Unit 6: Open Economy - International Trade and Finance

Students will examine the concept of an open economy in which a country interacts with the rest of the world through product and financial markets.

Open-Economy Basics & Net Exports

Exports are domestically produced goods and services sold abroad, and imports are foreign-produced goods and services purchased domestically. Net exports \(X_n\) (also written \(NX\)) equal exports minus imports. The expenditure identity is \(AD \equiv C + I + G + X_n\).
A trade surplus means \(X_n > 0\) and a trade deficit means \(X_n < 0\). The trade balance includes goods and services, while income and transfers are recorded elsewhere in the balance of payments. Sign conventions treat imports as a subtraction because they are not domestic production.
Holding the aggregate price level fixed, an increase in \(X_n\) shifts AD to the right. A decrease in \(X_n\) shifts AD to the left under the same condition. These statements classify the demand-side effect of external transactions in the model.
Determinants of \(X_n\) include relative income, relative prices, and the exchange rate. Higher domestic income raises imports and tends to lower \(X_n\) at given foreign conditions. Higher foreign income raises exports and tends to increase \(X_n\) at given domestic conditions.
The real exchange rate summarizes relative price competitiveness between domestic and foreign goods. A domestic appreciation reduces export competitiveness and raises import attractiveness, tending to lower \(X_n\). A domestic depreciation does the opposite and tends to raise \(X_n\).
In the saving–investment identity at course scope, \(X_n = S - I\) for the open economy. A trade deficit implies domestic investment exceeds domestic saving and is financed by net capital inflow. A trade surplus implies domestic saving exceeds investment and is associated with net capital outflow.

Balance of Payments (BOP) Accounting

The balance of payments records all international transactions using double-entry bookkeeping. The main subaccounts are the current account and the financial (capital) account, plus official reserve transactions. By construction, the BOP sums to zero once the statistical discrepancy is included.
The current account records trade in goods and services, net investment income, and net transfers. A current account surplus corresponds to net receipts from these items. A current account deficit corresponds to net payments on these items.
The financial account records purchases and sales of financial assets and real assets across borders. Net capital inflow is recorded as a financial account surplus, and net capital outflow is recorded as a financial account deficit. These labels track asset-side transactions rather than goods flows.
Official reserve transactions reflect central-bank purchases or sales of foreign assets to influence the exchange market. A purchase of foreign reserves is recorded as a financial account outflow with an offsetting entry. A sale of foreign reserves is recorded as a financial account inflow with an offsetting entry.
The accounting link implies that a current account deficit is matched by a financial account surplus of equal magnitude. Equivalently, a current account surplus is matched by a financial account deficit. These equalities enforce the double-entry requirement in the BOP.
Model identities align with \(X_n = S - I\) and with net capital outflow equal to \(X_n\) at course depth. A negative \(X_n\) implies net capital inflow financing the deficit. A positive \(X_n\) implies net capital outflow associated with the surplus.

Foreign Exchange Market (FOREX)

The foreign exchange market determines the nominal exchange rate between currencies. Let \(E\) denote units of foreign currency per one unit of domestic currency for the diagram. An increase in \(E\) is a domestic currency appreciation and a decrease is a domestic currency depreciation under this convention.
Demand for the domestic currency arises from foreigners needing it to buy domestic goods, services, and assets. Supply of the domestic currency arises from domestic residents exchanging it for foreign currency to buy foreign goods, services, and assets. Market equilibrium occurs where quantity demanded equals quantity supplied at \(E^{*}\).
In the “domestic currency” market, the demand curve slopes downward in \(E\) and the supply curve slopes upward. A higher \(E\) makes domestic goods more expensive to foreigners and reduces quantity demanded of domestic currency. A higher \(E\) makes foreign goods cheaper to domestic residents and increases quantity supplied of domestic currency.
Appreciation of the domestic currency reduces export volume and raises import volume at given incomes. Depreciation raises export volume and reduces import volume at given incomes. These directional statements map into movements in \(X_n\) in the AD identity.
Shifters of currency demand and supply include real interest rate differentials, expected returns, relative income, relative price levels, and preferences. A higher domestic real interest rate raises the demand for domestic currency and/or reduces its supply, tending to appreciate it. Higher domestic income raises imports and shifts the supply of domestic currency right, tending to depreciate it.
Under a floating regime, the exchange rate adjusts to clear the market without official intervention. Under a fixed or managed regime, the central bank uses reserves to maintain a target and offsets excess demand or supply. These institutional settings change whether \(E\) moves or reserves move for a given disturbance.

Determinants of Exchange Rates

A higher domestic real interest rate \(r\) raises the expected return on domestic assets relative to foreign assets. This increases demand for domestic currency and/or reduces its supply in the foreign exchange market. Under \(E\) = units of foreign currency per domestic unit, these pressures produce an appreciation (higher \(E\)).
Higher domestic inflation relative to foreign lowers the real purchasing power of the domestic currency. Demand for domestic goods and currency weakens while supply of domestic currency to buy foreign goods rises. In the long-run PPP view, these forces lead to depreciation (lower \(E\)).
An increase in domestic real income \(Y\) raises imports at given prices. Residents supply more domestic currency to obtain foreign currency, shifting the supply curve right. This produces depreciation pressure (lower \(E\)), while higher foreign income raises demand for domestic currency and tends to appreciate it.
If the domestic currency is expected to appreciate, portfolios shift toward domestic assets today. Current demand for domestic currency rises and current supply falls as conversions are delayed. The immediate effect is appreciation pressure; expected depreciation reverses these shifts.
Preference changes toward domestic goods raise foreign demand for the domestic currency at every \(E\). Greater domestic preference for foreign goods raises the supply of domestic currency at every \(E\). Trade barriers can alter these demands, but offsetting currency movements under floating rates limit effects on \(X_n\).
Perceived risk, liquidity, and institutional quality affect cross-border asset attractiveness. Lower perceived domestic risk or improved access increases capital inflow and currency demand. Higher perceived risk induces capital outflow and depreciation pressure on the domestic currency.

Exchange Rate Regimes & Policy Tools

Under a floating regime, the nominal exchange rate is determined by currency supply and demand. The central bank does not commit to a parity and allows \(E\) to adjust to shocks. Monetary policy remains instrument independent and reserves need not change to clear the market.
Under a fixed (pegged) regime, the central bank commits to maintain \(E\) at a target level. It buys or sells foreign reserves to offset excess demand or supply for domestic currency at the peg. Unsterilized intervention changes the monetary base, while sterilized intervention offsets that base change with open market operations.
A managed float permits discretionary interventions without a hard parity. A crawling peg adjusts the target rate in small, announced steps over time. Both frameworks use reserves and domestic instruments while preserving some exchange-rate flexibility.
In a fixed regime, a discrete downward change in the peg is a devaluation and an upward change is a revaluation. In a floating regime, market-driven decreases in \(E\) are depreciations and increases are appreciations. These are nominal movements and are distinct from real exchange rate changes driven by relative prices.
Core tools for managing the rate include reserve transactions, policy interest rates, and course-level capital-account measures. Raising domestic policy rates increases returns on domestic assets and supports the currency by attracting funds. Lowering policy rates has the opposite effect and, under a peg, may require reserve use to maintain parity.
The policy trilemma states that a country cannot simultaneously have a fixed exchange rate, free capital mobility, and independent monetary policy. With free flows, a hard peg requires domestic interest rates to track foreign rates. With independent monetary policy, the exchange rate must float or capital mobility must be restricted.

Policy Effects in an Open Economy

Expansionary monetary policy increases money supply and lowers the nominal interest rate \(i\). Via \( r \approx i - \pi^{e} \), the lower real rate induces capital outflow and depreciation under a float. Depreciation raises \(X_n\) by stimulating exports and reducing imports at given incomes, shifting AD right.
Contractionary monetary policy decreases money supply and raises \(i\). The higher real return attracts capital inflow and appreciates the domestic currency under a float. Appreciation reduces \(X_n\) and shifts AD left by lowering net external demand.
Expansionary fiscal policy raises \(G\) or lowers \(T\), shifting AD right directly. In loanable funds, higher public borrowing raises \(r\), draws in capital, and appreciates the currency. Appreciation lowers \(X_n\), producing a net export effect that partially offsets the initial AD increase.
Contractionary fiscal policy lowers \(G\) or raises \(T\), shifting AD left directly. Lower public borrowing reduces \(r\), induces capital outflow, and depreciates the currency. Depreciation raises \(X_n\) and partially offsets the initial AD decrease through the external channel.
Import restrictions reduce import quantity at initial prices but also raise demand for the domestic currency. Under a float, the currency tends to appreciate, which reduces exports and increases other imports through relative-price changes. Consequently, \(X_n\) shows little systematic change, so AD effects are limited at AP scope.
With a fixed rate and free capital flows, monetary policy is constrained by parity defense. Attempts to lower \(i\) trigger reserve losses as outflows emerge, forcing reversal or large interventions. Fiscal policy remains effective for AD, but its interest-rate and \(X_n\) effects are shaped by the central bank’s reserve operations.

Loanable Funds & International Capital Flows

The open-economy loanable funds market determines the real interest rate \(r\) where saving equals investment. The saving–investment identity at course scope is \( X_n = S - I \). A negative \( X_n \) implies domestic investment exceeds saving and is financed by net capital inflow.
Net capital inflow is recorded as additional funds available to lend domestically. In the diagram, an inflow shifts the supply of loanable funds to the right at each \(r\). The equilibrium shows a lower \(r\) and a higher quantity of funds.
Net capital outflow withdraws funds from the domestic market at each \(r\). In the diagram, an outflow shifts the supply of loanable funds to the left. The equilibrium shows a higher \(r\) and a lower quantity of funds.
Real interest rate differentials are a key driver of cross-border flows. A higher domestic real return relative to foreign attracts inflow until differentials narrow. A lower domestic real return induces outflow until differentials narrow.
Government budget position enters through public saving in the supply of loanable funds. A higher deficit reduces public saving and is represented as greater borrowing or lower saving in the diagram. The result is upward pressure on \(r\) and potential reduction in private investment \(I\).
Balance-of-payments accounting links these flows to the current account. A current account deficit is matched by a financial account surplus of equal magnitude. Equivalently, \( X_n < 0 \) corresponds to net capital inflow and \( X_n > 0 \) corresponds to net capital outflow.

Purchasing Power Parity & Real Exchange Rate (Conceptual)

Let \(E\) denote units of foreign currency per one unit of domestic currency. The real exchange rate is \( \varepsilon \equiv E \cdot \frac{P_{\text{dom}}}{P_{\text{for}}} \). It measures the relative price of domestic goods in terms of foreign goods.
Absolute purchasing power parity states that identical baskets should cost the same when expressed in a common currency. Under exact parity, \( \varepsilon = 1 \) for a common basket definition. This is a long-run benchmark rather than a short-run condition in the course.
Relative PPP links inflation differentials to nominal exchange rate changes. With \(E\) defined as foreign per domestic, \( \%\Delta E \approx \pi_{\text{for}} - \pi_{\text{dom}} \). Higher domestic inflation than foreign implies a lower \(E\) over time under this convention.
A rise in \( \varepsilon \) is a real appreciation of the domestic currency. Domestic goods become relatively more expensive than foreign goods after adjusting for price levels. This tends to reduce net exports \(X_n\) at given incomes.
A fall in \( \varepsilon \) is a real depreciation of the domestic currency. Domestic goods become relatively cheaper than foreign goods after adjusting for price levels. This tends to increase net exports \(X_n\) at given incomes.
Short-run deviations from PPP arise from transport costs, nontradable components, and market frictions. These factors allow \( \varepsilon \) to differ from one for extended periods. The course treats PPP as a long-run tendency guiding comparative statements.

Trade Balances, Deficits, and Sustainability (Course-Level)

The current account records trade in goods and services, net investment income, and net transfers. The financial account records net purchases of assets and equals the opposite sign of the current account aside from a discrepancy. By construction, the overall balance of payments sums to zero.
The identity \( X_n = S - I \) classifies trade positions. A trade deficit \( (X_n<0) \) means investment exceeds saving and is financed by net capital inflow. A trade surplus \( (X_n>0) \) means saving exceeds investment and is associated with net capital outflow.
Debt sustainability is discussed using the debt-to-GDP ratio at course scope. Its evolution depends on the primary balance and on the relationship between the interest rate and nominal GDP growth. A stable or falling ratio is consistent with long-run feasibility of existing policies.
Persistent current account deficits accumulate external liabilities. Financing through inflow can support investment while increasing the stock of claims on domestic income. Financing through reduced investment can slow capital accumulation and potential output growth.
Under a floating regime, sustained inflows place appreciation pressure on the domestic currency. Appreciation tends to reduce \(X_n\) and can reinforce the deficit through relative-price effects. Under a fixed regime, reserve changes accommodate the external position instead of nominal rate changes.
Policy assessments distinguish demand management from structural change. Adjustments that alter productivity, incentives, or resource growth shift LRAS and can affect long-run external positions. Purely nominal demand changes do not resolve structural external imbalances in the long run.

Effects of Changes in Policies and Economic Conditions on the Foreign Exchange Market

Let \(E\) denote units of foreign currency per one unit of domestic currency, so a higher \(E\) is a domestic appreciation and a lower \(E\) is a domestic depreciation. Demand for domestic currency comes from foreigners purchasing domestic goods, services, and assets. Supply of domestic currency comes from residents exchanging it for foreign currency to purchase foreign goods, services, and assets.
Expansionary monetary policy raises \(MS\) and tends to lower the nominal rate \(i\) and real rate \(r\) at a given \( \pi^{e} \). Lower \(r\) induces capital outflow that increases the market supply of domestic currency. Under this convention, \(E\) falls and the domestic currency depreciates.
Contractionary monetary policy lowers \(MS\) and tends to raise \(i\) and \(r\) at a given \( \pi^{e} \). Higher \(r\) attracts capital inflow that increases demand for domestic currency. Under this convention, \(E\) rises and the domestic currency appreciates.
Expansionary fiscal policy (higher \(G\) or lower \(T\)) tends to raise \(r\) in the loanable funds framework. Higher \(r\) draws capital inflow and shifts currency demand right at each \(E\). The domestic currency appreciates and \(E\) rises in the diagram.
Higher domestic real income \(Y\) raises imports at given relative prices. Residents supply more domestic currency to obtain foreign currency, shifting supply right. The domestic currency depreciates and \(E\) falls.
Higher foreign real income raises demand for domestic exports at given relative prices. Foreigners demand more domestic currency at each \(E\), shifting demand right. The domestic currency appreciates and \(E\) rises.
Higher domestic inflation relative to foreign reduces the real purchasing power of the domestic currency. Demand for domestic currency weakens and supply increases as buyers substitute toward relatively cheaper foreign goods. The domestic currency depreciates over time and \(E\) falls under the stated convention.
Expectations about future movements shift today’s currency demand and supply. Expected domestic appreciation raises current demand and reduces current supply of domestic currency. Expected domestic depreciation raises current supply and reduces current demand, moving \(E\) downward.
Import restrictions reduce residents’ immediate need to exchange domestic for foreign currency at initial prices. The supply of domestic currency in FOREX shifts left, placing appreciation pressure on the domestic currency. Under a float, \(E\) rises and the stronger currency partially offsets the initial import reduction.
Under a fixed or pegged regime with free capital flows, the central bank uses reserves to keep \(E\) at the parity. A shock that would depreciate the currency leads to reserve sales and a contraction of domestic reserves to absorb excess supply. A shock that would appreciate the currency leads to reserve purchases and an expansion of domestic reserves to absorb excess demand.

Changes in the Foreign Exchange Market and Net Exports

Let \(E\) be units of foreign currency per one unit of domestic currency, so a higher \(E\) is a domestic appreciation and a lower \(E\) is a domestic depreciation. Holding incomes and foreign prices constant, appreciation makes domestic goods relatively more expensive to foreigners and imports relatively cheaper to residents. Therefore, \(X_n\) decreases with appreciation and increases with depreciation.
The relevant competitiveness measure is the real exchange rate \( \varepsilon \equiv E \cdot \frac{P_{\text{dom}}}{P_{\text{for}}} \). A real appreciation (higher \( \varepsilon \)) reduces export volume and raises import volume at given incomes. A real depreciation (lower \( \varepsilon \)) raises export volume and reduces import volume, increasing \(X_n\).
A rightward shift in demand for domestic currency (e.g., from higher real returns on domestic assets) appreciates the currency. Appreciation lowers \(X_n\) because exports fall and imports rise at the new relative price. A leftward shift in demand does the opposite and raises \(X_n\).
A rightward shift in the supply of domestic currency in FOREX (e.g., from greater desire to buy foreign assets) depreciates the currency. Depreciation increases \(X_n\) by improving price competitiveness of domestic goods. A leftward supply shift appreciates the currency and lowers \(X_n\).
Net capital inflow increases demand for domestic currency and tends to appreciate it. Appreciation reduces \(X_n\) at given domestic and foreign incomes by lowering exports and raising imports. Net capital outflow has the opposite effect and tends to increase \(X_n\).
Monetary expansions that lower the domestic real interest rate induce depreciation under a float. Depreciation increases \(X_n\) and, through \(AD \equiv C+I+G+X_n\), shifts aggregate demand to the right in the short run. Contractionary monetary moves that appreciate the currency reduce \(X_n\) and shift AD left.
Fiscal expansions that raise the real interest rate tend to attract capital inflow and appreciate the currency under a float. Appreciation lowers \(X_n\) and partially offsets the direct AD increase from higher \(G\) or lower \(T\). Fiscal contractions reverse these directions and partially offset the direct AD decrease via higher \(X_n\).
Trade barriers that directly cut imports reduce the supply of domestic currency in FOREX and appreciate the currency under a float. The stronger currency reduces exports and encourages other imports, limiting the net change in \(X_n\). Thus, the induced appreciation offsets the initial import reduction at course scope.
If the domestic price level rises relative to foreign while \(E\) is unchanged, \( \varepsilon \) still appreciates. Real appreciation lowers \(X_n\) even without a nominal exchange-rate move. Conversely, lower domestic inflation than abroad implies real depreciation and a higher \(X_n\) at given incomes.
Under a fixed or pegged regime with free capital flows, the central bank’s reserve operations prevent \(E\) from moving. With \(E\) held at parity, \(X_n\) does not adjust via currency changes and instead reflects income and price-level movements. Therefore, the FX–\(X_n\) link operates through real exchange rate changes driven by relative prices or through regime adjustments, not through nominal \(E\).

Diagram Integration & Problem Types

Model links use common variables across markets: \(MS \rightarrow i\) (money), \(i \rightarrow r\) via \( r \approx i - \pi^{e}\) (rates), \(r \rightarrow E\) (FOREX via capital flows), and \(E \rightarrow X_n \rightarrow AD \rightarrow Y,P\) (AD–AS). Consistency requires keeping the exchange-rate convention fixed: let \(E\) be units of foreign currency per one domestic unit. Under this convention, a higher \(E\) is a domestic appreciation and a lower \(E\) is a domestic depreciation.
Monetary expansion shifts \(MS\) right, lowers \(i\), and lowers \(r\) for a given \( \pi^{e} \). Lower \(r\) induces capital outflow, which raises the supply of domestic currency in FOREX and produces depreciation (lower \(E\)). Depreciation raises \(X_n\), shifting \(AD\) right and increasing \(Y\) in the short run with upward-sloping \(SRAS\).
Fiscal expansion raises \(G\) or lowers \(T\), shifting \(AD\) right directly and raising \(r\) in loanable funds. Higher \(r\) attracts capital inflow, increasing demand for domestic currency and producing appreciation (higher \(E\)). Appreciation lowers \(X_n\), partially offsetting the initial \(AD\) increase through the net export channel.
Under a fixed (pegged) exchange rate with free capital mobility, monetary policy is constrained by parity defense. Attempts to lower \(i\) trigger reserve losses and reversal, while fiscal expansion that raises \(r\) invites inflows and requires reserve purchases that expand \(MB\). The qualitative implication is “fiscal more effective, monetary less effective” at maintaining the peg in this course framework.
FOREX curve logic under \(E\) defined as foreign per domestic: demand for domestic currency slopes downward in \(E\) and supply slopes upward. A rightward shift of demand or a leftward shift of supply appreciates the domestic currency (higher \(E\)), and opposite shifts depreciate it (lower \(E\)). Relate each shift back to its determinant: \(r\) differentials, income changes, inflation differentials, expectations, or preferences.
Balance-of-payments identities must hold in all problems: a current account deficit is matched by a financial account surplus of equal magnitude. Equivalently, \(X_n = S - I\) so \(X_n<0\) implies net capital inflow and \(X_n>0\) implies net capital outflow. These relations anchor multi-market answers when quantities are described qualitatively.
Relative income changes map cleanly: higher domestic \(Y\) raises imports, shifts the supply of domestic currency right in FOREX, and depreciates the currency (lower \(E\)). Higher foreign \(Y\) raises demand for domestic exports, shifts demand for domestic currency right, and appreciates the currency (higher \(E\)). The corresponding \(X_n\) response follows directly from the sign of the currency movement at given prices.
Relative price level or inflation differentials matter for direction: higher domestic inflation than foreign weakens demand for domestic goods and raises supply of domestic currency. Under the stated convention, this produces depreciation over time (lower \(E\)) and tends to raise \(X_n\) only after relative-price adjustments are complete. Lower domestic inflation than foreign produces the opposite tendency and appreciation pressure.
Trade barriers under a floating rate have limited \(AD\) impact at course depth because induced appreciation offsets the initial import reduction. A tariff that cuts imports reduces the supply of domestic currency in FOREX, appreciates the currency, and dampens exports while encouraging other imports. Net exports \(X_n\) show little systematic change once the offsetting price effect is recognized.