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 policy and other macroeconomic phenomena in a global context.

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

• Studying open economies helps us understand the impact of global factors on domestic 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.

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

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

• If NX = 0: Balanced trade

Example: Canada’s exports and imports as a percentage of GDP fluctuate over time, reflecting changes in trade balance.

The Flow of Financial Resources

Financial flows accompany trade in goods and services, captured by net capital outflow.

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

• NCO is influenced by:

  • Relative real interest rates on foreign assets

  • Government controls on foreign ownership of domestic assets

Accounting Identity: Net Exports = Net Capital Outflow

This identity holds by definition: every international transaction involves both goods/services and financial assets.

• 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 and investment are linked to international flows.

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

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

• Saving-investment identity:

$S_{national} = I + NX$

Or equivalently,

$S_{national} = I + NCO$

• If national saving > domestic investment, NCO is positive: the country invests abroad.

• If domestic investment > national saving, NCO is negative: the country borrows from abroad.

• Example: U.S. trade deficits with China mean 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:

$e = \frac{E \cdot P}{P^*}$

• $E$ = 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 exchanges for 0.875 baskets of American goods.

• At the macro level, $P$ and $P^*$ represent the price of a basket of goods and services in each country.

Canadian Dollar Exchange Rate: Key Observations

• Movements in the real exchange rate are mainly driven by changes in the nominal exchange rate.

• Relative price levels between countries tend to move together over time.

Exchange Rate Determination: Purchasing-Power Parity (PPP)

Theory of Purchasing-Power Parity

Purchasing-power parity (PPP) states 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.

• PPP implies that exchange rates adjust so that the purchasing power of a currency is the same in every country.

PPP Formula

$E = \frac{P^*}{P}$

• Nominal exchange rate equals the ratio of foreign to domestic price levels.

Implications of PPP Theory

• If the central bank increases the money supply, domestic prices rise, leading to currency depreciation.

• PPP predicts that the real exchange rate should equal one, but in practice, this is rarely observed.

Limitations of PPP Theory

• Ignores costs of arbitrage (e.g., shipping costs may exceed price differences).

• Many goods are non-tradeable (e.g., haircuts).

• Tradeable goods may not be perfect substitutes across countries.

• Price differences may persist due to consumer preferences or product differentiation.

Example: Consumers may buy imported goods even if they are more expensive than domestic alternatives.

Interest Rate Determination in an Open Economy

Small Open Economy with Perfect Capital Mobility

A small open economy is one that trades with the world but does not affect global prices or interest rates. Perfect capital mobility means residents and foreigners can freely buy and sell financial assets across borders.

• People can borrow/lend internationally, hold foreign bonds, and trade foreign stocks.

Interest Rate Parity

Interest rate parity is a condition that must hold in a small open economy with perfect capital mobility.

• Formula:

$r = r^*$

• $r$ = real interest rate in the domestic economy

• $r^*$ = real interest rate in the rest of the world

• If $r < r^*$, domestic lending to the rest of the world increases, pushing up $r$.

Limitations to Interest Rate Parity

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

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

Example: If a country’s corporate bonds are riskier, their interest rates will be higher than those in safer countries.