Lecture 16 - Open Economy I

Closed economy: An economy that does not engage in trade or financial transactions with other countries.
Open economy: An economy that interacts with other economies through trade in goods, services, and financial assets.

An open economy introduces external demand and supply channels. Domestic economic outcomes are no longer determined solely by internal factors but also by global conditions.

Exports (X): Domestically produced goods sold abroad.
Imports (M): Foreign-produced goods consumed domestically.
Net exports (NX):

Net exports capture the external demand component of aggregate demand. In an open economy, equilibrium output depends not only on domestic spending but also on foreign demand for domestic goods.

Higher domestic income → higher imports → lower NX
Stronger foreign income → higher exports → higher NX

This reflects globalisation, driven by:

• Reduced trade barriers
• Technological progress in transport and communication
• Financial integration

• Trade has grown significantly relative to GDP
• Open economy effects are increasingly important for macroeconomic analysis

Net capital outflow (NCO):

Higher domestic interest rates → capital inflow → lower NCO

Accounting identity:

This identity reflects a fundamental constraint:

• A country exporting more than it imports must be accumulating foreign assets
• A country importing more must be borrowing from abroad

Always link trade balances to financial flows
Marks are awarded for recognising that goods flows and capital flows are two sides of the same coin.

National saving: Income not consumed or spent by the government.

This connects to intertemporal trade:

• Trade deficits allow countries to consume more today by borrowing
• Trade surpluses reflect deferred consumption via lending

• determines international financial position
• Trade imbalances are fundamentally saving-investment imbalances

Nominal exchange rate (e):
The rate at which one currency can be exchanged for another.

Appreciation → imports cheaper → exports less competitive → NX falls

Real exchange rate:
Measures relative price of domestic goods in terms of foreign goods

Lower relative price → substitution towards domestic goods

Confusing nominal and real exchange rates
Nominal changes do not necessarily imply changes in competitiveness unless adjusted for prices.

Exchange rates are determined in asset markets, not just goods markets. Expectations, speculation, and capital mobility play a central role.

• links trade and finance
• links saving and global capital allocation
• Exchange rates determine competitiveness
• Global integration amplifies macroeconomic interdependence