Open Economy Concepts: International Macroeconomics Essentials

Open Economy Concepts

Introduction

This chapter introduces the foundational concepts of international macroeconomics, focusing on how countries interact through trade and financial flows. Key areas include the trade balance, international flows of assets, and exchange rates.

• Trade balance: Understanding deficits and surpluses in international trade.

• International flows of assets: How capital moves across borders.

• Exchange rates: The value of one currency relative to another.

The Flow of Goods & Services

Exports, Imports, and Net Exports

Countries engage in international trade by exporting and importing goods and services. The difference between these two flows is called net exports (NX), also known as the trade balance.

• Exports: Domestically-produced goods and services sold abroad.

• Imports: Foreign-produced goods and services purchased domestically.

• Net exports (NX): $\text{NX} = \text{Exports} - \text{Imports}$

Example: If the U.S. exports $200 billion and imports $250 billion, NX = -$50 billion (trade deficit).

Variables Affecting Net Exports

• Foreign economic conditions: A recession in a trading partner (e.g., Canada) reduces their demand for U.S. exports, lowering U.S. NX.

• Domestic consumer preferences: If U.S. consumers buy more domestic goods, imports fall and NX rises.

• Relative prices: If foreign goods (e.g., from Mexico) become more expensive relative to U.S. goods, U.S. exports may rise and imports fall, increasing NX.

Trade Surpluses & Deficits

• Trade deficit: Imports exceed exports ($\text{NX} < 0$).

• Trade surplus: Exports exceed imports ($\text{NX} > 0$).

• Balanced trade: Exports equal imports ($\text{NX} = 0$).

The U.S. Economy's Increasing Openness

Over time, the U.S. economy has become more open, with both exports and imports rising as a share of GDP from 1960 to 2024. This reflects greater integration into the global economy.

The Flow of Capital

Net Capital Outflow (NCO)

Net capital outflow measures the net flow of funds invested abroad by a country’s residents minus the funds invested domestically by foreigners.

• Definition: $\text{NCO} = \text{Domestic purchases of foreign assets} - \text{Foreign purchases of domestic assets}$

• Also called net foreign investment.

Forms of Capital Flow

• Foreign direct investment (FDI): Domestic residents actively manage foreign investments (e.g., McDonald's opens a restaurant in Moscow).

• Foreign portfolio investment: Domestic residents purchase foreign stocks or bonds, supplying loanable funds to foreign firms.

Interpreting NCO

• NCO > 0: Capital outflow—domestic residents invest more abroad than foreigners invest domestically.

• NCO < 0: Capital inflow—foreigners invest more domestically than residents invest abroad.

The Equality of Net Exports and Net Capital Outflow

Accounting Identity: $\text{NCO} = \text{NX}$

Every international transaction affects both the trade balance and capital flows by the same amount.

• When a foreigner buys a U.S. good, U.S. exports and NX increase, and the U.S. acquires foreign assets (NCO rises).

• When a U.S. resident buys a foreign good, U.S. imports rise (NX falls), and the foreign country acquires U.S. assets (NCO falls).

Saving, Investment, and International Flows

National Income Accounting Relationships

• National income identity: $Y = C + I + G + NX$

• Rearranged: $Y - C - G = I + NX$

• Since $S = Y - C - G$, then $S = I + NX$

• Because $NX = NCO$, $S = I + NCO$

Implications:

• If $S > I$, the excess is invested abroad (NCO > 0).

• If $S < I$, the country finances investment with foreign funds (NCO < 0).

Exchange Rates

The Nominal Exchange Rate

The nominal exchange rate is the rate at which one country’s currency can be exchanged for another’s.

• Expressed as foreign currency per unit of domestic currency.

• Examples (as of July 2025, per US$):

  • Canadian dollar: 1.37

  • Euro: 0.86

  • Japanese yen: 146.44

  • Mexican peso: 18.62

Appreciation and Depreciation

• Appreciation: An increase in the value of a currency (it buys more foreign currency).

• Depreciation: A decrease in the value of a currency (it buys less foreign currency).

• Example: In 2007, the U.S. dollar depreciated 9.5% against the Euro but appreciated 1.5% against the South Korean Won.

The Real Exchange Rate

The real exchange rate measures the relative price of goods between countries, adjusting for price levels.

• Formula: $\text{Real exchange rate} = \dfrac{e \times P}{P^*}$

• $e$ = nominal exchange rate (foreign currency per unit of domestic currency)

• $P$ = domestic price level

• $P^*$ = foreign price level

Example: If a Big Mac costs $5.15 in the U.S. and 450 yen in Japan, with$e = 146$ yen per dollar:

• Price of U.S. Big Mac in yen: $146 \times 5.15 = 751.9$ yen

• Real exchange rate: $\dfrac{751.9}{450} = 1.67$ Japanese Big Macs per U.S. Big Mac

Real Exchange Rate with Many Goods

• Use aggregate price levels (e.g., GDP deflator, CPI) for $P$ and $P^*$.

• If the real exchange rate appreciates, domestic goods become more expensive relative to foreign goods.

The Law of One Price and Purchasing-Power Parity (PPP)

The Law of One Price

The law of one price states that identical goods should sell for the same price in all markets, assuming no transportation costs or trade barriers.

• Arbitrage: Buying goods where they are cheaper and selling where they are more expensive, which equalizes prices across markets.

Purchasing-Power Parity (PPP)

PPP is a theory stating that a unit of currency should buy the same quantity of goods in all countries, based on the law of one price.

• Implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries.

• PPP formula: $e = \dfrac{P^*}{P}$

• If inflation is higher in one country, its currency will depreciate relative to others.

Example: If a Ford Escape SUV sells for $24,000 in the U.S. and 720,000 rubles in Russia, PPP implies the exchange rate should be$e = \dfrac{720,000}{24,000} = 30$ rubles per dollar.

Limitations of PPP Theory

• Many goods and services cannot be traded internationally (e.g., haircuts, movie tickets).

• Foreign and domestic goods are not always perfect substitutes due to consumer preferences.

• Price differences may persist due to these factors, so PPP does not always hold in practice.

Summary Table: Key Open Economy Concepts

Concept	Definition	Formula
Net Exports (NX)	Exports minus imports	$\text{NX} = \text{Exports} - \text{Imports}$
Net Capital Outflow (NCO)	Domestic purchases of foreign assets minus foreign purchases of domestic assets	$\text{NCO} = \text{Domestic purchases of foreign assets} - \text{Foreign purchases of domestic assets}$
Nominal Exchange Rate (e)	Rate at which one currency exchanges for another	e.g., 146 yen per US$
Real Exchange Rate	Relative price of domestic goods in terms of foreign goods	$\dfrac{e \times P}{P^*}$
Purchasing-Power Parity (PPP)	Exchange rate adjusts to equalize price levels	$e = \dfrac{P^*}{P}$

Practice Questions

1. Which of the following statements about a country with a trade deficit is not true?

   • A. Exports < imports

   • B. Net capital outflow < 0

   • C. Investment < saving

   • D. $Y < C + I + G$

2. A Ford Escape SUV sells for $24,000 in the U.S. and 720,000 rubles in Russia. If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)?

   • $P^* = 720,000$ rubles

   • $P = 24,000$ dollars

   • $e = \dfrac{720,000}{24,000} = 30$ rubles per dollar