Module 6

Open Economy Macroeconomics

How do international trade and financial flows affect domestic macroeconomic outcomes? We extend the closed-economy framework to incorporate exchange rates, trade balances, and international capital mobility.

Openness in Goods & Financial Markets

Three dimensions of openness:

Goods markets: Tariffs, quotas, trade agreements. Consumers choose between domestic and foreign goods.
Financial markets: Capital controls, foreign asset ownership. Investors choose between domestic and foreign bonds.
Factor markets: Firms choose production locations; workers choose where to work.

Exchange Rates

Nominal Exchange Rate

The nominal exchange rate $E$ is the price of domestic currency in terms of foreign currency (e.g., USD per GBP). Alternatively quoted as foreign currency per domestic unit.

Real Exchange Rate

Real Exchange Rate: $\quad \varepsilon \equiv \frac{E P}{P^*}$ — the relative price of domestic goods in terms of foreign goods.

Real appreciation ($\varepsilon \uparrow$): domestic goods become relatively more expensive.
Real depreciation ($\varepsilon \downarrow$): domestic goods become relatively cheaper.

In countries with low and stable inflation, nominal and real exchange rates move closely together.

Multilateral Exchange Rates

Bilateral exchange rates are aggregated into a trade-weighted multilateral (effective) exchange rate using trade shares as weights.

Goods Market in Open Economy

Demand for Domestic Goods

Total demand for domestic goods:

$Z \equiv C + I + G + X - \frac{IM}{\varepsilon}$

Key distinction: domestic demand for goods $\neq$ demand for domestic goods. Expenditure $C, I, G$ is on a mix of domestic and foreign goods.

Import and Export Functions

Imports: $IM = IM(Y, \varepsilon)$ — increasing in domestic output and in the real exchange rate (foreign goods cheaper).
Exports: $X = X(Y^*, \varepsilon)$ — increasing in foreign output, decreasing in the real exchange rate (domestic goods pricier abroad).

Marshall-Lerner Condition

Net Exports and the Real Exchange Rate

$NX(\varepsilon) \equiv X(Y^*, \varepsilon) - \frac{IM(Y, \varepsilon)}{\varepsilon}$

The real exchange rate enters in three places:

Exports $X$ decreasing in $\varepsilon$ (substitution effect).
Imports $IM$ increasing in $\varepsilon$ (substitution effect).
Denominator $1/\varepsilon$ (valuation effect).

Marshall-Lerner Condition: A real depreciation ($\varepsilon \downarrow$) improves net exports if the sum of export and import demand elasticities exceeds 1. The valuation effect is smaller than the substitution effects.

Interest Parity Condition

Uncovered Interest Parity (UIP)

If domestic and foreign bonds are perfect substitutes (perfect capital mobility), expected returns must equalize:

UIP: $\quad 1 + i_t = (1 + i_t^*) \frac{E_t}{E_{t+1}^e}$

Rearranging for the exchange rate:

$\displaystyle E_t = \frac{1+i_t}{1+i_t^*} \bar{E}^e$

Higher domestic $i_t$ $\Rightarrow$ $E_t \uparrow$ (domestic currency appreciates).
Higher foreign $i_t^*$ $\Rightarrow$ $E_t \downarrow$ (domestic currency depreciates).

Approximation

For small interest rates and expected depreciation:

$i_t \approx i_t^* + \frac{\bar{E}^e - E_t}{E_t}$ — the domestic rate equals the foreign rate plus expected depreciation.

Mundell-Fleming Model

The open-economy IS-LM model with floating exchange rates, incorporating the interest parity condition.

Open-Economy IS Curve

$Y = C(Y, T) + I(Y, i) + G + NX\!\left(Y, Y^*, \frac{1+i}{1+i^*}\bar{E}^e\right)$

Changes in $i$ affect the economy through two channels:

Direct: Through investment $I$.
Indirect: Through exchange rate effects on net exports $NX$.

The IS curve slopes down — higher $i$ reduces output via both channels.

LM Curve

As in the closed economy, the central bank sets: $i = \bar{i}$. The LM curve is horizontal at the policy rate.

Monetary & Fiscal Policy in Open Economy

Monetary Contraction

An increase in $i$ reduces output (shift along IS) and appreciates the currency (along the interest parity curve). Both channels reduce demand.

Fiscal Expansion

An increase in $G$ shifts IS right, raising output. If the central bank keeps $i$ unchanged, the exchange rate remains unchanged. If the CB raises $i$, the currency appreciates — dampening the output expansion.

Fixed Exchange Rates

Under a credible exchange rate peg ($E_t = \bar{E}^e = \bar{E}$):

Interest parity forces $i_t = i_t^*$ — the domestic interest rate equals the foreign rate. The central bank loses monetary policy independence for domestic stabilization.

The Mundell-Fleming Trilemma

The Trilemma (Impossible Trinity): A country cannot simultaneously maintain:

Perfect international capital mobility
Independent domestic monetary policy
A fixed exchange rate

At most two of the three can hold.

Implications

US/Eurozone: Capital mobility + independent monetary policy $\Rightarrow$ floating exchange rates.
Hong Kong: Fixed exchange rate + capital mobility $\Rightarrow$ no independent monetary policy.
China (historically): Fixed exchange rate + independent policy $\Rightarrow$ capital controls.

Savings, Investment & Twin Deficits

Fundamental Identity

From $Y = C + I + G + NX$ and $S \equiv Y - T - C$:

$NX = (S - I) + (T - G)$

A trade surplus corresponds to excess of total saving over investment.

Twin Deficits Hypothesis

If private saving $S - I$ remains constant, an increase in the government budget deficit ($T - G$ more negative) implies a deterioration of the trade balance — the "twin deficits." Empirically, the relationship is not always robust, as private saving may adjust endogenously.

Effects of Government Spending

An increase in $G$ raises output but reduces net exports (trade deficit). The open-economy multiplier is smaller than the closed-economy multiplier because part of the increased demand leaks abroad through imports.