Lecture 6 Open Economy

1. Lecture 6Open Economy

2. Open and Closed Economies • 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. • An Open Economy • An open economy interacts with other countries in two ways. • It buys and sells goods and services in world product markets. • It buys and sells capital assets in world financial markets.

3. Trade Balance • Exports are goods and services that are produced domestically and sold abroad. • Imports are goods and services that are produced abroad and sold domestically. • Net exports (NX) are the value of a nation’s exports minus the value of its imports. • Net exports are also called the trade balance. • A trade deficit is a situation in which net exports (NX) are negative. • Imports > Exports • A trade surplus is a situation in which net exports (NX) are positive. • Exports > Imports • Balanced trade refers to when net exports are zero—exports and imports are exactly equal.

4. Net Exports Domestic Spending Output Y = C + I + G + NX After some manipulation, the national income accounts identity can be re-written as: NX = Y - (C + I + G) This equation shows that in an open economy, domestic spending need not equal the output of goods and services. If output exceeds domestic spending, we export the difference: net exports are positive. If output falls short of domestic spending, we import the difference: net exports are negative.

5. Let’s call this S, national saving . Trade Balance (net exports) Net Foreign Investment Net Foreign Investment & the Trade Balance Start with the national income accounts identity. Y=C+I+G+NX. Subtract C and G from both sides and obtain Y-C-G = I+NX. So, now we have S=I+NX. Subtract I from both sides to obtain the new equation, S-I=NX. This form of the national income accounts identity shows that an economy’s net exports must always equal the difference between its saving and its investment. S-I=NX

6. If S-I and NX are positive, we have a trade surplus. We would be net lenders in world financial markets, and we are exporting more goods than we are importing. If S-I and NX are negative, we have a trade deficit. We would be net borrowers in world financial markets, and we are importing more goods than we are exporting. If S-I and NX are exactly zero, we have balanced trade since the value of imports equals the value of exports.

7. Balance of payments • Balance of payments (BoP) accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers. The BoP accounts summarize international transactions for a specific period, usually a year, and are prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items. • When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned from its foreign investments, by running down central bank reserves or by receiving loans from other countries.

8. BOP The two principal parts of the BOP accounts are the current account and the capital account. • Current Account: It is the sum of the balance of trade (i.e., net revenue on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors) and cash transfers. • Capital Account: Whereas the current account reflects a nation's net income, the capital account reflects net change in national ownership of assets. A surplus in the capital account means money is flowing into the country, but unlike a surplus in the current account, the inbound flows will effectively be borrowings or sales of assets rather than earnings. A deficit in the capital account means money is flowing out the country, but it also suggests the nation is increasing its claims on foreign assets.

9. Net Capital Outflow and Inflow Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Net capital outflow= Capital Outflow – Capital Inflow If outflow > inflow then Net capital outflow is positive that means capital is going out of the country in net amount. Net capital inflow refers to the purchase of domestic assets by foreign residents minus the purchase of foreign assets by domestic residents. Net capital inflow= Capital Inflow – Capital Outflow If inflow > outflow then Net capital inflow is positive that means capital is coming into the country in net amount.

10. Determination of Capital flow • Capital inflow and outflow is influenced by interest rate. If interest rate is high in a country then foreigners will be willing to lend more to the domestic country because the return is high. So there will be capital inflow in domestic country. • On the other hand if interest rate is low in domestic country and foreign interest rate is higher then domestic interest rate then domestic resident will lend money to foreignersbecause return of capital is high in foreign country. • Let r be the domestic interest and rfbe the foreign interest rate. • Case : 1 if r>rfthen we have capital inflow in domestic country • Case: 2 if r<rf then we have capital outflow in domestic country • Case : 3 if r=rfthen we have neither capital outflow nor inflow in domestic country • Note: Here in discussion we use capital inflow and outflow of domestic country not foreign country because in the graph in X axis we use domestic interest rate. • Question: If you are asked to discuss about capital inflow and outflow between two countries A and B then if you put the interest rate of country A in X axis then you have to discuss about capital inflow and outflow of country A.