Macroeconomics in an Open Economy: Study Notes (Chapter 14)

Macroeconomics in an Open Economy

Chapter Overview

This chapter explores how open economies interact with the rest of the world through trade and financial flows, the determination of exchange rates, and the implications for macroeconomic policy. It uses Canada as a primary example and discusses the balance of payments, exchange rate systems, and the effects of globalization.

The Balance of Payments: Linking Canada to the International Economy

Definition and Structure

• Balance of Payments (BoP): A record of a country's transactions with the rest of the world, including trade in goods, services, and financial assets.

• Countries are linked internationally by:

  • Trade in goods and services

  • Flows of financial investment

Open vs. Closed Economies

• Open Economy: Engages in international trade and finance (e.g., Canada).

• Closed Economy: No international trade or finance (rare; e.g., North Korea).

Components of the Balance of Payments

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

• Financial Account: Purchases of assets abroad and foreign purchases of domestic assets.

• Capital Account: Minor transactions (e.g., migrants’ transfers, sales of non-produced, nonfinancial assets).

Table: The Canadian Balance of Payments, 2020

Account	Main Items	2020 Value (million CAD)
Current Account	Exports of goods	552,183
	Imports of goods	-562,008
	Balance of trade	-39,825
	Exports of services	125,801
	Imports of services	-131,337
	Balance of services	-5,536
	Net income on investments	14,450
	Net transfers	-8,504
	Balance on current account	-39,415
Financial Account	Net lending/borrowing	-39,273
Capital Account	Balance	-48
Statistical Discrepancy		-78,736
Total Balance of Payments		0

Key Points

• The sum of the current, financial, and capital accounts must equal zero (any discrepancy is a statistical adjustment).

• Trade Surplus: Exports > Imports; Trade Deficit: Imports > Exports.

The Foreign Exchange Market and Exchange Rates

Exchange Rate Concepts

• Nominal Exchange Rate: Value of one currency in terms of another (e.g., $1 USD = ¥100 JPY).

• Real Exchange Rate: Adjusts the nominal rate for price level differences between countries.

Determination of Exchange Rates

• Exchange rates are set by supply and demand in the foreign exchange market.

• Demand for Domestic Currency:

  • Foreigners buying domestic goods/services

  • Foreign investment in domestic assets

  • Currency traders/speculators

• Supply of Domestic Currency: Domestic agents buying foreign goods/services or assets.

• Equilibrium Exchange Rate: Where quantity supplied equals quantity demanded.

Exchange Rate Movements

• Appreciation: Currency value rises relative to others.

• Depreciation: Currency value falls relative to others.

Factors Shifting Demand and Supply

• Relative demand for goods/services

• Relative investment attractiveness (interest rates)

• Expectations about future currency values

Currency Speculation

• Speculators buy/sell currencies to profit from expected changes in exchange rates.

Impact on Trade

• Depreciation makes exports cheaper and imports more expensive, increasing net exports and aggregate demand.

• Appreciation has the opposite effect.

Exchange Rate Systems

Types of Exchange Rate Systems

• Floating Exchange Rate: Determined by market forces (e.g., Canadian dollar).

• Fixed Exchange Rate: Set by government/central bank intervention (e.g., Chinese yuan for many years).

• Managed Float: Mostly market-determined, but with occasional government intervention.

• Pegging: Fixing a currency’s value to another (e.g., U.S. dollar).

Historical Systems

• Gold Standard: Currencies redeemable for gold at fixed rates.

• Bretton Woods System: Post-WWII system fixing currencies to the U.S. dollar, which was convertible to gold.

The Euro

• 19 European countries use a common currency, the euro, with permanently fixed exchange rates among them.

The International Sector and National Saving and Investment

Saving and Investment Equation

• National Saving (S): Private saving + Public saving

• Equation: $S = I + NFI$ Where $I$ = domestic investment, $NFI$ = net foreign investment

• If net exports are negative, national saving is less than domestic investment.

Government Budget Deficits

• Budget deficits reduce national saving, leading to either lower domestic investment or lower net foreign investment.

• Higher interest rates from deficits can appreciate the currency, reducing net exports (the "twin deficits").

Monetary and Fiscal Policy in an Open Economy

Monetary Policy

• More effective in an open economy: Lower interest rates depreciate the currency, boosting net exports and aggregate demand.

Fiscal Policy

• Less effective in an open economy: Higher government spending or tax cuts may raise interest rates, appreciate the currency, and reduce net exports.

Key Terms and Formulas

• Nominal Exchange Rate: $E_{nom}$

• Real Exchange Rate: $E_{real} = E_{nom} \times \frac{P_{domestic}}{P_{foreign}}$

• Saving and Investment Equation: $S = I + NFI$

Common Misconceptions

• Do not confuse balance of trade, balance of services, and current account balance.

• Appreciation means the domestic currency buys more foreign currency; depreciation means it buys less.