The Open Economy

Introduction

This section explores the macroeconomic concepts of the open economy, focusing on the balance of payments, exchange rates, and the market for foreign exchange. Understanding these topics is essential for analyzing international trade and financial flows between countries.

Balance of Payments Equilibrium

Definition and Structure

• Balance of Payments (BOP) is a comprehensive record of a country's economic transactions with the rest of the world over a specific period.

• It consists of three main accounts:

  • Current Account: Records flows of goods and services (imports and exports).

  • Capital and Financial Account: Records flows of assets and financial capital.

  • Official Settlements Account: Records changes in official reserves (government holdings of foreign currency).

• Each international transaction is entered twice: once as a credit (+) and once as a debit (-).

  • Debit: Payment to foreigners.

  • Credit: Receipt from foreigners.

Balance of Payments Identity

The balance of payments must always balance due to double-entry accounting:

Example: If the U.S. official reserves increase, the official settlements account is negative.

Current Account

Components

• Imports and Exports:

  1. Merchandise (goods like DVDs)

  2. Services (legal, shipping, tourism, etc.)

  3. Income receipts (interest, dividends, earnings of firms and workers abroad)

• Net Unilateral Transfers:

  • Gifts, foreign aid, retirement pensions

The current account balance (CAB) is calculated as:

Example: Importing a 4K disc of Japanese anime using a debit card is recorded as a debit in the current account and a credit in the financial account.

Capital and Financial Account

Components

• Records foreign investment in the U.S. minus U.S. investment abroad.

• Includes purchases of stocks, bonds, and other financial assets.

Example: Buying $500 in Sony stock is recorded as a purchase in the financial account and a credit in the financial account for the bank deposit.

Official Settlements Account

Components

• Records changes in U.S. official reserves (government holdings of foreign currency).

• If U.S. official reserves increase, the official settlements account is negative.

Borrowers and Lenders, Debtors and Creditors

Definitions

• Net Borrower: A country borrowing more from the rest of the world than it is lending.

• Net Lender: A country lending more to the rest of the world than it is borrowing.

• Debtor Nation: Has borrowed more from the rest of the world than it has lent over its history.

• Creditor Nation: Has invested more in the rest of the world than other countries have invested in it.

Example: Since 1986, the United States has been a debtor nation.

Additional info: The distinction between borrower/lender and debtor/creditor nations reflects the difference between flows (annual transactions) and stocks (cumulative positions) of financial capital.

Net Exports

Definition and Determinants

• Net Exports (NX) is the value of exports of goods and services (X) minus imports (M):

• Net exports are influenced by government budget, private saving, and investment.

The Foreign Exchange Market

Introduction

To buy goods and services from another country, one needs the currency of that country. The market where currencies are exchanged is called the foreign exchange market.

• Foreign currency includes bank notes, coins, and bank deposits denominated in another country's money.

Exchange Rate

• The exchange rate is the price of one currency in terms of another.

• Currency depreciation: Fall in value of a currency relative to another.

• Currency appreciation: Rise in value of a currency relative to another.

• (where E is the exchange rate, B is country B's currency, A is country A's currency)

Example: If E increases, country A's currency is appreciating and country B's currency is depreciating.

Implications for Net Exports

• If a currency appreciates:

  • Foreign goods become cheaper at home (imports increase).

  • Domestic goods become more expensive abroad (exports decrease).

  • Net exports decrease.

• If a currency depreciates:

  • Foreign goods become more expensive at home (imports decrease).

  • Domestic goods become cheaper abroad (exports increase).

  • Net exports increase.

Market for Foreign Exchange

Demand for Foreign Exchange

• The quantity of dollars traders plan to buy depends on:

  • The exchange rate

  • World demand for U.S. exports

  • Interest rates in the U.S. and other countries

  • The expected future exchange rate

• Law of Demand for Foreign Exchange: The higher the exchange rate, the smaller the quantity of dollars demanded.

• Sources of demand:

  • Exports effect: Higher U.S. exports increase demand for dollars.

  • Expected profit effect: Higher expected profit from holding dollars increases demand.

Changes in Demand for Dollars

• Factors shifting the demand curve:

  • World demand for U.S. exports (increase shifts demand rightward)

  • U.S. interest rate differential (increase shifts demand rightward)

  • Expected future exchange rate (increase shifts demand rightward)

Supply in the Foreign Exchange Market

• The quantity of dollars supplied depends on:

  • The exchange rate

  • U.S. demand for imports

  • Interest rates in the U.S. and other countries

  • The expected future exchange rate

• Law of Supply for Foreign Exchange: The higher the exchange rate, the greater the quantity of dollars supplied.

• Sources of supply:

  • Imports effect: Higher U.S. imports increase supply of dollars.

  • Expected profit effect: Lower expected profit from holding dollars increases supply.

Changes in Supply for Dollars

• Factors shifting the supply curve:

  • U.S. demand for imports (increase shifts supply rightward)

  • U.S. interest rate differential (increase shifts supply leftward)

  • Expected future exchange rate (increase shifts supply leftward)

Market Equilibrium

Determination of Exchange Rate

• The exchange rate is determined by the intersection of demand and supply in the foreign exchange market.

• Changes in demand or supply shift the equilibrium exchange rate.

• Exchange rates can be volatile due to changes in interest differentials and expectations.

Arbitrage, Speculation, and Market Fundamentals

Key Concepts

• Arbitrage: Profiting by buying in one market and selling in another.

• Law of One Price: Identical goods should sell for the same price in different markets.

• No Round-Trip Profit: Arbitrage eliminates profit from round-trip currency transactions.

• Purchasing Power Parity (PPP): Currencies should have equal purchasing power for the same basket of goods.

• Interest Rate Parity: Returns on two currencies should be equal when adjusted for expected appreciation/depreciation.

Formulas

• Real Exchange Rate (Q):

  • If PPP holds,

• Interest Rate Parity:

  • Where is the domestic interest rate, is the foreign interest rate, is the expected future exchange rate, and is the current exchange rate.

Summary Table: Balance of Payments Accounts

Conclusion

The open economy framework is essential for understanding how countries interact through trade and finance. The balance of payments, exchange rates, and the foreign exchange market are interconnected, influencing national income, monetary policy, and global economic stability.