- Study Guide (Course-wide Content)
A. Foreign Trade and Economic Activity
- An open economy is one that engages in international exchange of goods, services, and investments. Exports are goods and services sold to buyers outside the country, while imports are those purchased from foreigners. The difference between exports and imports of goods and services is called net exports.
- When foreign trade is introduced, domestic demand can differ from national output. Domestic demand comprises consumption, investment, and government purchases (C + I + G). To obtain GDP, exports (Ex) must be added and imports (Im) subtracted, so GDP = C + I + G + X where X = net exports = Ex − Im. Imports are determined by domestic income and output along with the prices of domestic goods relative to those of foreign goods; exports are the mirror image, determined by foreign income and output along with relative prices. The dollar increase of imports for each dollar increase in GDP is called the marginal propensity to import (MPm).
- Foreign trade has an effect on GDP similar to that of investment or government purchases. As net exports rise, there is an increase in aggregate demand for domestic output. Net exports hence have a multiplier effect on output. But the expenditure multiplier in an open economy will be smaller than that in a closed economy because of leakages from spending into imports. The multiplier is
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Clearly, other things equal, the open-economy multiplier is smaller than the closed-economy multiplier, where MPm = 0. - The operation of monetary policy has new implications in an open economy. An important example involves the operation of monetary policy in a small open economy that has a high degree of capital mobility. Such a country must align its interest rates with those in the countries to whom it pegs its exchange rate. This means that countries operating on a fixed exchange rate essentially lose monetary policy as an independent instrument of macroeconomic policy. Fiscal policy, by contrast, becomes a powerful instrument because fiscal stimulus is not offset by changes in interest rates.
- An open economy operating with flexible exchange rates can use monetary policy for macroeconomic stabilization which operates independently of other countries. In this case, the international link adds another powerful channel to the domestic monetary transmission mechanism. A monetary tightening leads to higher interest rates, attracting foreign financial capital and leading to a rise (or appreciation) of the exchange rate. The exchange-rate appreciation tends to depress net exports, so this impact reinforces the contractionary impact of higher interest rates on domestic investment.
- In the longer run, operating in the global marketplace provides new constraints and opportunities for countries to improve their economic growth. Perhaps the most important element concerns saving and investment, which are highly mobile and respond to incentives and the investment climate in different countries.
- The foreign sector provides another source of funds for investment and another outlet for saving. Higher domestic saving—whether through private saving or government fiscal surpluses—will increase the sum of domestic investment and net exports. Recall the identity
X = S + (T − G) − I or Net exports = private saving + government saving − domestic investment
In the long run, a country's trade position primarily reflects its national saving and investment rates. Reducing a trade deficit requires changing domestic saving and investment. One important mechanism for bringing trade flows in line with domestic saving and investment is the exchange rate. - Besides promoting high saving and investment, countries increase their growth through a wide array of policies and institutions. Important considerations are a stable macroeconomic climate, strong property rights for both tangible investments and intellectual property, a convertible currency with few restrictions on financial flows, and political and economic stability.
- Popular analysis looks at large trade deficits and sees "deindustrialization." But this analysis overlooks the important distinction between productivity and competitiveness. Competitiveness refers to how well a nation's goods can compete in the global marketplace and is determined primarily by relative prices. Productivity denotes the level of output per unit of input. Real incomes and living standards depend primarily upon productivity, whereas the trade and current-account positions depend upon competitiveness. There is no close linkage between competitiveness and productivity.
- Fixed exchange rates are a source of instability in a world of highly mobile financial capital. Recall the fundamental trilemma of fixed exchange rates: A country cannot simultaneously have a fixed but adjustable exchange rate, free capital and financial movements, and an independent domestic monetary policy.
- In 1999, European countries chose to move to a common currency and a unitary central bank. A common currency is appropriate when a region forms an optimal currency area. Advocates of European monetary union point to the improved predictability, lower transactions costs, and potential for better capital allocation. Skeptics worry that a common currency—like any irrevocably fixed exchange-rate system—will require flexible wages and prices to promote adjustment to macroeconomic shocks.