Open Economy Macro Notes

Introduction to Open Economy Macro

National Income Identity and Trade Balance

In a closed economy, domestic output is entirely consumed and invested domestically. However, in an open economy, transactions occur with foreign economies, allowing a country to spend more or less than it produces through importing and exporting.

  • Closed Economy Identity: Y=C+I+GY = C + I + G

    • Where:

      • YY = Output

      • CC = Consumption (private and public)

      • II = Investment

      • GG = Government spending

  • Open Economy Identity: Y=C+I+G+X−MY = C + I + G + X - M

    • Where:

      • XX = Exports

      • MM = Imports

  • Trade Balance (Net Exports): NX=X−MNX = X - M

    • Trade Surplus: If X > M, then NX > 0. The economy spends less than it produces, lending to the rest of the world.

    • Trade Deficit: If X < M, then NX < 0. The economy spends more than it produces, borrowing from the rest of the world.

  • National Accounting Identity: NX=Y−(C+I+G)NX = Y - (C + I + G)

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

International Capital Flows

In a closed economy, savers can only lend to domestic borrowers, and firms can only borrow from domestic savers, leading to savings equaling investment (S=IS = I). However, in an open economy, savings doesn't necessarily equal investment.

  • A country's financial funds can be used for domestic investment or to finance foreign investment (e.g., buying bonds from a foreign company).

  • International borrowing and lending are referred to as international capital flows.

  • Foreign Investment:

    • Purchase of financial assets (stocks, bonds, etc.).

    • Purchase of physical assets (e.g., direct ownership in office buildings or factories).

Net Capital Outflow

  • Net Capital Outflow (NCO): NCO=S−INCO = S - I

    • If S > I, the excess funds flow abroad (country is a net lender).

    • If S < I, firms borrow the excess on international financial markets (country is a net borrower).

  • Relationship between Capital Outflow and Trade Balance:

    • Using the national identity: Y−C−G=S=I+NXY - C - G = S = I + NX

    • Hence, S−I=NXS - I = NX

    • Trade balance equals net capital outflow.

    • A country with persistent trade deficits (NX < 0) has low saving relative to investment and is a net borrower of assets.

Balance of Payments

The balance of payments records all transactions between a country and the rest of the world in a given period, typically one year or one quarter. It is divided into two main parts:

  • Current Account: Records exports and imports of goods and services, receipts and payments of investment income, and transfer payments.

    • Net exports.

    • Net factor payments from abroad.

    • Transfer payments.

  • Financial Account: Records purchases and sales of foreign assets by domestic residents and purchases and sales of domestic assets by foreign residents.

Nominal Exchange Rate

The nominal exchange rate is the price of one currency in terms of another.

  • Two Ways to Quote:

    • Relative price of domestic currency in terms of foreign currency (e.g., 1.12 EUR = 1£).

    • Relative price of foreign currency in terms of domestic currency (e.g., 0.89£ = 1 EUR).

Real Exchange Rate

The real exchange rate is the relative price of domestic goods in terms of foreign goods.

  • Formula: ε=ePP∗\varepsilon = e \frac{P}{P^*}

    • Where:

      • ε\varepsilon = Real exchange rate

      • ee = Nominal exchange rate

      • PP = Price level at home

      • P∗P^* = Price level abroad

Law of One Price

Assuming no transportation costs and no barriers to trade, the same good sold in two different countries must have the same price when prices are expressed in a common currency.

  • If this condition is not met, arbitrage opportunities arise.

    • Arbitrage involves buying a good where it is cheaper and selling it where it is more expensive to make a profit.

    • Arbitrage activities will restore the equality of the price of the good.

  • In the international context: eP=P∗eP = P^*, where ePeP is the price level in the domestic country expressed in foreign currency.

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

    • Nominal exchange rate equals the ratio of countries' price levels.

    • Otherwise, international arbitrage occurs.

Law of One Price - Real World Considerations

The Law of One Price does not always hold in real-world data due to:

  • International arbitrage not always possible

  • Non-traded goods

  • Transportation costs

  • Goods from different countries not being perfect substitutes

The lecture covers the following main topics:

  1. National Income Identity and Trade Balance

    • Closed and open economy identities

    • Trade balance definition and implications of trade surplus and deficit

    • National accounting identity

  2. International Capital Flows

    • Differences between closed and open economies regarding savings and investment

    • Definition of foreign investment and international capital flows

  3. Net Capital Outflow

    • Calculation of net capital outflow and its implications for borrowing and lending

    • Relationship between capital outflow and trade balance

  4. Balance of Payments

    • Breakdown of current account and financial account

  5. Nominal Exchange Rate

    • Definitions and methods of quoting nominal exchange rates

  6. Real Exchange Rate

    • Formula and significance of the real exchange rate

  7. Law of One Price

    • Explanation of the law and its relation to arbitrage opportunities

    • Introduction of Purchasing Power Parity (PPP)

  8. Law of One Price - Real World Considerations

    • Discussion on factors that affect the law of one price in practice.