Open-Economy Macroeconomics

Balance of payment

Main Textbook Reference: Mankiw and Taylor CH25

 Outline
v Accounting identities; Balance of payments
v How saving, domestic investment, and net capital outflow are related.
v Trade deficit: is it problematic?

Y BAI
 Open Economies
The International Flows Of Goods And Capital
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.
◦ It buys and sells goods and services in world product markets.

◦ It buys and sells capital assets in world financial markets.

Balance of Payment
Balance of payment (BoP)
A record of all economic transactions between residents of the country and the rest of the
world, in a particular period of time.

-Current account
-Capital and financial account
Current Account
records the flow of goods and services in and out of a country
(1) Trade balance: net trade in goods and services
+
(2) net income (such as interest and dividends)
+
(3) transfers (such as foreign aid),

(2) And (3) are usually a small fraction of the total.

The Flow of Goods: Exports, Imports, Net Exports
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.
The Flow of Goods: Exports, Imports, Net Exports
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.

Trade deficit is the major part of current account deficit (which includes
other components – income and current transfers)
The Flow of Goods: Exports, Imports, Net Exports
Factors That Affect Net Exports

◦ Consumer tastes for domestic and foreign goods.

◦ The prices of goods at home and abroad.
◦ The incomes of consumers at home and abroad.
◦ The exchange rates at which people can use domestic currency to
buy foreign currencies.
◦ The costs of transporting goods from country to country.
◦ The policies of the government toward international trade.
Source: IMF

Y BAI
The total trade deficit, excluding precious metals, increased in November 2020
Changes in the UK trade balances, excluding non-monetary gold and other precious
metals, exports and imports

Y BAI
Y BAI
 Is trade deficit always a problem?

Questions A: depends on the causes, are they cyclical or structural?

…

Y BAI
Is trade deficit a problem?
Answer Hints:
Is it persistent trade deficit?
Cyclical: An increase in trade deficit may be because it is importing the materials it needs to
produce goods and services it will export in the future; Business Cycle: In a strong
expansion, imports provide price competition, which can keep inflation in check;
In a recession, exports create jobs
Structural: difference in price and non price competitiveness -
persistent productivity gap;
Currency devalue..
How to finance the deficit? Government debt or FDI?
Capital and financial account
The Capital account records the transfer of funds for the purchase
and sale of non-financial assets such as land, the forgiveness of
debt
The Financial account records the flows of funds between the
domestic economy and foreigners for investment.

..a record of the inflows and outflows of capital that directly affect
a nation’s foreign assets and liabilities…covers all transactions
associated with changes of ownership in the foreign assets and
liabilities of an economy.
The Flow of Financial Resources: Net Capital Outflow
Net capital outflow (NCO)
the purchase of foreign assets by domestic residents minus the
purchase of domestic assets by foreigners.

◦ When a UK resident buys shares in BMW, the German car company, the
purchase ___UK net capital outflow.

◦ When a Japanese resident buys a bond issued by the UK government, the

purchase ___ the UK net capital outflow.
The Flow of Financial Resources: Net Capital Outflow
Variables that Influence Net Capital Outflow

◦ The real interest rates differences being paid on foreign assets and
domestic assets.
◦ The perceived economic and political risks of holding assets
abroad.
◦ The government policies that affect foreign ownership of domestic
assets.
The Equality of Net Exports and Net Capital Outflow
Net exports (NX) and net capital outflow (NCO) are closely linked.
Trade Identity Equation
For an economy as a whole, NX and NCO must balance each other so that:

NX = NCO
This holds true because every transaction that affects one side must also affect the other
side by the same amount.

*Current account should balance with the capital and financial account
BoP must add up to zero
Balance of Payment must add up to zero
BoP=
current account
(NX + net foreign investment earnings + transfers)
+capital /+ finanical account
(net capital inflows: FDI and portfolio investment …)
= 0*

*floating exchange rate

If under fixed or ‘managed’ exchange rate: changes in central bank
foreign reserves (often included in capital /financial account)
An Example
Surplus in Current Account à Must buy foreign assets to balance current
account – Capital outflows à buys real assets such as foreign homes companies
or farmland OR financial Assets such as foreign stocks or Bonds

Y BAI
Saving, Investment, and Their Relationship to the
International Flows
Net exports is a component of GDP:
Y = C + I + G + NX
National saving is the income of the nation that is left after paying for current
consumption and government purchases:
Y - C - G = I + NX

National saving (S) = Y - C - G :

S = I + NX
Saving, Investment, and Their Relationship to the
International Flows

Saving =
Domestic +
Net Capital
Investment Outflow

S = I + NCO
National savings = Domestic Investment + Foreign
Investment
And
S – I = NX
Table 1 International Flows of Goods and Capital: Summary
Issues with Trade Deficit
 Trade Deficit = I - S :
An excess of investment over savings
Trade Deficit is the gap between total investment (from both domestic
and foreign investors) and the national (both public and private)
savings
A current account deficit may reflect: a ____ level of national savings
relative to investment or a ______ rate of investment—or both.
Q : can the trade deficit be good?
…spurs faster economic growth for capital- poor developing countries;
…a buffer due to a temporary shock

Import is not bad: A main reason to export is to be able to import,

wider variety of goods..
 Is Trade Deficit Problematic? Depends

Deficits reflect underlying economic trends, which may be desirable or undesirable for
a country at a particular point in time.
1. Is it persistent?
No à Cyclical: expansion phase – can be beneficial; low TD may be a sign of
recession; import factors for production
Yes àIs it due to :
Exchange rate ?
Structural problem, low competitiveness / productivity gap ?
Saving Glut, high investment relative to low national saving…or lack of capital
[driven by excess imports or excess investment?]
 Is trade deficit problematic? Depends
1. Is it persistent?

ØAn excess of imports over exports:

- Competitiveness problems

ØAn excess of investment over savings:

- high I: growing economy.
- low S: reckless fiscal policy or a consumption binge.

2. Default risk? Sudden painful payback?

3. Substantial reduction in living standards during the repayment periods?
Problems of large and persistent Trade Deficit
ØSolvency problem
ØRisk of an abrupt and painful reversal of financing.
Causes?
: overvalued real exchange rate + inadequate foreign exchange
reserves, excessively fast domestic credit growth, unfavourable
terms of trade shocks, balance sheet vulnerabilities, low growth,
higher interest rates, volatile short-term investment flows, weak
financial sectors etc.
Risk of having persistent trade imbalances
ØThreat to globalization
Ø Less spending, less investment à less jobs à less growth, especially during the
repayment period. Depreciation : depends on the demand for the currency ;
can correct the deficit in the long run
ØSmall countries: Inflation + Large proportion of the country’s assets and
resources owned by foreigners

*but the data suggests that unemployment levels can actually persist at very low levels even with a trade deficit
and high unemployment may occur in countries with surpluses.
 Is the US trade deficit a problem?
This short video explains that at times of high growth, a trade deficit can help the
economy, but when economic slowdown occur, trade deficits can aggravate
the problem

A fun question to think about: Was the US China Trade War necessary?
Y BAI
What caused the US-China Trade Deficit?
Cost

The investment dimension of the relationship.

The biggest categories of U.S. imports from China were computers, cell
phones, apparel, and toys and sporting goods. A lot of these imports are
from U.S. manufacturers that send raw materials to China for low-cost
assembly. Once shipped back to the United States, they are considered
imports.
Exchange rate
 RMB/US$

weaker RMB ↑

Source Macrotrends
 How to reduce trade deficit
…increasing the value of its exports relative to the value of imports:

Ø Restrictions on imports: tariffs or quotas à Trade war

Ø Promote export: import substitution, industrialization, or policies that improve
domestic companies' global competitiveness.
Q: Are these demand or supply side policies?
Ø Devaluation, which reduces the country’s export costs.

UK current account balance

How to reduce trade deficit and global trade imbalances?

Tariff and quotas? à trade war

Devalue the currency? à currency war
Surplus countries: import more i.e. expansionary policies;
e.g. Expanding imports to meet consumption demand and opening the service
to boost China’s consumption and reduce China’s trade surplus with the US. [VS
1980 Japan’s ‘self-restraint of exports’]
Deficit countries : address a range of supply-side weaknesses in improve
domestic companies’ global competitiveness
…
Global trade imbalances
 Revision: accounting identities
Balance of payments
current account (CA) + capital and financial account = 0 (should balance)
* CA of a country is the money it receives and pays for goods and services.. + income
and current transfer i.e. all transactions (other than those in financial items) that involve
economic values and occur between resident and non-resident entities
* capital and financial account: a record of the inflows and outflows of capital that
directly affect a nation’s foreign assets and liabilities. (positive à net borrower to the
rest of the world)
 Revision: accounting identities
NX = X- M < 0 : trade deficit
NX = NCO : NX=NCO accumulative claims on foreigners
negative NX, trade deficit, net borrower
*Positive NX, positive NCO: the purchase foreign assets by domestic residents is larger
the purchase than the domestic asset by foreigners, net lender
NX=S-I
S= I +NCO
Summary
① Net exports are the value of domestic goods and services sold
abroad minus the value of foreign goods and services sold
domestically.
② Net capital outflow is the acquisition of foreign assets by
domestic residents minus the acquisition of domestic assets by
foreigners.
③ An economy’s net capital outflow always equals its net exports.
④ An economy’s saving can be used to either finance investment at
home or to buy assets abroad.
Summary
⑤ The nominal exchange rate is the relative price of the currency of
two countries.
⑥ The real exchange rate is the relative price of the goods and
services of two countries.
⑦ When the nominal exchange rate changes so that each euro
buys more foreign currency, the euro is said to appreciate or
strengthen.
⑧ When the nominal exchange rate changes so that each euro
buys less foreign currency, the euro is said to depreciate or
weaken.
Summary
⑨ According to the theory of purchasing power parity, a unit of
currency should buy the same quantity of goods in all
countries.
⑩ The nominal exchange rate between the currencies of two
countries should reflect the countries’ price levels in those
countries.