Open Economy Macroeconomics
What is Open Economy?
Economic activity between domestic
community and outside.
FOREIGN TRADE AND ECONOMIC
ACTIVITY
Open-economy macroeconomics is
the study of how economies behave when
the trade and financial linkages among
nations are considered.
Total Aggregate demand (or AD )
is the total or aggregate quantity of
output that is willingly bought at a given
level of prices, other things held constant.
AD is the desired spending in all product
sectors: consumption, private domestic
investment, government purchases of
goods and services, and net exports.
Total aggregate demand = C+I+G+X
It has four components:
1. Consumption.
Consumption (C) is primarily determined by
disposable income, which is personal
income less taxes. Other factors affecting
consumption are longer-term trends in
income, household wealth, and the
aggregate price level
2. Investment.
Investment (I) spending includes purchases
of buildings, software, and equipment and
accumulation of inventories.
3. Government purchases.
A third component of aggregate demand is
government purchases of goods and
services (G).
4. Net exports.
A final component of aggregate demand is
net exports (X ), which equal the value of
exports minus the value of imports.
x= net exports
Net exports are defined as exports of
goods and services minus imports of goods
and services.
Imports, which are goods and services
produced abroad and consumed
domestically. Exports are goods and
services produced domestically and
purchased by foreigners.
X= Ex – Im
When a country has positive net exports, it
is accumulating foreign assets. The
counterpart of net exports is net foreign
investment, which denotes net U.S.
savings abroad and is approximately equal
to the value of net exports.
Figure 28-1
Determinants of Trade and Net Exports
Imports into the United States are
positively related to U.S. income and output.
When U.S. GDP rises, imports into the U.S.
increase
(1) because some of the increased C +I +G
purchases (such as cars and shoes) come
from foreign production and also
(2) because America uses foreign-made
inputs (like oil or lumber) in producing its
own goods.
To calculate the total production of
American goods and services, we need to
add trade to domestic demand. That is, we
need to know the total production for
American residents as well as the net
production for foreigners. This total includes
domestic expenditures (C + I +G) plus sales
to foreigners (E ) minus domestic purchases
from foreigners ( Im ). Mpm- measures the changes in spending
Total output, or GDP, equals consumption on imports for each dollar change in GDP
plus domestic investment plus government
purchases plus net exports:
Mpm = change in imports
Total domestic output = GDP Change in GDP
= C +I +G +X

Imports and exports are determined Slope of total spending line

primarily by incomes, relative price
differences, and foreign exchange rates. = total change in spending
When a nation’s exchange rate rises, the Change in GDP
prices of imported goods fall while its
exports become more expensive to The Open-Economy Multiplier
foreigners.
Open Economy Multiplier
Two basic exchange rate systems:
= 1/ 1-(MPC+MPm)
Flexible exchange rate - the market forces
of supply and demand determine the rate at where in :
which currencies are traded MPC- Marginal propensity to consume
Fixed exchange rate - the government MPm- Marginal propensity to import
specifies the rate at which its nation’s
currency will be traded for other currencies.
Another way of calculating the multiplier is
Short-run Impact of trade on GDP as follows:

Open-economy Multiplier
There are two major new macroeconomic
= 1/ MPS+MPm
elements in the presence of international
trade: First, we have a fourth component of where in:
spending, net exports, which adds to
aggregate demand. Second, an open MPS =marginal propensity to save and
economy has different multipliers for private MPm =marginal propensity to import.
investment and government domestic
spending because some spending leaks out
to the rest of the world.
Table 28-1

Figure 28.2

Marginal Propensity to Import and the TRADE AND FINANCE FOR THE
Spending Line UNITED STATES UNDER FLEXIBLE
EXCHANGE RATES

GRAPH (FIGURE 28.3)
This is an index of the real exchange rate of
the U.S. dollar against other major
currencies. The real exchange rate corrects
for movements in the price levels in different
countries.
Fixed Exchange Rates. The key feature of
countries with fixed exchange rates and
high capital mobility is that their interest
rates must be very closely aligned.
Flexible Exchange Rates. A flexible
exchange rate has a reinforcing effect on
monetary policy.

GRAPH( FIGURE 28.6)

GRAPH (FIGURE 28.4)
This graph shows the real component of net
exports. This is the ratio of real net exports
to real GDP. .
GRAPH ( FIGURE 28.5)
This shows the important relationship
between real exchange rates and the trade
deficit. It illustrates the dramatic effect of the
appreciating dollar on trade flows.
This shows the monetary transmission
mechanism under flexible exchange rates.
Foreign trade produces a new and powerful
link in the monetary transmission
mechanism when a country has a flexible
exchange rate. When monetary policy
changes interest rates, this affects
exchange rates and net exports as well as
domestic investment. Monetary tightening
leads to an appreciation in the exchange
rate and a corresponding decline in net
exports; monetary easing does the
opposite. The impact of changes in interest
rates on net exports reinforces the impact
on domestic investment.

THE MONETARY TRANSMISSION

MECHANISM IN AN OPEN ECONOMY

How is the monetary transmission

mechanism different in an open economy?

Surprisingly, the answer to these questions

depends crucially on whether the country
has a fixed or a flexible exchange rate.

"When financial investments can flow easily

among countries and the regulatory barriers
to financial investments are low, we say that
these countries have high mobility of
financial capital."
 PROMOTING GROWTH IN THE OPEN
ECONOMY
Graph

Increasing the growth of the output IMPACT OF THE INVESTMENT

in an open economy involves more than just ON NATIONAL INCOME
waving a magic wand that will attract
investors or savers.

Ways to Improve Open Economies’

Growth Rate

1. Adopts best practice techniques

Single most important way of
increasing per capita output and living
standards is to ensure that the country
adopts best-practice techniques.

2. Trade Policies
Evidence shows that an open
economy trading system promotes
competitiveness and adoption of best-
practice techniques.

3. Investing on Intangible Capital

Studies show that countries that
invest in human capital through
education tend to perform well and be
resilient in the face of shocks.

4. Immigration and Emigration

one of the most complex factors in
a country’s growth.

5. Institutions of the Market

The most successful open
economies have provided a secure
environment for investment and
entrepreneurship.

6. Stable Macroeconomic Climate

Taxes are reasonable and
predictable and that inflation is low, so
lenders no need to worry about inflation
confiscating their investments.