Open-Economy Macroeconomics:

Basic Concepts
 Basic Concepts
A closed economy is one that does not interact with other economies
in the world.
There are no exports, no imports, and no capital flows.

An open economy is one that interacts freely with other economies

around the world.
It buys and sells goods and services in world product markets.
It buys and sells capital assets in world financial markets.

Exports are goods and services that are produced domestically and
sold abroad.

Imports are goods and services that are produced abroad and sold
domestically
 THE INTERNATIONAL FLOW OF
GOODS AND CAPITAL
An Open Economy
The United States is a very large and open
economyit imports and exports huge
quantities of goods and services.

Over the past four decades, international trade

and finance have become increasingly
important.
 The Flow of Goods: Exports, Imports, Net Exports

Net exports (NX) = the value of a nations

exports minus the value of its imports, also
called the trade balance.
Value of exports value of imports = Net Exports (NX)

trade deficit - Imports > Exports

trade surplus - Exports > Imports
Balanced trade refers to when net exports are
zeroImports = Exports are exactly equal.
 THE FLOW OF CAPITAL ABROAD
Foreign direct investment:
Domestic residents actively manage the
foreign investment, e.g., Starbucks opens a
caf in Berlin.

Foreign portfolio investment:

Domestic residents purchase foreign stocks or
bonds, supplying loanable funds to a
foreign firm.
 Factors That Affect Net Exports
The tastes of consumers for domestic and foreign
goods.
The prices of goods at home and abroad.
The exchange rates at which people can use
domestic currency to buy foreign currencies.
The incomes of consumers at home and abroad.
The costs of transporting goods from country to
country.
The policies of the government toward
international trade.
What are three reasons for increased international
trade over the past several decades?
 Practice Problem #1
Variables that affect NX

What do you think would happen to U.S. net exports if:

a. Canada experiences a recession
(falling incomes, rising unemployment)

b. U.S. consumers decide to be patriotic and

buy more products Made in the U.S.A.

c. Prices of goods produced in Mexico rise faster

than prices of goods produced in the U.S.
Answers
A. Canada experiences a recession (falling incomes, rising unemployment)
U.S. net exports would fall due to a fall in Canadian consumers
purchases of U.S. exports
B. U.S. consumers decide to be patriotic & buy more products Made
in the U.S.A.
U.S. net exports would rise due to a fall in imports
C. Prices of Mexican goods rise faster than prices of U.S. goods
This makes U.S. goods more attractive relative to
Mexicos goods.
Exports to Mexico increase, imports from Mexico
decrease, so U.S. net exports increase.
The Flow of Financial Resources: Net Capital Outflow
Net capital outflow/net foreign investment refers to the
purchase of foreign assets by domestic residents minus the
purchase of domestic assets by foreigners.

Outflow can be positive or negative

Positive (outflow) domestic residents (Americans) are
buying more foreign assets than foreigners are buying of
domestic/American assets

Negative (inflow) - domestic residents (Americans) are

buying less foreign assets than foreigners are buying of
domestic/American assets
 Net capital outflow/net foreign investment
Example 1
When a U.S. resident buys $500 worth of stock in Telmex, the
Mexican phone company and a Japanese residents buys a $300 bond
issued by the U.S. government
Net Capital Outflow $500-$300 = 200 net capital outflow (positive
outflow, Americans buying more, money is flowing out of the
country)
Example 2
U.S. resident opens Starbucks in Norway spending $500,000 and a
BMW a German company spends $1,000,000 to open a factory in
South Carolina
Net Capital Outflow $500,000 -$1,000,000 = $500,000 net capital
outflow (negative outflow, foreigners buying more, money flows
into the US, aka capital inflow)
The Equality of Net Exports & Net Capital Outflow

Net exports (NX) and net capital outflow (NCO)

are closely linked.

For an economy as a whole, NX and NCO must

balance each other so that:

NCO = NX
This holds true because every transaction that affects
one side must also affect the other side by the same
amount.
 The Equality of NX and NCO
An accounting identity: NCO = NX
arises because every transaction that affects NX also
affects NCO by the same amount
(and vice versa)

When a foreigner purchases a good from the U.S.,

U.S. exports and NX increase
the foreigner pays with currency or assets, so the U.S.
acquires some foreign assets, causing NCO to rise.
 The Equality of NX and NCO
An accounting identity: NCO = NX
arises because every transaction that affects NX also affects NCO
by the same amount (and vice versa)

When a U.S. citizen buys foreign goods,

U.S. imports rise, NX falls
the U.S. buyer pays with U.S. dollars or assets, so
the other country acquires U.S. assets, causing
U.S. NCO to fall.
 Saving, Investment, & their Relationship to the
International Flows
Net exports is a component of Gross Domestic Product (GDP):
Y= GDP
C= Consumption
I=investment/business
G= Government spending
NX= (exports-imports)
Y = C + I + G + NX

National saving is the income of the nation that is left after

paying for current consumption and government purchases:
Y - C - G = I + NX
 Saving, Investment, & their Relationship to the
International Flows

National saving (S) equals Y - C - G so:

S = I + NX
or
Saving =
Domestic + Net Exports
Investment
S = I + NX
Or NX= NCO so

S = I + NCO
 Saving, Investment, and International Flows
of Goods & Assets
Y = C + I + G + NX accounting identity
Y C G = I + NX rearranging terms
S = I + NX since S = Y C G
S = I + NCO since NX = NCO
When S > I, the excess loanable funds flow abroad in the
form of positive net capital outflow.
When S < I, foreigners are financing some of the countrys
investment, and NCO < 0.
Figure 2 National Saving, Domestic Investment,
and Net Foreign Investment

(a) National Saving and Domestic Investment (as a percentage of GDP)

Percent
of GDP
20

Domestic investment
18

16

14

12 National saving

10
1960 1965 1970 1975 1980 1985 1990 1995 2000

Copyright 2004 South-Western

Figure 2 National Saving, Domestic Investment,
and Net Foreign Investment

(b) Net Capital Outflow (as a percentage of GDP)

Percent
of GDP
4

2
Net capital
1 outflow

4
1960 1965 1970 1975 1980 1985 1990 1995 2000

Copyright 2004 South-Western