Unit 6: Open Economy—International Trade and Finance

Open economy

An economy that interacts with the rest of the world through trade in goods and services, financial (asset) flows, and currency exchange.

Comparative advantage

The ability to produce a good or service at a lower opportunity cost than another producer; the main reason countries specialize and trade.

Opportunity cost

What must be given up to produce one more unit of a good; the basis for determining comparative advantage.

Absolute advantage

The ability to produce more of a good with the same resources (higher productivity); not the basis for gains from trade.

GDP expenditure identity (open economy)

The spending approach to GDP: Y = C + I + G + (X − M), where net exports capture trade’s effect on measured domestic production.

Exports (X)

Goods and services produced domestically and sold to foreigners; included in GDP because they are domestic production.

Imports (M)

Goods and services produced abroad and purchased domestically; subtracted in GDP accounting to avoid counting foreign production in C, I, or G.

Net exports (NX)

Exports minus imports: NX = X − M; the trade component of GDP that can be positive (surplus) or negative (deficit).

Trade balance

Typically exports minus imports of goods and services; often used interchangeably with net exports.

Trade deficit

A situation where imports exceed exports, so NX < 0; not automatically a sign of economic weakness.

Balance of payments (BOP) statement

An accounting record summarizing a nation’s international transactions (payments received from and sent to foreign countries) over a period of time.

Current account (CA)

The BOP account that records flows of goods and services (trade) plus income flows and unilateral transfers.

Investment income (current account component)

Interest, dividends, and other income received from abroad or paid to foreign investors; recorded in the current account.

Unilateral transfers (current account component)

One-way transfers such as gifts or remittances; recorded in the current account.

Financial (capital) account (FA)

The BOP account that records purchases/sales of real and financial assets across countries (stocks, bonds, deposits/loans, direct investment).

Capital inflow

Foreigners buying domestic assets, causing financial capital to flow into the country (recorded in the financial account).

Capital outflow

Domestic residents buying foreign assets, causing financial capital to flow out of the country (recorded in the financial account).

Official reserves account (OR)

The central bank’s transactions in foreign currency reserves used to help offset deficits or surpluses in other BOP accounts.

Simplified BOP identity (AP logic)

Often assuming official reserves do not change: CA + FA = 0, so a current account deficit implies a financial account surplus of equal size.

Full BOP identity

Including official reserves explicitly: CA + FA + OR = 0; overall balance of payments must sum to zero as an accounting identity.

Exchange rate

The price of one currency in terms of another; in AP problems, always follow the stated quotation (e.g., euros per dollar).

Appreciation

An increase in the value of the domestic currency (when quoted as foreign currency per unit of domestic currency, the exchange rate rises).

Depreciation

A decrease in the value of the domestic currency (when quoted as foreign currency per unit of domestic currency, the exchange rate falls).

Foreign exchange market (FOREX)

The market where currencies are bought and sold; the “price” determined is the exchange rate.

Demand for dollars (currency demand)

In a market for dollars, foreigners demand dollars to buy U.S. exports or U.S. assets; quantity demanded varies inversely with the exchange rate.

Supply of dollars (currency supply)

In a market for dollars, Americans supply dollars to buy imports or foreign assets; quantity supplied varies directly with the exchange rate.

FOREX equilibrium exchange rate

The exchange rate at which quantity demanded of a currency equals quantity supplied; shifts in demand/supply change the equilibrium rate and quantity exchanged.

Real interest rate differential

A key exchange-rate determinant: higher domestic real interest rates (relative to abroad) tend to attract capital inflows and appreciate the currency.

Relative income levels

A determinant of trade and exchange rates: higher domestic income raises imports (more currency supplied), while higher foreign income raises exports (more currency demanded).

Relative inflation/relative price level

If domestic inflation is higher than foreign inflation, domestic goods become relatively expensive, exports fall and imports rise, tending to depreciate the currency.

Tastes and preferences (FX determinant)

If domestic consumers prefer foreign goods, imports rise (more domestic currency supplied), tending to depreciate; if foreigners prefer domestic goods/assets, demand rises, tending to appreciate.

Speculation (currency as an asset)

Buying/selling currencies based on expected future returns; expectations of a currency rising can increase current demand and cause appreciation.

Expansionary monetary policy

Central bank actions that increase money supply and tend to lower interest rates (e.g., buying bonds); typically reduces currency demand and leads to depreciation, raising NX.

Contractionary monetary policy

Central bank actions that decrease money supply and tend to raise interest rates (e.g., selling bonds); typically increases currency demand and leads to appreciation, lowering NX.

Expansionary fiscal policy

Higher government spending and/or lower taxes that raise AD and real GDP in the short run; can increase imports via higher income and may raise interest rates, affecting the exchange rate.

Contractionary fiscal policy

Lower government spending and/or higher taxes that reduce AD and real GDP in the short run; tends to reduce import spending via lower income and may reduce interest-rate-driven capital inflows.

Aggregate demand with net exports

AD = C + I + G + NX; changes in NX shift aggregate demand (NX up shifts AD right; NX down shifts AD left).

Imported inflation

Inflation pressure caused by currency depreciation making imported consumer goods and imported inputs more expensive in domestic currency.

Inbound capital flow

Funds entering a country through foreigners purchasing domestic assets; often encouraged by relatively higher domestic real interest rates.

Outbound capital flow

Funds leaving a country through residents purchasing foreign assets; often increases when domestic real interest rates fall relative to abroad.

Tariff

A tax on imported goods; generally raises domestic prices of the imported good, reduces imports, and protects domestic producers.

Revenue tariff

A tariff mainly intended to raise government revenue, often on goods not produced domestically.

Protective tariff

A tariff intended to shield domestic producers from foreign competition by raising the price of imports.

Import quota

A legal limit on the quantity of a good that can be imported; tends to raise domestic prices and reduce imports, similar to a protective tariff (without tariff revenue in the basic comparison).

Subsidy

A government payment that lowers production costs for domestic firms; can increase exports by making domestic goods cheaper, but uses government funds and may create inefficiencies.

Deadweight loss (from trade barriers)

A net loss of total surplus due to inefficient resource allocation caused by tariffs or quotas (some gains to producers/government do not offset total consumer losses).

Floating exchange rate system

An exchange-rate regime where currency values are determined largely by supply and demand in the FOREX market.

Fixed (pegged) exchange rate system

An exchange-rate regime where a government/central bank commits to keeping the exchange rate at or near a target value through intervention.

Central bank intervention (defending a peg)

Actions to maintain a fixed rate: buy domestic currency (reduce supply) to stop depreciation, or sell domestic currency (increase supply) to stop appreciation, using reserves.

Devaluation

An official, policy-driven reduction in the pegged value of a currency under a fixed exchange rate system (distinct from market-driven depreciation).