Open Macroeconomy

Global Economy and Policy

Goodwin et.al. 2018, European edition Ch.14, 15 & 17

Goodwin et.al. 2019, 3rd edition Ch.14 & 15
Goodwin et.al. 2023, 4th edition Ch.13 & 14
 Outline
I. Open Economies – An introduction
II. Exchange Rates
– Nominal e.r. vs. Real e.r.
– PPP exchange rates
– Exchange Rate Regimes
III. Balance of Payments
IV. Implications of Macroeconomics in an Open Economy
– Savings-Investment relation in an open economy
– Spending multiplier and fiscal policy in an open economy
– GDP-GNP differences
 What is an Open Economy?
• Closed economy: an economy with no international linkages
• Open economy: an economy with international linkages
through
1. international trade
– flows of goods and services across borders
– exports & imports
2. international finance
– flows of capital across borders
• buying/selling of real and financial assets
– flows of income across borders
• remittances, profit income, dividend/interest/rent income
3. international labor migration
– movements of workers across borders

Also transfers of technology, know-how, cultural products and other

intangibles, etc.
Figure 13.1 Trade Expressed as a Percentage of
Production, World and United States, 1970–2020

Source: World Development Indicators, World Bank, 2021.

Trade (X and IM) as % GDP, OECD countries, 2022

OECD, May 2023

Foreign Direct Investment FDI Stock as % GDP, OECD countries,
2022

OECD, May 2023

Foreign Direct Investment FDI Flows as % GDP,
Turkey and select OECD countries, 2006-2022

OECD, May 2023

Figure 13.3 Leakages and Injections in an Open Macroeconomic Model
 Implications of an Open Economy:
New Macroeconomic Variables and Balances
• Exchange Rates

• Balance of Payments (BoP)

– The balance between foreign currency spent by a macroeconomy versus
earned/received
– Current account balance (Trade balance)
– Capital account balance

• Export and Import functions (in addition to consumption and investmet

functions); changing magnitude of the spending multiplier
• Savings-Investment relation in an open economy
• Domestic vs. foreign interest rates
• Domestic vs. foreign (national) incomes
• Domestic vs. foreign prices
 Exchange Rates
Nominal exchange rate E
– 1 unit of domestic currency exchanges for how many foreign currency units?
– If domestic economy is U.S., then E: 1 USD = 0.91 Euros
– E: Euros per USD

Modelling determination of E
– Supply and Demand Model of the market for domestic vs. foreign currency

Horizontal axis: Quantity of domestic currency

• Supply of domestic currency in exchange for foreign currency (i.e. domestic demand for
foreign currency)
• Demand for domestic currency in exchange for foreign currency (i.e. foreign demand for
domestic currency)

Vertical axis: E, unit Price of domestic currency measured in foreign currency

e.g. if domestic economy is Turkey 1 TRY = 0.05 USD
if domestic economy is U.S. 1 USD = 0.91 Euros
if domestic economy is EU 1 Euro = 1.10 USD
 Figure 13.4 A Foreign Exchange Market for Dollars
IF: Due to an unstable Supply of domestic currency by
domestic domestic residents:
macroeconomy and Import demand;
very high inflation; Investment demand to purchase real or
domestic residents financial assets in other countries;
start withdrawing Transfers of domestic incomes abroad.
from domestic assets As E↑ ⟹ S↑
and investing in
foreign assets;
how to analyze? Demand for domestic currency by
foreigners:
Eeq Export demand;
Investment demand to purchase real or
financial assets in domestic economy;
Transfers of foreign incomes home.
As E↑ ⟹ D↓
 Figure 13.5 A Supply Shift in a Foreign Exchange Market
Supply Curve shifts out; at the same scale of E, more
domestic currency is supplied to the market to be
exchanged into foreign currency

As E goes down; D for

E1 domestic currency
increases; S of doesmtic
At E1 and S2: currency decreases;
excess supply of E2 Until a new E is
domestic established at lower E2
currency
E goes down;
domestic
currency
depreciates

D1=S1 D2=S2 S’
 Exchange Rate Regimes
Flexible e.r. regime
• E is determined in foreign currency markets through forces of supply and
demand of domestic currency vs. foreign currency.
– Pure flexible e.r. regimes: USA, UK, Canada, Japan
Fixed e.r. regime
• E is fixed at a certain rate; the Central Bank announces this rate and makes a
commitment to it.

Crawling peg
• Some countries peg their currency to the dollar or operate under a crawling
peg by moving to an exchange rate target slowly.
• Under the European Monetary System (EMS - 1978 to 1998), member
countries agreed to maintain their e.r. relative to the other currencies in the
system within narrow bands around a central parity.
• In 1999, a number of those European countries adopted a common
currency, the euro.
• Currently 19 out of the 28 EU members are in the Eurozone.
Figure 13.7 Foreign Exchange Intervention by the Central Bank

E2
Central Bank uses
foreign reserves to
purchase domestic
currency;

or provides
subsidies/incentives
to convince holders of
domestic currency to
keep their position
(kur korumalı
mevduat).
 Changes in Exchange Rates

• Currency depreciation: when a currency becomes less valuable, for example due to
a decrease in demand for a country’s exports, or an increase in its demand for
imports.
• Currency appreciation: when a currency becomes more valuable; for example, when
increased demand for a country’s exports causes an increase in demand for its
currency.

• Some of the factors that influence a currency’s price: relative prices, GDP growth,
interest rates, relative investment attractiveness, and speculation.

Note: currency depreciation/appreciation vs. currency devaluation/revaluation

currency devaluation/revaluation:
Under a fixed exchange rate regime, when the Central Bank decreases/increases the
fixed e.r. so as to devalue/revalue the domestic currency.
 Nominal vs. Real Exchange Rates
In the choice between domestic vs. foreign goods:
• E gives only part of the information we need.
• We also need to relative prices of goods (P in the domestic country vs.
P* in the foreign country) to determine the real purchasing power of
our domestic currency.

Real exchange rate e

– Exchange rate adjusted for inflation
– 1 unit of domestic good exchanges for how many foreign
goods?
– e = E (P/P*)
– P: domestic price level; P*: foreign price level
– Price level – GDP deflator or CPI
 Real Exchange Rates – An example

e.g. the real exchange rate between the U.S. and the U.K.

Assume the only goods that the U.S. and the U.K. produce are a Cadillac and a
Jaguar respectively.
Given the following info:
– price of a Cadillac in the US = $40,000,
– E: 1 USD = 0.50 UK pounds,
then the price of a Cadillac in pounds is
$40,000 X 0.50 = £20,000

– If the price of a Jaguar in the UK = £30,000,

– then the price of a Cadillac in terms of Jaguars is
£20,000/ £30,000 = 0.66
– 1 U.S. good (a Cadillac) can purchase 0.66 U.K. goods (Jaguars)
– e = 0.66 foreign (UK) goods per domestic (US) good

To generalize this example to all of the goods & services in the economy,
we use a price index for the economy, such as the GDP deflator.

e = E (P/P*)
 Real Exchange Rates

• The real exchange rate, the price of U.S. goods in terms of British goods, is

The Construction of the Real Exchange Rate

Nominal Exchange Rate, USD-TRY 2002-2023

1 TRY = 0.05 USD

500% nominal depreciation

1 TRY = 0.25 USD

Trading Economies, May 2023

 REAL Exchange Rate, TRY 2002-2023

TRY Reel Kur

160,00

140,00

120,00 4% real depreciation

100,00

80,00
68,52
67,93
63,56 65,98
60,00 60,36 58,60
40,00 53,04 49,97 47,63

20,00

0,00
01.00
07.00
01.01
07.01
01.02
07.02
01.03
07.03
01.04
07.04
01.05
07.05
01.06
07.06
01.07
07.07
01.08
07.08
01.09
07.09
01.10
07.10
01.11
07.11
01.12
07.12
01.13
07.13
01.14
07.14
01.15
07.15
01.16
07.16
01.17
07.17
01.18
07.18
01.19
07.19
01.20
07.20
01.21
07.21
01.22
07.22
01.23
TÜFE Bazlı Reel Efektif Döviz Kuru (2003=100)
TÜFE-Gelişmekte Olan Ülkeler Bazlı Reel Efektif Döviz Kuru (2003=100)
TÜFE-Gelişmiş Ülkeler Bazlı Reel Efektif Döviz Kuru (2003=100)

TCMB, May 2023

 Nominal vs. Real Exchange Rates

the real exchange rate between TRY and developed economy currencies:
68.52 (2018) to 65.98 (2023)
the nominal exchange rate between TRY and USD:
1 TRY = 0.25 USD (2018) to 0.05 USD (2023)

E depreciated five-fold, while e depreciated by about 4%.

• What does this imply about relative prices (inflation) between Turkey
and developed economies?
• What does this imply about the possibility of the so-called “new”
economic model, i.e. export-led growth for Turkey?

e = E (P/P*)
 Purchasing Power Parity and Exchange Rates
• Purchasing power parity (PPP)
Under certain idealized conditions (currencies traded freely against each other, goods freely
traded and totally identical across countries, and transportation costs not significant),
• the exchange rate between the currencies of two countries should be such that the
purchasing power of currencies is equalized.
• i.e. 1 USD should be able purchase the same consumer basket anywhere.
• e.g. If a winter jacket costs USD 200 in NY, E: 1 USD = 0.80 Euros; it should not cost more
(or less) than 200 x 0.80 = 160 Euros in Europe.

WHY? Arbitrage and Law of One Price

• If international price differences in tradable goods,
• one would purchase winter jackets where it is cheaper (let’s say US)
• and sell them where it is more expensive (let’s say EU);
• taking advantage of arbitrage opportunities.
• Demand for jackets in US where they are cheaper would ↑ ⟹ Price of jackets in US
would ↑
• Supply of jackets in EU where they are more expensive would ↑ ⟹ Price of jackets in EU
↓
• These transactions would continue until the price of jackets are equalized across borders.
 Purchasing Power Parity and Exchange Rates
Limitations of the theory of PPP:
In the real world, national economies are not nearly as integrated as this theory assumes.
• Not all consumer items are tradable; non-tradable prices dominate (housing-rents, many
services);
• Transportation costs do matter;
• there are many varieties of goods;
• markets for goods and services do not work as quickly, smoothly, and rationally as sometimes
assumed;
• and exchange rates are often “managed.”

Rather than simply using going (nominal) exchange rates to convert all the various income levels into
a common currency,

PPP adjustments try to take into account the fact that the cost of living varies among countries.
• The Big Mac Index: An index invented by The Economist magazine in 1986 as a lighthearted guide
to whether currencies are at their “correct” level. It is based on the theory of purchasing-power
parity (PPP), the notion that in the long run exchange rates should move towards the rate that
would equalise the prices of an identical basket of goods and services (in this case, a burger) in
any two countries.
PPP and Exchange Rates: Big Mac Index and TRY
 Balance of Payments (BoP)
BOP account: the national account that tracks inflows and outflows arising from
international trade, earnings, transfers, and transactions in assets.

Consists of 2 main components:

1. Current account: the national account that tracks inflows and outflows arising from
international trade, earnings, and transfers.
• • Trade account: the portion of the current account that tracks inflows and outflows
arising exclusively from international trade in goods and services.

2. Financial Account (or Capital account): the account that tracks flows arising from
international transactions in assets. Transactions such as foreign borrowing and lending,
foreign portfolio investment, and foreign direct investment are included in capital
account.

• Portfolio investment: investment in stocks or bonds of a foreign country or company.

• Foreign direct investment (FDI): investment in a business in a foreign country.
• Official reserve account: the account reflecting the foreign exchange market
operations of a nation’s central bank.

BoP = Current account balance + Capital Account balance

+ Net change in official reserve account + statistical discrepancy
=0
Table 13.1:U.S. Balance of Payments Account–Current Account U.S. 2020 (billions USD)

Source: U.S. Bureau of Economic Analysis, U.S. International Transactions Accounts Data, Table 1,
with rearrangements and simplifications by authors.
Table 13.1:U.S. Balance of Payments Account–Capital Account U.S. 2020 (billions USD)

Source: U.S. Bureau of Economic Analysis, U.S. International Transactions Accounts Data, Table 1,
with rearrangements and simplifications by authors.
Figure 13.6 U.S. Imports and Exports of Goods and
Services, 1960–2020

Source: BEA NIPA Tables 4.1 and 1.1.5, 2021

 Balance of Payments Account – Türkiye (millions USD)
2019 2020 2021

A CURRENT ACCOUNT 5.303 -35.537 -13.959

1. Exports 182.200 168.387 224.711
2. Imports 198.981 206.250 253.943
Balance on Goods -16.781 -37.863 -29.232
3. Services: Credit 62.741 35.429 58.006
4. Services: Debit 28.657 23.891 31.609
Balance on Goods and Services 17.303 -26.325 -2.835
5. Primary Income: Credit 6.331 6.221 6.726
6. Primary Income: Debit 19.156 15.613 18.758
Balance on Goods, Services and Primary Income 4.478 -35.717 -14.867
7. Secondary Income 825 180 908

B. CAPITAL ACCOUNT 34 -36 -64

C. FINANCIAL ACCOUNT -1.269 7.618 28.375

Net acquisition of financial assets 18.076 4.249 21.646
Net incurrence of liabilities 19.345 11.867 50.021
Current, Capital and Financial Accounts 6.606 -27.955 14.352
D. Statistical discrepancy -282 -3.907 8.978

E. RESERVE ASSETS 6.324 -31.862 23.330

Source: Central bank of the Republic of Turkey

 Curent Account, Financial Account of Turkey (Million USD)
$20.000

$10.000

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I-CURRENT ACCOUNT-Level III-FINANCIAL ACCOUNT-Level Stati stical discrepancy

 Implications of an Open Economy:
Balance between Savings, Investment and Net Borrowing
• Investment-Savings Equality in a Closed Economy
An Alternative Way of Thinking about the Goods Market Equilibrium: Behind the IS Curve

Private Savings S = YD – C
YD = Y – T ; hence S =Y–T–C
YD: Disposable Income
Equilibrium condition in the Goods market (when closed):
Production = Demand
Y=C+I+G
Subtract T from both sides and move C to the left
Y–T–C=I+G–T
S=I+G–T
Rearranging S + (T – G) = I
Sum of Private and Public Savings in other words
Total Savings = Total Investment
in a closed economy.
 Investment-Savings Equality in an Open Economy

• Equilibrium condition in the Goods market (when open):

Production = Demand
Y = C + I + G + NX
• Subtract T from both sides and move C to the left
Y – T – C = I + G – T + NX
S = I + G – T + NX
• Rearranging S + (T – G) = I + NX

• Equivalently S + (T – G) = Stotal = I + NX
• Total Savings = Total Investment + Net Exports
• Remember from Balance of Payments BoP:
– NX trade balance ⇢ ⇢ Current Account Balance CAB

Stotal = I + CAB
CAB = Stotal – I
I = Stotal – CAB
 Investment-Savings Equality in an Open Economy

CAB = Stotal – I
CAB = S + (T-G) – I
• If total domestic savings (S+T-G) is less (more) than domestic investment I, then there is a CA deficit
(surplus),
– CA deficit = Financial Account FA surplus ⇢ ⇢ Some of the domestic I over and above domestic
S is being met by foreign capital (FA surplus)
– CA surplus = FA deficit ⇢ ⇢ Excess domestic S over and above domestic I is being directed to
foreign investments

• An increase in investment must be reflected either an increase in private saving (S) or public saving
(T-G), or in a deterioration of the current account balance (CA).

• A deterioration in the government budget balance (T-G) must be reflected in an increase in either
private saving (S), or in a decrease in investment, or else in a deterioration of the current account
balance (CA).

• A country with a high saving rate must have either a high investment rate or a large current account
surplus (e.g. Germany).
 Implications of an Open Economy:
AD and spending multiplier
Aggregate Demand AD in an open economy:
• AD = C + I + G + NX; NX = X – IM
hükümet!n b!r harcaman!n !ncome'a etk!s!
-> yaptığı
Effects on the Spending Multiplier
• The multiplier effect for an increase in exports X is essentially the same as that for an
increase in autonomous consumption (C0) or investment (I0) or G.
• i.e. change in Y triggered through a change in X = s.m. times the change in X
• BUT the s.m. in an open economy is smaller than in a closed economy due to imports
because
• When people receive extra income, some portion of it “leaks” away into imports.
This portion does not stimulate the domestic economy, so multiplier effects are
smaller and the economic response a bit less dynamic.
• Closed economy s.m. = 1 / (1-c1)
– where c1 = marginal propensity to spend (on domestic goods)
• Open economy s.m. = 1 / (1-c1+m1)
– where m1 = marginal propensity to import (i.e. to spend on imported goods)
• m1: marginal propensity to import (between 0 and 1)
 Implications of an Open Economy:
AD, Imports and Fiscal Policy

Differences with a closed economy: her an en

1. Smaller effect of expansionary fiscal policy (G or T) on stimulating output Y, because

some of the AD triggered by higher G and/or lower T will be absorbed by import demand
rather than demand for domestically produced goos; the spending multiplier (s.m.) is
smaller in the open economy

2. An increase in output Y is not only good news any more because

– Effect on trade balance: An increase in Y might now lead to a trade deficit

Hence expansionary fiscal policy (increase in G and/or decrease in T) triggers a

relatively lower recovery in the domestic economy (relatively lower increase in Y)
– and possibly a worsening trade balance NX = X - IM;
– and a worsening public budget balance G - T;
– i.e. the twin deficits problem
 Implications of an Open Economy: Fiscal Policy and
Cross-Country Coordination across Open Economies
• Imports go to stimulate someone else’s economy,
• and leads also to a deterioration of the trade balance (NX); BUT
• Benefits of imports
– domestic consumers and industry benefit from cheaper imported goods and
services, and industrial inputs.
– some money spent on imports may flow back into the domestic economy as
demand for domestic exports or foreign investment;
– Our trade partners’ import expenditures translate into our export earnings;
– An increase in foreign demand (X or NX) leads to an increase in domestic output
(Y) and an improvement in the trade balance (NX).

• Implications:
– Shocks to demand in one country affect all other countries.
– These open economy interactions complicate the task of policy makers because
they now have to watch both
• the internal macro balances (domestic goods market equilibrium and public budget
balance)
• AND also the external balances, the trade balance.
 Implications of an Open Economy: Fiscal Policy and
Cross-Country Coordination across Open Economies
Problem: When there is a negative shock to the global economy with repercussions on the
domestic economy,

• Should the Government act swiftly and use expansionary fiscal policy (increase spending G
and/or reduce T) to achieve a recovery?
• Y would increase but so would the trade deficit and the public budget deficit;
• With positive spillover effects on its trade partners (they would experience a recovery
through increasing their exports).

• Or should it wait for the other countries to intervene in their economies first?
• As trade partners increase their public spending, they would be facing the problems
of twin deficits;
• But the domestic economy would benefit from a recovery through growing exports;
• And not suffer the negative consequences of trade deficits

All countries may choose to wait for others to intervene with expansionary policies;
• This may lead to a downward spiral of worsening global recession.
• Policy coordination is not so easy to achieve.
• Hence macroeconomic international coordination bodies such as the G-20.
 Implications of an Open Economy: Fiscal Policy and
Cross-Country Coordination across Open Economies

Additional optional reading on fiscal policy coordination under Covid-19:

• https://www.g20-insights.org/policy_briefs/coordinated-and-comprehensive-fiscal-and-
monetary-stimulus-for-tackling-the-covid-19-crisis/
• https://www.eastasiaforum.org/2020/04/08/covid-19-calls-for-international-economic-
policy-coordination/
 Implications of an Open Economy:
GDP vs. GNP

• GDP measures value added domestically.

• Gross national product (GNP) measures the value added by domestic factors of
production

GNP = GDP + NI

where NI denotes net income—payments received from the rest of the world less
/

income paid to the rest of the world

-

NI = income payments received from RoW – income payments made to RoW

In a closed economy GDP = GNP

In an open economy, GDP can be greater or smaller than GNP depending on the
macroeconomy’s balance of payments structure.