The Open Economy

Balance of Payments Accounts

An open economy engages in international trade and international borrowing and lending. A country's spending need not equal its production in every period. By importing more than it exports and borrowing from abroad to make up the difference, a nation can temporarily spend more than it produces.

The balance of payments is a record of a country's trade in goods, services, and financial assets with the rest of the world.

Any international transaction involves two opposite flows of equal value:

• 1. credit - flow for which the country is paid, e.g. exports, sale of assets

  2. debit - flow for which the country must pay, e.g. imports, purchase of assets

Each transaction is recorded twice in the balance of payments: once as a credit and once as a debit. This is called double-entry bookkeeping. As a result, the balance of payments must balance.

The balance of payments consists of two parts: (1) the current account, which measures the country's trade in currently produced goods and services, and (2) the capital account, which records trade between countries in existing assets.

current account

The current account balance =  exports of goods, services, and investment income                              - imports of goods, services, and investment income                              + net unilateral transfers 

Services include transportation, tourism, insurance, education, and financial services. Investment income includes interest payments and dividends people receive from assets owned outside of their own country. A unilateral transfer occurs when one party gives something but receives nothing in return, e.g. foreign aid.

capital account

A capital inflow occurs when the home country sells an asset to another country, e.g. Rockefeller Center is sold to a Japanese company.

A capital outflow occurs when the home country buys an asset from abroad, e.g. an American obtains a Swiss bank account.

The capital account balance = capital inflows - capital outflows

A country has a capital account surplus when its residents sell more assets to foreigners than they buy from foreigners.

Current Account balance + Capital Account balance = Zero

When a country runs a current account deficit, it means that it received fewer funds from its exports than the funds paid for imports. To finance this deficit, it must sell its assets to the foreigners. So, a current account deficit must be accompanied by a capital account surplus. The balance of payments must balance.

Included in the capital account is the official settlements balance. The official settlements balance records transactions conducted by central banks. It measures the net increase in a country's official reserve assets, assets that can be used in making international payments. The official settlements balance is called the balance of payments.

Exchange Rates

Foreign exchange is the money of another country. The exchange rate is the price of one country's currency in terms of another country's money. For example, say, $1 = 5.6415 French francs.

Suppose the exchange rate becomes $1 = 5.7 French francs. Then the value of the dollar has appreciated or gone up. The price in dollars of French goods has fallen while the price of U.S. goods has increased for the French. So, our exports will fall and imports will rise.

If the exchange rate, instead, became $1 = 5.4 French francs, the value of the dollar has fallen or depreciated. Now, American goods are cheaper in terms of the French franc while French products are more expensive for U.S. consumers. Exports will rise and imports will fall.

The real exchange rate, R, takes price levels into account. It measures the price of foreign goods relative to domestic goods, measured in the same currency.

The BP Line

There are two policy problems under fixed exchange rates:

• 1. external balance - maintaining the BOP so the exchange rate can remain fixed because a BOP deficit puts downward pressure on the value of the dollar while a BOP surplus puts upward pressure

  2. internal balance - control AD to maintain full-employment without inflation

With fixed exchange rates, the BOP reflects private trading between the domestic and foreign currency. A BOP surplus causes a net inflow of money from abroad while a BOP deficit causes a net outflow.

Influences on BOP

• 1. current account balance = NX(Y, R)

  2. financial capital flows = F(r)

The BP line shows combinations of Y and r that allow equilibrium in the foreign exchange market. Point to the left of the BP line represent a BOP surplus while points to the right of the line represent a BOP deficit.

In the short run (meaning we are ignoring the FE line), the economy is in equilibrium at the intersection of the IS and LM curves. Equilibrium can be at any BOP position: surplus, deficit, or balanced.

Fixed Exchange Rates and Economic Policy

monetary policy

fiscal policy

Fiscal policy is more effective than monetary policy when exchange rates are fixed.

Perfect Capital Mobility

Perfect capital mobility means that money is free to move between countries in search of the highest interest rate. So, the interest rate all over the world is fixed at rw.

monetary policy

fiscal policy