Lecture 11: Open-Economy Macroeconomics - Basic Concepts Notes

An open economy interacts with other world economies by trading goods and services in world product markets and capital assets in world financial markets.
A closed economy is one that does not interact with other economies at all.
Key interactions include exports (domestically produced goods sold abroad) and imports (foreign-produced goods sold domestically).

Net exports ( $NX$ ), or the trade balance, is calculated as the value of a nation’s exports minus the value of its imports.
Trade Surplus: A situation where $NX > 0$ ( $\text{Exports} > \text{Imports}$ ).
Trade Deficit: A situation where $NX < 0$ ( $\text{Exports} < \text{Imports}$ ).
Balanced Trade: A situation where $NX = 0$ ( $\text{Exports} = \text{Imports}$ ).
Factors influencing $NX$ include consumer tastes, prices of goods at home and abroad, exchange rates, consumer incomes, transport costs, and government trade policies.

Net capital outflow ( $NCO$ ) is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
Specific examples from the transcript include a Zambian resident buying stock in DSTV (increases Zambia’s net foreign investment) and a Japanese resident buying a bond issued by the Zambian government (reduces Zambia’s $NCO$ ).
Influencing variables: Real interest rates on domestic and foreign assets, perceived economic and political risks, and government policies regarding foreign ownership.

The fundamental identity relating trade and capital flows is $NCO = NX$ .
Gross Domestic Product ( $Y$ ) in an open economy: $Y = C + I + G + NX$ .
National saving ( $S$ ) is the income remaining after consumption and government spending: $S = Y - C - G$ .
The relationship between saving, investment, and international flows is expressed as: $S = I + NX$ $S = I + NCO$
When $S > I$ , the country is a net lender ( $NCO > 0$ ); when $S < I$ , the country is a net borrower ( $NCO < 0$ ).

The Balance of Payments (BoP) is a periodic statement of the money value of all transactions between residents of one country and the rest of the world.
Current Account: Includes payments for goods, services (e.g., tourism, insurance), and income on assets.
Capital Account: Includes all payments related to the purchase and sale of assets and borrowing/lending activities.
Official Reserve Account: Consists of official reserves held by the government, such as foreign currencies, gold, and Special Drawing Rights (SDRs).
SDR: An international money created by the International Monetary Fund (IMF) in the form of bookkeeping entries to settle international payments.
Disequilibrium occurs when there is a surplus ( $\text{Credit} > \text{Debit}$ ) or a deficit ( $\text{Debit} > \text{Credit}$ ).

Nominal Exchange Rate: The price at which a person can trade the currency of one country for another (e.g., if $1\,USD = K29.50$ , then $1\,ZMW = 0.0339\,USD$ ).
Appreciation: An increase in a currency's value (e.g., shifting from $1\,USD = K29.5$ to $1\,USD = K20$ ).
Depreciation: A decrease in a currency's value.
Real Exchange Rate: The rate at which goods and services of one country trade for those of another. Formula: $Real\,exchange\,rate = \frac{Nominal\,exchange\,rate \times Domestic\,price}{Foreign\,price}$
A fall in the real exchange rate makes domestic goods cheaper, raising exports and lowering imports.

Fixed Exchange Rate: The currency is set at a fixed rate by the state and defended by the central bank. It is susceptible to speculative attack if investors doubt the economy's health.
Flexible (Floating) Exchange Rate: The market determines the rate based on supply and demand without government intervention.
Under a fixed regime, value changes are called devaluation or revaluation; under a flexible regime, they are called depreciation or appreciation.

Monetary policy is more effective under flexible exchange rates because it affects both investment and net exports through interest rate and currency value changes.
The International Monetary Fund (IMF) acts as a lender of last resort, providing loans to stabilize economies during BoP deficits or private investor flight.
IMF loans often come with conditions, such as reducing fiscal deficits to signal reform, though this conditionality is sometimes criticized for exacerbating crises.