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 ($CFA$).

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.

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

Transactions are recorded by the direction money moves. Any transaction that causes money to flow into a country is a credit to its balance of payments, and any transaction that causes money to flow out is a debit. So a US export is a credit in the current account and a US import is a debit. A foreign purchase of a US bond is a credit in the capital and financial account, and a US purchase of a foreign stock is a debit. Because $CA+CFA=0$, the sum of all credit entries should match the sum of all debit entries.

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 $CFA$ as purely being due to changes in savings or capital investments. 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.

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

Thus we can see that in an open economy 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 ($r^W$). At the AP Macroeconomics level, comparing the hypothetical domestic interest rate in a closed economy, the rate where domestic supply and demand intersect, with the world interest rate tells us about capital flows in the open economy.

If $r<r^W$, then $I<S$. There is a negative balance in $CFA$, and net capital outflows can be expected. If $r>r^W$, then $I>S$. There is a positive balance in the $CFA$, corresponding to net inflows of capital.

The pool of funds readily available to be moved internationally to take advantage of short-term interest rate differences is called hot money.

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.

In the foreign exchange market, 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 left and the removal of restrictions as a shift to the right.

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.