroeconomic Theory of the Open Economy (Chapter 32)

Two Inter-linked Markets (simultaneous equilibrium)

1. Market for Loanable Funds (LF)
2. Market for Foreign-Currency Exchange (FX)
   Assume GDP ($Y$) & domestic price level ($P$) fixed (short run).

Market for Loanable Funds

• Supply: National saving $S(r)$; upward-sloping: \partial S/\partial r > 0.
• Demand: Domestic investment $I(r)$ + $NCO(r)$; both downward-sloping:
  \partial I/\partial r < 0, \; \partial NCO/\partial r < 0.
• Equilibrium interest rate $r^<em>$ satisfies $S(r^</em>) = I(r^<em>) + NCO(r^</em>)$.
• Interpretation: LF = domestically generated resources financing either home projects ($I$) or foreign projects ($NCO$).

Market for Foreign-Currency Exchange

• Supply of domestic currency: $NCO$ (vertical, independent of $E$).
• Demand for domestic currency: $NX(E)$ (downward-sloping; higher $E$ ⇒ home goods expensive ⇒ $NX \downarrow$).
• Equilibrium real exchange rate $E^<em>$ satisfies $NCO = NX(E^</em>)$.

Role of Net Capital Outflow

• Bridges the two markets: $NCO$ appears as
  • Demand component in LF, and
  • Supply component in FX.
• Key determinant: Real interest rate $r$ (↑ $r$ → domestic assets more attractive → $NCO \downarrow$).

Comparative-Static Experiments

1. Government Budget Deficit ↑ (Twin Deficits)

• National saving ↓ ⇒ LF supply shifts left.
• $r\uparrow$ ⇒ $NCO\downarrow$.
• FX supply of currency ↓ ⇒ $E\uparrow$ (real appreciation).
• Results: Investment crowded out, currency stronger, $NX\downarrow$.

2. Trade Policy (e.g., Import Quota or Tariff)

• Directly lowers imports of targeted good.
• $S$ and $I$ unchanged ⇒ $NCO$ unchanged.
• In FX market: Demand for domestic currency ↑ (foreigners need dollars to buy unchanged $X$ but fewer $M$) ⇒ $E\uparrow$ (appreciation).
• Appreciation offsets initial $NX$ rise ⇒ trade balance unchanged; only micro-allocation shifts.

3. Capital Flight / Political Instability

• Sudden ↑ in perceived risk ⇒ investors sell domestic assets ⇒ $NCO\uparrow$.
• LF demand shifts right ⇒ $r\uparrow$.
• FX supply ↑ ⇒ currency depreciates ($E\downarrow$).
• Case study: 1994 Mexican peso crisis.

Graphical Summary (three-panel diagram)

• Panel (a): LF market – $S$ vs. $I+NCO$ curve.
• Panel (b): $NCO(r)$ slope negative.
• Panel (c): FX market – vertical $NCO$ supply, downward $NX(E)$ demand.
• Intersection points show $r^<em>$, $NCO^</em>$, $E^*$.

Key Take-Aways & Formulas

• Accounting identities:
  • $NX = NCO$
  • $S = I + NCO$
• Exchange rates:
  • Nominal: $e$ (foreign / home).
  • Real: $E = eP/P^*$.
  • PPP equilibrium: $e = P^*/P$ ⇒ $E=1$.
• Policy linkages:
  • Fiscal deficit → $S\downarrow$ → $r\uparrow$ → $NCO\downarrow$ → $E\uparrow$ → $NX\downarrow$.
  • Import quota → $NX$ unchanged in long run, $E\uparrow$.
  • Capital flight → $NCO\uparrow$ → $r\uparrow$ → $E\downarrow$.
• Empirical evidence:
  • Hyperinflations show tight co-movement of money growth, price level, and $e$.
  • U.S. data: Growing globalization – imports + exports now ~25-30 % of GDP.

Ethical / Practical Considerations

• Trade deficits financed by asset sales may raise sustainability issues (foreign ownership, interest burden).
• Capital controls vs. free flows: trade-off between stability and efficiency.
• Exchange-rate policy (fixed vs. floating) interacts with PPP validity and inflation discipline.

Connections to Prior Principles

• Quantity Theory of Money: $MV = PY$; excess $M$ growth → $P$ ↑ → via PPP, $e$ depreciates.
• Loanable-funds logic echoes closed-economy saving-investment model but adds $NCO$ channel.
• Opportunity cost of capital & interest parity underpin $NCO(r)$ relationship.