Macroeconomics In an Open Economy

What about other countries? Our CA = X - M account is the opposite of that of our trading partners. Let us call our home country “Inland” and the whole rest of the world (ROW) “Outland.” So, with a change of signs, Inland’s X - M = Outland’s - (X - M). This leads to the reasonable conclusion that the sum of world exports = the sum of world imports.

Inland & Outland But if the trade balances are equal, and opposite in sign, (X i – M i ) = - (X o – M o ), and (I i - S i ) + (G i - T i ) = -(I o - S o ) - (G o - T o ) Or, for the entire world: G - T = S – I {The subscripts indicate In- & Outland.}

Implications   Government budget deficits must be financed by inducing saving rates that are high enough (or investment rates low enough) to create an excess of saving over investment.   However, if the governments run net surpluses, the unused tax receipts revert to the economy to finance private investment.

MARKETS IN PRACTICE You are familiar with supply and demand. P Q S D Excess Supply Excess Demand PHPH PLPL If a price is too high (P H ), there is excess supply. If too low (P L ), there is excess demand. Either way, the price adjusts to move the market to the point of equilibrium at E. E

S + T = supply & I + G = demand r S+T I+G r0r0 I + G = S + T S + T > I + G I + G > S + T r1r1 r2r2

What are those gaps? S + T > I + G => (I - S) + (G - T) < 0. Therefore, X - M > 0 (CA surplus). The gap is a current account surplus. If the interest rate rises, saving rises and investment & consumption fall. Therefore, purchase of importables and exportables falls. CA heads toward surplus. The other gap is the opposite.

What role for Outland? InlandOutland I i + G i S i + T i S o + T o I o + G o World Interest Rate (Assumes perfect capital mobility) X i - M i > 0 X o - M o < 0 INLAND: Relatively high saving rate, CA surplus, small budget deficit (or surplus), low spending, money left over to lend to Outland. OUTLAND: Relatively low saving rate, current account deficit, large budget deficit, high spending levels, need for loans from Inland.

Further Implications (I i - S i ) + (G i - T i ) = -((I o - S o ) + (G o - T o )) < 0. Remember that if X i - M i = - (X o - M o ) > 0, If Inland saving is high & budget is balanced or in surplus, LHS < 0. Hence, Inland’s spending is low & CA > 0. If Inland saving is low & budget is balanced or in deficit, LHS > 0. Hence, Inland’s spending is high & CA < 0.

Do Elasticities Matter?  You bet they do! InlandOutland Ex i = Im o Im o = Ex i Small price adjustment Big Price Adjust- ment

Do Incomes Matter?  Inland’s GDP rises relative to Outland’s.  Inland’s demand for everything rises relative to Outland’s.  Inland’s imports rise relative to Outland’s imports.  Inland keeps more exportables at home  Outland enables more exports.  (X i – M i ) falls; (X o – M o ) rises.  X i = M o both fall; M i = X o both rise.