Open-Economy Macroeconomics: Basic Concepts (Chapter 12) – Study Notes

Open-Economy Macroeconomics: Basic Concepts

Introduction

Open-economy macroeconomics studies how economies interact with the rest of the world through trade and financial flows. Understanding these interactions is essential for analyzing the effects of monetary and fiscal policy in a global context.

• Open economy: An economy that engages in international trade of goods, services, and financial assets.

• Importance: Studying open economies helps explain the impact of global markets on domestic policy and economic outcomes.

International Flows of Goods and Capital

Cross-Border Flows of Goods

International trade involves the exchange of goods and services across borders, measured by net exports.

• Net exports (NX): The value of exports minus the value of imports.

• Trade balance: Another term for net exports.

• Trade surplus: NX > 0 (exports > imports)

• Trade deficit: NX < 0 (imports > exports)

• Balanced trade: NX = 0

• Example: If Canada exports $500 million and imports $400 million, NX = $100 million (trade surplus).

Exports and Imports in Canada

Exports and imports as a percentage of GDP fluctuate over time, reflecting changes in global demand, domestic production, and trade policies.

• Data trends: Canadian exports and imports have generally increased as a share of GDP since 1970, with notable fluctuations around global events (e.g., financial crises).

• Application: Monitoring these trends helps policymakers assess the health of the external sector.

The Flow of Financial Resources

International trade in goods is accompanied by flows of financial assets, measured by net capital outflow.

• Net capital outflow (NCO): Purchase of foreign assets by domestic residents minus purchase of domestic assets by foreigners.

• Influencing factors:

  • Relative real interest rates on foreign assets

  • Government controls on foreign ownership of domestic assets

• Accounting identity: Net exports = Net capital outflow

• Example: If net exports increase by ¥100, domestic residents acquire ¥100 in foreign assets, increasing NCO by ¥100.

Saving and Investment in an Open Economy

National saving, investment, and net capital outflow are linked through the open-economy income-expenditure identity.

• National saving: $S_{national} = Y - C - G$

• Income-expenditure identity: $Y = C + I + G + NX$

• Saving-investment identity:

  • $S_{national} = I + NX$

  • Or, $S_{national} = I + NCO$

• Interpretation:

  • If saving > investment, NCO > 0: Economy uses excess saving to buy foreign assets.

  • If investment > saving, NCO < 0: Economy borrows from abroad to finance investment.

• Example: U.S. trade deficit with China (NX < 0) means some U.S. investment is financed by Chinese residents.

Exchange Rates

Nominal Exchange Rate

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

• Definition: The amount of foreign currency per unit of domestic currency.

• Example: USD/CAD exchange rate of 0.71 means 1 CAD = 0.71 USD.

• Appreciation: Domestic currency buys more foreign currency (exchange rate rises).

• Depreciation: Domestic currency buys less foreign currency (exchange rate falls).

Real Exchange Rate

The real exchange rate measures the rate at which goods and services of one country can be traded for those of another country.

• Formula: $e = \frac{E \cdot P}{P^*}$ Where: $E$ = nominal exchange rate (foreign currency per unit of domestic currency) $P$ = domestic price level $P^*$ = foreign price level

• Example: If $E = 0.75$ USD/CAD, $P = 140$, $P^* = 120$, then $e = 0.75 \times 140 / 120 = 0.875$ One basket of Canadian goods and services can exchange for 0.875 baskets of American goods and services.

• Interpretation: Real exchange rate reflects the relative price of domestic goods in terms of foreign goods.

Canadian Dollar Exchange Rate Trends

Movements in the real exchange rate are mainly driven by changes in the nominal exchange rate, while domestic and foreign price levels tend to move together over time.

• Implication: To understand real exchange rate dynamics, focus on nominal exchange rate determinants.

Exchange Rate Determination: Purchasing-Power Parity (PPP)

Theory of Purchasing-Power Parity

Purchasing-power parity (PPP) posits that one unit of currency should buy the same quantity of goods in all countries, based on the law of one price.

• Law of one price: Identical goods must sell for the same price in all locations, otherwise arbitrage opportunities arise.

• Arbitrage: Profiting from price differences by buying in low-price markets and selling in high-price markets.

• PPP implication: $E = \frac{P^*}{P}$ The nominal exchange rate equals the ratio of foreign to domestic price levels.

• Example: If $P^* = 120$, $P = 140$, then $E = 120/140 = 0.857$

Implications of the PPP Theory

• Real exchange rate: PPP implies the real exchange rate equals one ($e = 1$).

• Money supply: An increase in domestic money supply raises domestic prices, leading to currency depreciation.

• Empirical evidence: Real exchange rates rarely equal one due to market frictions.

Limitations of PPP Theory

• Arbitrage costs: Shipping and transaction costs may exceed price differences.

• Non-tradeable goods: Many services (e.g., haircuts) cannot be traded internationally.

• Imperfect substitutes: Tradeable goods from different countries may not be perfect substitutes, limiting arbitrage.

• Conclusion: PPP is a useful benchmark, but real-world deviations are common.

Interest Rate Determination

Small Open Economy with Perfect Capital Mobility

A small open economy trades with the world but does not affect global prices or interest rates. Perfect capital mobility means unrestricted access to international financial markets.

• Features:

  • Residents can borrow/lend internationally

  • Hold foreign bonds and stocks

  • Foreigners can invest in domestic assets

Interest Rate Parity

Interest rate parity states that, in a small open economy with perfect capital mobility, domestic and world real interest rates should be equal.

• Formula: $r = r^*$ Where $r$ is the domestic real interest rate, $r^*$ is the world real interest rate.

• Adjustment: If $r < r^*$, domestic residents lend abroad, increasing $r$ until parity is restored.

Limitations to Interest Rate Parity

• Default risk: Countries with higher risk must offer higher interest rates to attract investors.

• Tax differences: Higher taxes on asset returns require higher interest rates to compensate investors.

• Result: Interest rate parity may not hold perfectly due to these factors.