Open Economy Macroeconomics

Closed economies assume that there is no exports nor imports, but many economies across the world require trade to function
These are open economies, and they are important because many countries and industries rely on international trade

National Income Accounting

In a closed economy, the equations Y = C + I + G and S = I are true because there is no outside trade
- G and T represent government spending and taxes
- Household disposable income is Y - T
- Household consumption and saving is Y - T - C = S^H, where C is a function of Y - T s.t. C = C(Y - T)
- Government saving is T - G = S^G
- National savings are S = S^H + S^G
In an open economy, these terms change
- C = C^d + C^f (where d = domestic and f = foreign)
- I = I^d + I^f
- G = G^d + G^f
- X = exports of domestically produced goods and services to other nations
- IM = imports of internationally produced goods and serivces to a home nation
- NX = exports - imports
These terms imply that domestic spending might not equal domestic output, nor will domestic saving equal domestic investment
- Foreign spending and saving can make up the difference
- Other terms might not be equal due to foreign-held capital and labor, but these differences are fairly insignificant
In an open economy:
- C^d + I^d + G^d + X - (C + I + G)
- = (C^d - C) + (I^d - I) + (G^d - G) + X
- = -C^f - I^f - G^f + X
- -> X - IM = 0 = NX

The current account is a country’s net exports of goods and services plus net foreign aid to the country
If NX > 0, then there is a trade surplus; if NX < 0, then there is a trade deficit
Net (financial) capital outflows: S - I = the net outflow of “lonable funds” = net purchases of foreign assets
- AKA domestic country’s purchases of foreign assets minus foreign purchases of domestic assets
S > I, country is a net lender; S < I, country is a net borrower
Capital account is the inverse of net capital outflows

NX = Y - (C + I + G) \\ = (Y - C - G) - I \\ = (Y - T - C - G + T) - I = S - I \\ \text{trade balance} = \text{net capital outflows} \\ \text{current account} = -\text{capital account} \\ \text{current account} + \text{capital account} = 0\\ NX + I - S = 0

In some cases, yes; in others, no
If a country has a trade deficit because they have bad domestic products, then the deficit is bad
If a country has a trade deficit because everyone wants to import into the US, then the deficit is good

Three assumptions
- Domestic and foreign bonds are perfect substitutes
- Perfect capital mobilityL no restrictions on international trade in assets
- Economy is small: cannot affect the world interest rate
Similar to the loanable funds model
- Production function: Y = F(K, L)
- Consumption function: C = C(Y - T)
- Investment function: I = I(r)
- Exogenous policy variables: G bar, T bar, etc.

Nominal exchange rate (e): The relative price of domestic currency in units of foreign currency
Real exchange rate (ε): The relative prive of domestic goods in units of foreign goods
- Normally equal to 1 (e.g. one JP car is same as one US car)
- Can be thought of as the relative price of a basket of goods vs. a basket of foreign goods

\epsilon = e \frac{P^d}{P^f}

Exports and imports depend on the exchange rate
- When ε goes up, US goods become more expensive relative to foreign goods, meaning that exports goes down and imports go up, so net exports goes down
  - X and NX down, IM up
- When ε goes down, the opposite happens; foreign goods are expensive, so exports goes up and imports go down, so net exports goes up

NX = S - I
- S is determined on domestic factors, as it represents savings
- I is determined by the world interest rate r*
- ε adjusts the net export demand to be equal to the capital account balance

The world economy is a closed economy
- Can use closed economy models for the world

The US and China are considered the two large open economies
- This means they lie in between a closed economy and a small open economy
- Analysis of a large open economy will lie between a closed and small open economy; similar to taking the average