The Open Economy

1
The Open Economy
2
The Open Economy

• Sushi and demand for Blue Tuna
• The circular flow
• Balance of payments accounts
• Foreign exchange markets
• Trends in globalization U.S. balance of payments
• Net investment position and balance of payments

3
The Circular Flow
Sourcewww.washingtonpolicy.org/images/STAMPfig1Ci
rcularFlow
4
A Countrys International Transactions

• An open economy exports goods and services, X.
• It also imports goods and services, IM.
• It sends savings abroad and receives an inflow of
  foreign savings the net inflow is SF.
• Past inflows and outflows of savings generate a
  net inflow of returns on assets, rF.
• There is also a net inflow of international
  transfers, TrF.

5
Outsourcing, Vertical Specialization, and
International Trade

• Outsourcing explains a large part of the
  international trade in intermediate goods.
• Increasingly, international outsourcing is driven
  by vertical specialization.
• Vertical specialization occurs when producers in
  one country import foreign materials, parts,
  components, etc., in order to produce goods that
  may then be exported to yet another country.

6
The Logic of the Balance of Payments

• The open-economy circular flow diagram shows that
  the net flows of payments for goods and services,
  asset purchases, returns on accumulated foreign
  assets, and transfers across a countrys border
  must sum to zero
• (X-IM) SF rF TrF 0
• This logical conclusion lies behind the balance
  of payments accounting.
• In the balance of payments, the sum total of
  outflows of payments across the border for
  products, assets, and transfers equals the sum
  total of payment inflows from abroad.

7
The Logic of the Balance of Payments

• The current account contains all transactions
  related to the trade of goods and services
• The current account also contains payments to
  factors of production and earnings on assets
• Finally, the current account contains transfers
  between people and organizations in different
  countries
• In terms of the notation used earlier, the
  current account balance (X-IM) TrF rF

8
The Logic of the Balance of Payments

• The financial account contains all payments
  related to the sale and purchase of assets.
• In terms of the notation above, the financial
  account balance SF
• Since foreign payments must be exactly offset by
  foreign receipts, the current account and the
  financial account must sum to zero
• That is, (X-IM) TrF rF -SF

9
How Long Can the U.S. Continue to Run Large
Current Account Deficits?

• For the past 20 years, the U.S. has imported more
  products than it has exported
• As a country, it has paid for those extra imports
  by selling assets to foreigners
• That is, it has covered the deficit on the
  current account with a surplus on the financial
  account
• How much longer will foreigners be willing to
  accumulate large amounts of U.S. assets?

10
The Net International Investment Position

• The International Investment Position is the net
  sum of the value of (1) foreign assets that are
  owned by a countrys own citizens, firms, and
  government agencies and (2) domestic assets that
  are owned by foreign citizens, firms, and
  governments.
• The balance of payments measures flows of
  payments over the course of a year, the net
  investment position measures the accumulated
  stocks of assets at a point in time.
• The U.S.s recent financial account surpluses are
  reflected in its large negative net international
  investment position.

11
Table 2-2 The International Investment Position
of the United States(US billions, current cost
basis)

• U.S.-owned Foreign-owned U.S. Net
  International
• assets abroad assets in U.S.
  Investment Position
• 1988 2,008.4 1,997.9 10.5
• 1989 2,350.2 2,397.2 -47.0
• 1990 2,294.1 2,458.6 -164.5
• 1991 2,470.6 2,731.5 -260.8
• 1992 2,466.5 2,918.8 -452.3
• 1993 3,081.4 3,235.7 -144.3
• 1994 3,326.7 3,450.4 -123.7
• 1995 3,930.3 4,273.6 -343.3
• 1996 4,631.3 5,017.8 -386.5
• 1997 5,379.1 6,214.3 -835.2
• 1998 6,174.5 7,268.6 -1,094.2
• 1999 7,386.9 8,440.5 -1,053.6
• 2000 7,350.9 8,934.0 -1,583.2
• 2001 6,862.9 9,172.1 -2,309.1
• Source Table 2 in Elena L. Nguyen (2002), The
  International Investment Position of the United
  States at Yearend 2001, Survey of Current
  Business, July, 2002, pp. 18-19.

12
The Foreign Exchange Market

• The foreign exchange market is the set of markets
  where the worlds many different national
  currencies are exchanged.
• It is operated by large private international
  banking firms.
• The foreign exchange market can be represented by
  the familiar supply and demand curves.
• The foreign exchange rate is determined by the
  forces of supply and demand.
• In equilibrium, the supply of a currency equals
  the quantity demanded.

13
An Example The Market for Mexican Pesos

• The demand curve intersects the supply curve at
  the price .10.
• That is, one peso costs ten U.S. cents.
• We often use the letter e to represent the
  foreign exchange rate, so that the equilibrium
  can be written as e .10.

14
An Example An Increase in Demand for Pesos

• If holders of dollars want to engage in more
  foreign transactions that require Mexican pesos,
  the demand for pesos will increase.
• Such an increase in demand for pesos will cause
  the dollar to depreciate and the exchange rate e
  to rise, all other things equal.
• In the example shown, e rises from .10 to .125.

15
The Foreign Exchange Market The Mexican
Perspective

• The supply curve for dollars from the U.S.
  perspective is seen as the demand curve for pesos
  from Mexico
• Similarly, the U.S. demand curve for dollars is
  the supply curve of pesos
• Thus the equilibrium exchange rate from the
  Mexican perspective is 1/e 1/.10 10 pesos.

16
The Foreign Exchange Market A Shift in the
Supply of Pesos

• The shift in demand for dollars from the U.S.
  perspective is a shift in supply of pesos from
  the Mexican perspective
• The shift in supply causes the exchange rate to
  decline from 10 pesos, or 1/e 1/.10, to 1/e
  1/.125 8 pesos
• 37.5 million dollars are exchanged for 300
  million (8x37.5) pesos