International Linkages, Balance of Payments, and Policy in an Open Economy

Covid-19 and the Global Economy

Globalization and Economic Shocks

The Covid-19 pandemic highlighted the interconnectedness of the global economy. Uncertainty led to forecasting errors by firms, which, due to globalization, had significant worldwide effects.

• Example: Vehicle computer chip manufacturers underestimated demand, leading to a global chip shortage when Chinese manufacturers increased production. This shortage limited U.S. vehicle production and increased automobile prices in 2021.

The Balance of Payments: Linking the United States to the International Economy

International Linkages

Countries are linked at the macroeconomic level through:

• Trade in goods and services

• Flows of financial investment

Understanding these linkages is essential for analyzing the effects of fiscal and monetary policy in an open economy.

Open and Closed Economies

Definitions

• Open Economy: A country that interacts in trade or finance with other countries.

• Closed Economy: A country with no interactions in trade or finance with other countries (rare in practice; e.g., North Korea).

Balance of Payments (BoP)

Definition and Structure

The balance of payments is the record of a country's trade with other countries in goods, services, and assets.

• Current Account: Records net exports, net income on investments, and net transfers.

• Financial Account: Records purchases of assets a country has made abroad and foreign purchases of assets in the country (long-term flows).

• Capital Account: Records minor transactions such as migrants’ transfers and sales/purchases of nonproduced, nonfinancial assets (e.g., intellectual property).

U.S. Balance of Payments Example (2020, Billions of Dollars)

Account	Main Components	2020 Value (Billions $)
Current Account	Exports of goods, Imports of goods, Exports of services, Imports of services, Net income on investments, Net transfers	-971 (deficit)
Financial Account	Increase in foreign holdings of U.S. assets, Increase in U.S. holdings of foreign assets	741 (surplus)
Capital Account	Minor transactions (e.g., migrants’ transfers)	-5

Additional info: Values are illustrative; see official sources for precise data.

Trade Balance

• Trade Balance: The difference between the value of goods a country exports and the value of goods it imports.

• Positive = trade surplus; Negative = trade deficit.

• In 2022, the U.S. had a trade deficit of $1,183 billion.

Current Account Details

• Composed of the trade balance, balance of services, net income on investments, and net transfers.

• For the U.S., the sum of net income and net transfers is often close to zero, so net exports are often used as a proxy for the current account balance.

Financial Account Details

• Capital Outflows: Purchases of assets overseas by Americans.

• Capital Inflows: Purchases of American assets by foreigners.

• Assets include financial assets (stocks, bonds: foreign portfolio investment) and physical assets (factories: foreign direct investment).

Net Foreign Investment

• Net Foreign Investment (NFI): The difference between capital outflows and capital inflows. Also equal to net foreign direct investment plus net foreign portfolio investment.

• The balance on the financial account is a measure of net capital flows; NFI is its negative.

Capital Account

• Since 1999, the capital account only includes minor transactions.

• The balance is relatively small and often ignored in macroeconomic analysis.

Why Is the Balance of Payments Always Zero?

• The sum of the current account, financial account, and capital account balances must be zero.

• If a country spends more on foreign goods/services than it receives (current account deficit), the difference is offset by financial inflows (financial account surplus).

The Foreign Exchange Market and Exchange Rates

Exchange Rates

• Nominal Exchange Rate: The value of one country’s currency in terms of another country’s currency.

• Real Exchange Rate: The nominal exchange rate adjusted for differences in price levels between countries.

• Foreign exchange markets are highly active, with over $5 trillion traded daily.

Equilibrium in the Foreign Exchange Market

• Exchange rates are determined by supply and demand for currencies.

• Demand for U.S. dollars ($US):

  1. Foreign firms/households buying U.S. goods/services

  2. Foreign investment in U.S. assets

  3. Currency traders expecting the $US to rise

• Supply of $US: U.S. firms/households/traders wanting to buy foreign goods/assets and pay with dollars.

• The equilibrium exchange rate is where the quantity of dollars supplied equals the quantity demanded.

Market vs. Fixed Exchange Rates

• Most exchange rates are determined by the market, but some (e.g., Chinese yuan for over a decade) are fixed by government policy.

Shifts in Demand and Supply for Foreign Exchange

• Factors (other than the exchange rate itself) that shift demand/supply curves:

  1. Changes in demand for domestic vs. foreign goods/services

  2. Changes in investment attractiveness

  3. Expectations about future currency values

• Example: If U.S. incomes rise, demand for imports (e.g., Japanese goods) increases, raising the supply of $US in the foreign exchange market.

• If U.S. interest rates rise, demand for $US increases as U.S. assets become more attractive.

Exchange Rates, Imports, and Exports

• When the $US appreciates:

  • Dollar price of imports falls (imports become cheaper for Americans)

  • Foreign currency price of U.S. exports rises (exports become more expensive for foreigners)

• Example: If $1 = €1, a $200 iPhone costs €200. If $1 = €1.20, the same iPhone costs €240 in euros, so fewer are bought by Europeans.

Case Study: Toyota and Exchange Rates

• A stronger yen means the yen is worth more relative to the dollar; 1 U.S. dollar exchanges for fewer yen.

• A stronger yen reduces profits for Japanese exporters like Toyota by:

  1. Raising the price of Japanese exports in foreign currencies, reducing sales

  2. Reducing the yen value of foreign earnings when converted back to yen

• If Toyota produced all U.S.-sold cars in Japan, profits would be more exposed to exchange rate fluctuations. Producing in the U.S. reduces this risk.

Is a Strong Currency Good?

• A strong currency makes exports more expensive and imports cheaper.

• The effect on a country’s firms is mixed, as they may both import inputs and export outputs.

The International Sector, National Saving, and Investment

Linking Accounts and Investment

• When a country’s spending exceeds its income, it finances the difference by selling assets or borrowing.

• Key identity:

  • Current Account Balance + Financial Account Balance = 0

  • Current Account Balance = – Financial Account Balance

  • Net Exports = Net Foreign Investment

Domestic Saving, Investment, and Net Foreign Investment

• National Saving = Private Saving + Public Saving

• Formulas:

  • $S = S_{private} + S_{public}$

  • $S_{private} = Y + TR - C - T$

  • $S_{public} = T - G - TR$

  • $S = Y - C - G$

• From the national income identity:

  • $Y = C + I + G + NX$

  • $S = Y - C - G = I + NX$

  • Since $NX = NFI$, $S = I + NFI$

• Saving and Investment Equation: National saving equals domestic investment plus net foreign investment.

Application of the Saving and Investment Equation

• If net foreign investment (net exports) is negative, national saving is less than domestic investment.

• Example: Saving $1,000 and buying a bond from Amazon could finance domestic investment (U.S. facility) or foreign investment (site in China).

Government Budget Deficits and Investment

• When the government runs a budget deficit, public saving is negative, reducing national saving.

• To finance the deficit, the government sells bonds, often raising interest rates to attract buyers.

• Higher interest rates discourage private investment and attract foreign capital, causing the currency to appreciate and net exports to fall.

The Twin Deficits

• When government budget deficits lead to declines in net exports, this is called the twin deficits phenomenon.

• Historically, large U.S. budget deficits in the 1980s led to high interest rates, a strong dollar, and large current account deficits.

• Since 1990, the relationship between budget and current account deficits has been weaker.

U.S. Current Account Balance Trends

• The U.S. has run persistent current account deficits, making it the world’s largest debtor.

• By 2022, foreign investors owned over $16.2 trillion more in U.S. assets than U.S. investors owned abroad.

Policy and the Current Account

• U.S. policymakers have used tariffs and subsidies to encourage domestic production and reduce the current account deficit (e.g., CHIPS and Science Act).

• However, high-tech manufacturing requires more than subsidies: reliable supply chains and skilled labor are also necessary.

Global Capital Flows and Investment

• In the 2000s, global savings increased, with developing countries becoming net suppliers of savings to developed countries like the U.S.

• This led to higher U.S. asset prices and a stronger dollar.

• In the long run, it may be more efficient for high-income countries to lend to low-income countries, where returns to capital are higher.

Monetary and Fiscal Policy in an Open Economy

Policy Channels

• An open economy has more policy channels than a closed economy, affecting the effectiveness of monetary and fiscal policy.

Monetary Policy

• Expansionary monetary policy (lowering interest rates) in an open economy increases investment and consumption, and also causes the currency to depreciate, boosting net exports.

• Thus, monetary policy is more effective in an open economy.

Fiscal Policy

• Expansionary fiscal policy (increased government spending or tax cuts) raises aggregate demand but may increase interest rates, causing the currency to appreciate and reducing net exports.

• The multiplier effect is smaller in an open economy, as some spending leaks into imports.

• Overall, fiscal policy is less effective in an open economy than in a closed one.

Policy in a Recession

• In a recession, monetary policy that lowers interest rates can cause the currency to depreciate, increasing exports and aggregate demand.

• In a closed economy, this exchange rate channel does not exist.