Overhead 4 Introduction to Open Economy Macro

Introduction to Open Economy Macro

• Presented by Lukas Mayr.

National Income Identity and Trade Balance

• Closed Economy:

  • All output is consumed and invested domestically.

• Open Economy:

  • Engages in transactions with foreign economies.

  • Can import/export, spending can exceed or fall short of domestic production.

• National Accounting Identity in Closed Economy:[ Y = C + I + G ]

  • Output (Y) equals total spending of consumption (C) and investment (I) plus government spending (G).

• National Accounting Identity in Open Economy:[ Y = C + I + G + X - M ]

  • ( X ): Exports

  • ( M ): Imports

  • Trade Balance (Net Exports):[ NX = X - M ]

    • If ( X > M ): Economy has a trade surplus (( NX > 0 )).

    • If ( X < M ): Economy has a trade deficit (( NX < 0 )).

• Definition of Trade Balance:[ NX = Y - (C + I + G) ]

  • If domestic spending > output, then ( C + I + G > Y ) leading to ( NX < 0 ).

International Capital Flows

• Closed Economy Characteristics:

  • Savers lend only to domestic borrowers.

  • Investment financed solely by domestic savings: ( S = I ).

• Open Economy Characteristics:

  • Savings can exceed investment.

  • Financial funds used for both domestic and foreign investments (bonds, direct ownership).

• Nature of International Borrowing and Lending:

  • Known as international capital flows.

• Types of Foreign Investment:

  • Purchasing financial assets (stocks, bonds).

  • Purchasing physical assets (direct ownership of properties).

Understanding Net Capital Outflow

• Formula:[ NCO = S - I ]

  • ( S > I ): Excess funds flow abroad.

  • ( S < I ): Borrowing from international markets.

• Net Lender and Borrower Status:

  • ( S > I ): Country is a net lender.

  • ( S < I ): Country is a net borrower.

• Link Between Capital Outflow and Trade Balance:

  • From national identity:[ Y - C + G = S = I + NX ]

  • Relationship established:[ S - I = NX ]

  • Trade balance corresponds to net capital outflow.

• Example with Persistent Trade Deficits (e.g., US):

  • Indicates low saving relative to investment and positioning as a net borrower.

Saving-Investment Balance and Current Account

• Figure Analysis:

  • Comparison of net savings and current account between China and the US from 1995 to 2007.

The Balance of Payments

• Definition:

  • Records all transactions between a country and the rest of the world over time (usually annually or quarterly).

• Components:

  • Current Account:

    • Records goods/services exports/imports.

    • Includes investment income and transfer payments.

  • Financial Account:

    • Tracks purchases/sales of foreign and domestic assets.

UK Current and Financial Accounts Overview

• Current Account Components:

  • Balance of payments data illustrates trends in the UK's current account and financial account from 1987 through 2015.

Nominal Exchange Rate

• Definition:

  • Price of one currency in terms of another.

• Quoting Exchange Rate:

  • Domestic currency price in terms of a foreign currency and vice versa.

Real Exchange Rate

• Definition:

  • Relative price of domestic goods versus foreign goods.

  • Formula:[ \epsilon = e \frac{P}{P^*} ]

  • Where ( , e ): Nominal exchange rate, ( P ): Domestic price level, ( P^* ): Foreign price level.

Law of One Price

• Assumptions:

  • No transportation costs, no trade barriers.

• Implication:

  • Same good in different countries must have the same price expressed in a common currency due to arbitrage opportunities.

  • Enforces price equality via arbitrage if deviations occur.

• International Context:

  • If two countries produce similar baskets of goods, expectations are set as:[ eP = P^* ]

  • Purchasing Power Parity (PPP):[ e = \frac{P}{P^*} ]

  • Indicates nominal exchange rate equality with price levels ratio.

Limitations of the Law of One Price in Real World Data

• Not upheld due to various factors:

  • Nontraded goods.

  • Transportation costs.

  • Perceived differences in goods across countries.

Trade Balance and Real Exchange Rate Insights

• Further details covered via projection from presentation.