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^ satisfies S(r^) = I(r^) + NCO(r^).
  • 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^ satisfies NCO = NX(E^).

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^, NCO^, 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.