Open Macroeconomics: Basic Concepts

From Baripedia

A closed economy is one that does not interact with the rest of the world.

An open economy is one that interacts with other economies in the world. This interaction takes place in two ways:

• by buying (imports) and selling (exports) goods and services in world product markets (flows of goods and services).
• by buying and selling assets in the global financial markets (capital flows).

The document that summarises the economic and financial flows between residents and non-residents is the balance of payments.

International transactions and balance of payments

Net exports

Exports (EXP) = acquisition by the rest of the world of goods and services produced on the national territory.

Imports (IMP) = acquisition by residents of goods and services produced abroad.

Net exports (NX) = exports - imports = balance of trade (BC).

We speak of trade surplus when EXP > IMP (NX > 0) and of trade deficit when IMP > EXP (NX < 0). Trade is in equilibrium when the trade balance is = 0.

Factors influencing net exports

• Consumer tastes for domestic and foreign goods
• Prices of goods in the domestic country and abroad
• The exchange rate at which economic agents can exchange domestic currency for foreign currency.
• Consumer income in the domestic country and in the rest of the world (RoW)
• The cost of transporting goods and services

Capital flows

Purchase of foreign assets on the part of residents (= import of foreign assets) = export of capital.

Purchase of domestic assets on the part of foreigners (= export of domestic assets) = import of capital.

Example: a Frenchman buys a Ford share and a Japanese man buys a Greek government bond.

Definitions:

Net Capital Outflow (NCO = Net Capital Outflow) = (export of capital - import of capital) = (purchase of foreign assets from residents - purchase of domestic assets from foreigners) = - balance of the Balance of Capital Movements (BMC) = (export of domestic assets - import of foreign assets).

This gives us the net liability position of the country to RoW: if BMC > 0 (and thus NCO < 0) => the country is indebted to RoW.

Factors influencing capital flows

• The interest rate paid on foreign assets
• The interest rate paid on domestic assets
• Economic or political risk associated with holding securities abroad or in the domestic country
• The exchange rate at which economic agents can exchange domestic currency for foreign currency (spot and expected).
• Government policies influencing the holding of assets (taxes, controls, limits...)

The importance of capital flows

Increasingly important since the 1970s, with the gradual liberalisation of financial markets.

The simplified balance of payments

The Balance of Payments (BOP) summarises the transfers and settlements of economic transactions (goods and services, income from factors of production, capital movements) carried out during a year between a country's economy (residents) and abroad (non-residents).

BC et BMC

Hp: in the following we will assume that the balance of factor compensation balance (SBRF) is equal to 0 and therefore that the current account balance coincides with the trade balance (TB or NX).

Net exports and outward capital flows are strictly linked.

Any transaction in the trade balance (TB) has a counterpart in the capital movements balance (CMB) => it generates a change in the country's stock of assets and liabilities vis-à-vis foreign countries.

-Example: A watch producer in La Chaux-de-Fond sells watches to a major American distributor. The latter pays its bill by drawing a cheque on its Bank of America account.

Export = ↑ from the BC (export of goods).
Cheque in USD = ↑ of Swiss assets vis-à-vis foreign countries (import of a foreign asset).

Intuition: the transaction in the BMC represents the specific form of payment made or received in return for the import or export of a good.

Similarly, a transaction originating in the CCB (purchase or sale of securities on the international market) can only be financed by an equivalent flow of goods and thus changes the country's current position vis-à-vis the foreign country (TB balance).

- Example: direct investment abroad financed by an export of goods (our company in La Chaux-de-Fonds decides to set up a production unit in Boston and finances this investment operation with its export earnings). Investment transaction = ↑ of assets abroad (export of capital). Exports = ↑ of BC (export of goods).

NB: If, in the first example, the export of goods was perfectly offset by imports of the same amount → no change in the BMC; similarly, if in the second example, the direct investment abroad was financed by a foreign currency loan → no change in the TB.

TB = -BMC

So, for the economy as a whole, at any given time:

TB = -BMC (or NX = NCO)

(Flow equalization: each international transaction includes an exchange → if we sum all these exchanges, the NXs must equalize the OCNs)

Intuition: any transaction that has no counterpart in the same "sub-balance" must necessarily have a counterpart in the other "sub-balance". For example, in return for the export of one good there will be either the import of other goods or assets.

In return for an export of securities, there will be either an import of goods or an import of capital. If we add up all the transactions between the domestic country and the rest of the world, then, necessarily, on a net basis, NX = NCO

National accounting in an open economy

Open economy production and spending

As we have seen, in a closed economy there is necessarily equality between production and expenditure in a given year.

In an open economy, such a constraint does not necessarily have to be realized:

• the economy can spend more than it produces by borrowing from abroad (importing goods = borrowing)
• the economy can spend less than it produces by lending abroad (export of goods = loan)

National accounting in an open economy

We know that at any point in time in the market for goods and services total employment must equal total resources:

GDP + IMP (= resources) = C + I + G + EXP (= jobs or expenses)

Moving PMI,we've got:

GDP = C + I + G + (EXP – IMP) = C + I + G + TB

This equation can be rewritten as follows:

TB = GDP – (C + I + G) = GDP – absorption

The trade balance is equal to national production less the absorption of this production by domestic employment. If Absorption > GDP => TB deficit. If Absorption < GDP => TB surplus.

TB and Savings

As we have just seen, any excess of domestic expenditure over domestic production results in a TB deficit (developing countries, USA, Spain, etc.); any excess of domestic production over domestic expenditure results in a CB surplus (Germany, Japan, Switzerland, China, etc.).

Put differently, a country has a positive TB if it generates positive net savings (private and public sectors combined). Indeed, by explicitly considering taxes in the previous equation, at equilibrium we have:

${\displaystyle TB=(GDP-C-T)-I+(T-G)=S_{P}-I+S_{G}=S-I}$

The CB balance is equal to the surplus of private savings over investments plus any government budget surplus. Obviously, in the presence of a budget deficit, the CB balance is still positive only if private savings are sufficient to finance investments and the government deficit (= measure of the economy's financing requirement).

TB, savings and BCM

As we have seen before, the international financial flows and the flows of the current part of the BP are two sides of the same coin and the balance of the trade balance is equal to the balance of the balance of capital movements (or financial account) :

${\displaystyle BC+BCM=0}$

and therefore,

${\displaystyle -BCM=S_{P}-I+S_{G}=S-I}$

This implies that if the country generates net domestic savings, it exports capital (NCO > 0 and BCM < 0: net capital outflow = net creditor position), its TB is positive and it accumulates claims on foreigners. On the contrary, if the country has a net borrowing requirement (e.g. because the government deficit exceeds the surplus of private savings over investment), it imports capital (NCO < 0 and BCM > 0: capital inflow = net debtor position), its TB is in deficit and it incurs foreign debt.

International flows of goods and capital

NB: There is no "good" or "bad" trade balance. International trade allows countries to consume more or less of what they produce, just as borrowing and lending do for individuals.

USA: domestic savings and investment

The USA is the largest debtor country in the world (high C + succession of budget deficits). This debt is mainly financed by the Newly Industrialized Countries, NICs (China, South East Asia ...). Potential problem in the long run: confidence in the capacity of the USA to repay its debt (see additional reading).

Overall deficits and surpluses

In recent years, there are countries with very large surpluses (emerging countries + oil exporting countries) and countries with very large deficits (led by the USA + a number of developed countries).

Source: Feenstra and Taylor, 2008

Summary

• The balance of payments is the document that summarises the economic and financial flows recorded between 'resident' and 'non-resident' economic agents over a given period.
• The CB balance and the BMC balance are strictly linked.
• In the open economy, the CB balance is equal to national output minus the absorption of this output by domestic employment.
• The country has a positive CB if private savings are sufficient to finance investments and any government deficit.
• A country has a foreign debt position (and therefore a CB surplus) if its net domestic savings are positive.

Annexes

On international imbalances :

• A topsy-turvy world, The Economist, 14.09.2006
• When a flow becomes a flood, The Economist, 22.01.2009
• Les Etats-Unis peuvent-ils s’endetter sans limites?, Alternatives Economiques, septembre 2007
• Global imbalances, Feenstra et Taylor, 2008, p. 186-192