An open economy is one that interacts with other countries through various channels. Unlike a closed economy, it establishes linkages with the rest of the world through three primary markets:
Foreign trade influences aggregate demand in two ways: leakages (spending on imports escapes the circular flow, decreasing aggregate demand) and injections (exports enter the circular flow, increasing aggregate demand).
The Balance of Payments (BoP) records all economic transactions in goods, services, and assets between residents of a country and the rest of the world for a specified period, typically a year. It consists of two main accounts:
The Current Account records trade in goods and services, as well as transfer payments. Its components include:
The balance on the current account can be classified as:
| Current Account Status | Condition | Economic Meaning |
|---|---|---|
| Current Account Surplus | $$\text{Receipts} > \text{Payments}$$ | The nation is a net lender to the rest of the world. |
| Balanced Current Account | $$\text{Receipts} = \text{Payments}$$ | Equilibrium in current transactions. |
| Current Account Deficit | $$\text{Receipts} < \text{Payments}$$ | The nation is a net borrower from the rest of the world. |
Key components of the Current Account Balance:
The Capital Account records all international transactions of assets (money, stocks, bonds, government debt, real estate). It tracks how a country finances its current account imbalances.
Components of the Capital Account include:
A current account deficit must be financed by a capital account surplus or net capital inflow:
$$\text{Current Account} + \text{Capital Account} \equiv 0$$If the sum of current and capital accounts is not zero, the gap is bridged using foreign exchange reserves managed by the central bank:
The foreign exchange market is the market in which national currencies are traded for one another. The price of one currency in terms of another is the foreign exchange rate.
Exchange rates can be determined through different systems:
According to the Purchasing Power Parity (PPP) theory, exchange rates between two currencies adjust in the long run to reflect differences in the price levels of the two countries, ensuring that a basket of goods costs the same in both nations when measured in a common currency.
In an open economy, the national income identity includes net exports ($$NX$$):
$$Y = C + I + G + X - M$$Where the import function is defined as:
$$M = \bar{M} + mY$$Here, $$m$$ is the marginal propensity to import, representing the fraction of an extra unit of income spent on imports ($$0 < m < 1$$).
The equilibrium income ($$Y^*$$) is determined as:
$$Y^* = \frac{1}{1 - c + m} \bar{A}$$Where $$\bar{A}$$ represents total autonomous expenditure ($$\bar{C} - cT + \bar{I} + \bar{G} + \bar{X} - \bar{M}$$).
The open economy multiplier is given by:
$$\text{Multiplier} = \frac{1}{1 - c + m}$$Because $$m > 0$$, the open economy multiplier is smaller than the closed economy multiplier ($$\frac{1}{1-c}$$). Imports act as an additional leakage from the circular flow of domestic income.