Open Economy

Basic Concepts

An open economy trades goods, services, and assets across borders. Two key flows define its external position:

• Net exports (NX) : exports minus imports — the trade balance
• Net capital outflow (NCO) : domestic purchase of foreign assets minus foreign purchase of domestic assets

Every international transaction involves an exchange of value, so NX and NCO are always equal: a trade surplus must be offset by a capital outflow, and a trade deficit must be financed by a capital inflow.

The nominal exchange rate is the relative price of two currencies (e.g., 110 yen per dollar). The real exchange rate adjusts for price levels across countries:

$\varepsilon = \frac{e \times P}{P^*}$

where e is the nominal exchange rate, P is the domestic price level, and P* is the foreign price level. The real exchange rate determines the relative price of goods between countries.

Purchasing-power parity (PPP) predicts that exchange rates adjust so that a basket of goods costs the same in different countries. While PPP holds roughly in the long run for tradable goods, it often fails in the short run due to transport costs, tariffs, and non-tradable services.

Balance of Payments

The balance of payments records all transactions between a country and the rest of the world:

• Current account: trade in goods and services + net income from abroad + net transfers
• Capital account: transfers of non-produced, non-financial assets (minor in practice)
• Financial account: purchases of domestic assets by foreigners minus purchases of foreign assets by residents

By accounting identity, the current account balance plus the financial account balance equals zero: $CA + FA = 0$. A current account deficit implies a financial account surplus — the country is borrowing from abroad.

The Mundell-Fleming Model

The Mundell-Fleming model extends the IS-LM framework to an open economy. The key equations:

$IS^*: Y = C(Y - T) + I(r^*) + G + NX(e)$ $LM^*: \frac{M}{P} = L(Y, r^*)$

The world interest rate r* is taken as given (small open economy assumption). The exchange rate e is on the vertical axis; IS* slopes downward (depreciation boosts net exports), and LM* is vertical (the interest rate is fixed at r*).

Under floating exchange rates, monetary policy is powerful — an expansion shifts LM* right, depreciates the currency, and raises Y. Fiscal policy is ineffective because expansionary fiscal policy shifts IS* right, appreciates the currency, and crowds out net exports.

Under fixed exchange rates, the opposite holds: fiscal policy is powerful, while monetary policy is ineffective (the central bank must adjust the money supply to defend the peg).

Impossible Trinity

A country cannot simultaneously have all three of:

1. Free capital mobility (open financial markets)
2. Fixed exchange rate (pegged currency)
3. Independent monetary policy (ability to set interest rates freely)

A country must choose two of the three. For example, the Eurozone chose fixed rates and capital mobility, sacrificing independent monetary policy. China historically chose fixed rates and independent policy, sacrificing capital mobility via capital controls.

Interest Rate Parity

Covered interest parity (CIP) holds when the difference between domestic and foreign interest rates equals the forward premium on the exchange rate, ensuring no arbitrage in forward markets.

Uncovered interest parity (UIP) holds when the expected depreciation of the domestic currency equals the interest rate differential:

$i = i^* + \frac{E(e_{t+1}) - e_t}{e_t}$

If UIP holds, investors are indifferent between holding domestic and foreign bonds after accounting for expected exchange rate changes.

J-Curve and Marshall-Lerner Condition

A depreciation initially worsens the trade balance (because existing contracts are priced in the old exchange rate) before improving it — the J-curve effect.

The Marshall-Lerner condition states that a depreciation improves the trade balance in the long run only if the sum of the price elasticities of export demand and import demand exceeds 1. Evidence suggests this holds for most developed economies.

Currency Crises and Speculative Attacks

• First-generation models (Krugman, 1979): a currency crisis occurs when inconsistent policies — e.g., monetizing fiscal deficits while defending a peg — exhaust foreign reserves, triggering a speculative attack
• Second-generation models (Obstfeld, 1994): a crisis can be self-fulfilling. If investors believe a devaluation is coming, they sell the currency, forcing the central bank to raise rates or deplete reserves, making the devaluation inevitable

Modern crises often combine elements of both: fragile fundamentals plus a shift in market sentiment.

Sterilization

When a central bank intervenes in foreign exchange markets to defend a peg, it buys or sells foreign reserves, affecting the domestic money supply. Sterilization is the offsetting open-market operation that neutralizes this effect on the money supply. For example, if the central bank sells foreign reserves (contracting the money supply), it simultaneously buys domestic bonds to expand the money supply back. Sterilization is effective in the short run but limited by the stock of foreign reserves and the interest cost of holding them.