Balance of payments

An open economy complicates a number of previously discussed relationships. Spending and output are no longer equal, and savings does not have to equal investment.

We have covered the relationship between spending and output already. We add exports (X), goods produced in our country and purchased in other countries, and subtract imports (M), goods produced in other countries that are purchased in our country. The difference (X-M) is the trade balance and re-connects spending and production.

To adjust savings and investment, we need to understand international financial flows. This starts with the balance of payments, a summary of one country’s transactions with other countries similar to GDP for domestic transactions. It can be divided into two components, the current account (CA) and the capital and financial account (KA).

The current account covers payments that do not create future liabilities. These include:

• Net trade in goods and services (NX)

• Net factor income such as wages, interest payments, dividends

• International transfer payments such as foreign aid and remittances

The first two types of payments are in exchange for something, a good, a service, ongoing ownership or the holding of funds. Transfer payments are unilateral, a voluntary transfer of funds without receiving anything in return.

Transactions that do create future liabilities are in the capital financial account, reflecting net purchases of assets. This includes:

• Foreign Direct Investment (FDI)

• Portfolio investment - purchases of stocks and bonds

• Other investment - bank accounts and other financial assets

• Reserve account - central bank holdings of foreign exchange and foreign bonds

FDI includes capital investment from any foreign source. A common example would be a foreign company building a factory. Coca-Cola building a bottling plant in Mexico would count as positive FDI for Mexico and negative for the United States. This highlights the linked nature of asset transactions - a positive transaction for one country must be due to a negative transaction for some other country.

The balance of payments has a more fundamental link however. If everything is measured correctly, the current account plus the capital and financial account must equal zero. Following from this, any transaction in the current account must be balanced by an opposite transaction in the capital and financial account.

$$\begin{array}{r}CA+KA=0\text{or}CA=-KA\end{array}$$

So a large enough trade deficit is equivalent to a current account deficit and that needs to be matched by a positive transaction in the capital and financial account. This could be foreign purchases of stocks and bonds, or an increase in the reserve account.

To reduce the level of detail and complexity in these discussions, we usually make a few simplifying assumptions to give us a starting point to focus on the most important issues. One example of this is that for the United States net foreign income and net international transfers added together are a relatively small portion of the current account. So we do not lose a lot in taking $CA=NX$.

The other common simplification is to focus on changes in $KA$ as purely being due to loans. This allows us to connect these international flows to the loanable funds market.

Open economy loanable funds

Just as with the closed economy case, we can build the loanable funds market by starting with a GDP equation.

$$\begin{array}{rl}Y& =C+I+G+NX\\ \text{So }Y-C-G-I& =NX\\ S-I& =NX=CA=-KA\\ \text{or }I-S& =-NX=-CA=KA\end{array}$$

In an open economy I > S results from a positive balance in KA, net inflows of capital. On the other side I < S is due to a negative balance in KA, net outflows of capital. This is enabled because of one key shift in perspective. Domestic supply and demand for loanable funds no longer determines the interest rate!

In an unrestricted open economy loanable funds market, the level of savings, investment and capital flows is determined by the world interest rate ($r^W$). Comparing the hypothetical domestic interest rate in a closed economy, the rate where domestic supply and demand intersect, tells us about flows in the open economy. If $r<r^W$ capital outflows can be expected, if $r>r^W$ then capital inflows can be expected. The pool of funds readily available to be moved internationally to take advantage of short-term interest rate differences is called hot money.

There is a now an important distinction, with slightly different outcomes depending on whether an economy is large or small.

Definitions

Small open economy

An economy that is small relative to the size of the world capital market. For them $r^W$ is treated as fixed. Even when there are changes in the loanable funds market, $r^W$ does not change.

Large open economy

An economy that is large relative to the size of the world capital market. Changes in the loanable funds market cause $r^W$ to move with $r$.

In a small open economy, shifts in the loanable funds market cause changes in capital flows. This is true for most countries in the world.

In a large open economy, the world rate has a matching move to go along with the domestic change. It may be helpful to think of the large open economy as experiencing the same change as a closed economy, only with smaller shifts. The main example of a large open economy is the United States.

On the AP exam, any question should make it clear which case is being addressed. If it is not mentioned in a FRQ, it is fair to briefly mention what occurs in each case and why it is different.

Connection to the foreign exchange market

In an open economy, changes in the loanable funds market also spill over into the foreign exchange market. Imagine that the US interest rate is higher than the Eurozone interest rate.

Because this is a shifter in the foreign exchange market, any shift in the loanable funds market that leads to a new equilibrium interest rate also has an effect in the foreign exchange market.

The higher interest rate leads capital to flow to the US, leading to an increase in the demand for dollars and an increase in the supply of loanable funds. This causes the dollar to appreciate and drives the interest rate in the US lower. In the Eurozone, the supply of loanable funds decreases, pushing the interest rate higher. If there is free movement of capital, this process should stop when the two interest rates are equal again.

Capital controls

The main complication that can arise in this market is the presence of capital controls, legal restrictions on capital flows. In China, for example, there are legal restrictions on movements of funds, particularly out of the country. In Thailand foreigners cannot legally own land, with 30-year leases being a common workaround. The goal of such rules is often to provide economic stability, limiting the effects of movements of hot money, and to encourage domestic investment. Capital controls do impact exchange rates as well, which will be discussed at an appropriate time.

The introduction of rules on foreigners should be viewed as a demand shift to the left, and the removal of rules as a demand shift to the right. Conversely, rules on domestic actors should be viewed as supply shifts, with new restrictions acting as a shift to the right and the removal of restrictions as a shift to the left.

The main example for the United States exists for political reasons. Since 1963 the United States has had an embargo on Cuba, which strictly limits any funds transfers at all, including payment or investments. While the details have been adjusted in the intervening years, it is broad enough to nearly completely close off all economic exchange between the two countries, for goods, services or funds. In recent years there are small amounts of travel, through companies licensed by the U.S. government for a limited set of activities, including family visits, official government visits and humanitarian projects. This has a limited effect on the overall economy of the United States, but has severely limited the growth and opportunities of Cuba.

Data: recent examples

[trade flows chart - CA or NX (both?)]

Since the late 1980s the United States has had persistent trade deficits and a negative current account balance. The associated international capital flows into the United States allow domestic investment to be higher than domestic investment. The trade deficit is, in effect, funded by selling assets to foreigners.

[trade flows chart - CA or NX (both?)]

Germany presents the opposite trends. As the Euro was introduced and the European Union has strengthened, Germany has tended to run trade surpluses. With that comes current account surpluses, and international capital outflows. Germany effectively lends capital to foreigners to buy German goods and services.

Two way capital flows

A small realistic but odd detail is that that the open economy loanable funds market is a good description of net flows of capital, but says little about gross flows. Two way capital flows is a term to refer to funds flowing both in and out for reasons beyond interest rates.

These exist for a number of reasons and are country specific. Investors may desire to diversify risk by having exposure to a variety of markets. Companies may desire to reduce costs by engaging in foreign direct investment. There are a number of industries where this is common, cars are an easy example. So it is not uncommon for US car companies to build factories to assemble cars abroad for foreign sale and for foreign companies to also build factories for final assembly in the United States.

Certain cities act as financial centers. Modern examples include New York City, London, Singapore and Hong Kong. So countries that have such a city may experience inflows of funds from many other countries, into financial firms, and corresponding outflows when those funds are used to invest across the globe.