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 crucial 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: Policies in open economies can have different effects compared to closed economies due to cross-border flows.

International Flows of Goods and Capital

Cross-Border Flows of Goods

International trade involves the exchange of goods and services between countries, 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 $500B and imports $450B, NX = $50B (trade surplus).

Exports and Imports in Canada

Exports and imports as a percentage of GDP fluctuate over time, reflecting changes in trade policy, global demand, and economic conditions.

• Observation: Both exports and imports have generally increased as a share of GDP over the past decades.

• Application: Trade balances can impact national income and employment.

The Flow of Financial Resources

International trade in goods is accompanied by flows of financial assets, known as 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

• Accounting identity: Net exports = Net capital outflow

• Example: If Canadians buy ¥100 worth of Japanese bonds, NCO increases by ¥100.

Saving and Investment in an Open Economy

National saving in an open economy is related to domestic investment and net capital outflow.

• 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 is positive (country invests abroad).

  • If investment > saving, NCO is negative (country borrows from abroad).

• Example: U.S. trade deficit with China means Chinese residents finance some U.S. investment.

Exchange Rates

Nominal Exchange Rate

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

• Definition: Amount of foreign currency per unit of domestic currency.

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

• 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 $e = 0.75 \times 140 / 120 = 0.875$

• Interpretation: One basket of Canadian goods can be exchanged for 0.875 baskets of American goods.

• Note: Baskets of goods may differ between countries.

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 should sell for the same price in different locations.

• Arbitrage: Buying goods where they are cheaper and selling where they are more expensive.

• PPP implication: $E = \frac{P^*}{P}$

• Application: If PPP holds, the nominal exchange rate equals the ratio of foreign to domestic price levels.

Implications of PPP Theory

• Real exchange rate: PPP implies real exchange rate equals one.

• 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: Services like haircuts cannot be easily traded internationally.

• Imperfect substitutes: Tradeable goods may differ in quality or preference.

• Result: PPP may not hold exactly, but provides a useful benchmark.

Interest Rate Determination

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 unrestricted access to international financial markets.

• Features:

  • Residents can borrow/lend internationally

  • Can 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: $r$ = domestic real interest rate $r^*$ = world real interest rate

• Adjustment: If $r < r^*$, domestic lending abroad increases, raising $r$.

Limitations to Interest Rate Parity

• Default risk: Higher risk in one country leads to higher interest rates to compensate investors.

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

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

Summary Table: Key Identities and Formulas

Concept	Formula	Explanation
Net Exports	$NX = \text{Exports} - \text{Imports}$	Trade balance of goods and services
Net Capital Outflow	$NCO = \text{Domestic purchase of foreign assets} - \text{Foreign purchase of domestic assets}$	Net flow of financial assets
Saving-Investment Identity	$S_{national} = I + NX$ $S_{national} = I + NCO$	National saving equals domestic investment plus net capital outflow
Nominal Exchange Rate (PPP)	$E = \frac{P^*}{P}$	Foreign price level over domestic price level
Real Exchange Rate	$e = \frac{E \cdot P}{P^*}$	Relative price of domestic goods in terms of foreign goods
Interest Rate Parity	$r = r^*$	Domestic real interest rate equals world real interest rate

Additional info: These notes expand on the provided slides by including definitions, formulas, and examples for each concept, ensuring a self-contained study guide for exam preparation.