08 Open-Economy Macroeconomics

Lecture from: 04.11.2025 | Video: Video ETHZ

Finishing Lecture 7: Trade Policy Analysis

The analysis of international trade concludes with an examination of protectionist policies. While trade creates overall gains, it creates winners and losers, fueling political pressure for restriction.

The Effects of a Tariff

A tariff is a tax on imported goods, raising the domestic price above the world price.

Impact Analysis:

1. Price: Rises by the tariff amount.
2. Quantity: Domestic supply increases; Domestic demand decreases; Imports fall.
3. Welfare:
   • Consumer Surplus: Falls substantially (Area $-(D+E+F+C)$).
   • Producer Surplus: Rises ($+C$).
   • Government Revenue: Rises ($+E$).
   • Net Effect: A Deadweight Loss of $-(D+F)$. The loss to consumers exceeds the gains to producers and the government.

The Effects of a Domestic Subsidy

Instead of taxing imports, the government creates a subsidy for domestic producers.

1. Supply Shift: The subsidy lowers marginal costs, shifting the supply curve down.
2. Outcome: Domestic production rises, and imports fall.
3. Price: Consumers still pay the world price.
4. Welfare: Producers gain, consumers are unaffected, but the government (taxpayers) pays the cost. There is still a deadweight loss because production is shifted to high-cost domestic producers.

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Open-Economy Macroeconomics: Basic Concepts

The focus now shifts from single markets to the macroeconomics of an entire open economy, one that interacts freely with other economies through two main channels:

1. Product Markets: Buying/selling goods and services (Exports/Imports).
2. Financial Markets: Buying/selling assets (Capital Flows).

The Flow of Goods: Net Exports (NX)

$$\text{Net Exports (NX)}=\text{Exports}-\text{Imports}$$

• Trade Surplus: $NX>0$ (e.g., Switzerland, Germany).
• Trade Deficit: $NX<0$ (e.g., USA).

The Flow of Financial Resources: Net Capital Outflow (NCO)

$$\text{NCO}=\text{Purchase of Foreign Assets by Residents}-\text{Purchase of Domestic Assets by Foreigners}$$

NCO measures the net flow of funds invested abroad.

• Capital Outflow ($NCO>0$): Domestic residents buy more foreign assets than foreigners buy domestic assets. (Switzerland is a net lender).
• Capital Inflow ($NCO<0$): Foreigners buy more domestic assets. (USA is a net borrower).

The Fundamental Identity: NX = NCO

For an economy as a whole, the flow of goods must balance the flow of capital.

$$NCO=NX$$

Intuition: Two Sides of a Coin

Consider a Swiss firm exporting a watch to the US for $1,000.

1. Real side: Switzerland sends a watch ($NX\uparrow$1,000).
2. Financial side: Switzerland receives $1,000incash.ThiscashisaclaimonUSassets($NCO \uparrow $1,000).

Every transaction has balancing real and financial components. A country with a trade surplus ($NX>0$) is necessarily accumulating claims on the rest of the world ($NCO>0$); it is a net lender.

Derived from the national income identity: $Y-C-G=I+NX$ Since Saving $S=Y-C-G$: $S=I+NX⟹S-I=NX$ Since $S-I$ (Excess Saving) is lent abroad ($NCO$): $NCO=NX$

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The Prices for International Transactions: Exchange Rates

Two key prices link the domestic economy to the world.

1. The Nominal Exchange Rate ($e$)

The rate at which one currency trades for another.

• Appreciation: Currency gains value (buys more foreign currency).
• Depreciation: Currency loses value (buys less foreign currency).

Quotes Matter

In Switzerland, the rate is often quoted as CHF per Euro (e.g., 0.95 CHF/EUR). A fall in this number means the Franc has appreciated (it takes fewer Francs to buy a Euro).

2. The Real Exchange Rate ($ϵ$)

The rate at which the goods and services of one country trade for the goods and services of another. This measures true competitiveness.

$$\text{Real Exchange Rate}(ϵ)=\frac{\text{Nominal Rate}(e)\times \text{Domestic Price}(P)}{\text{Foreign Price}(P^{\ast })}$$

• Depreciation ($ϵ\downarrow$): Domestic goods become cheaper relative to foreign goods. Result: Exports rise, Imports fall, NX rises.
• Appreciation ($ϵ\uparrow$): Domestic goods become relatively expensive. Result: NX falls.

Purchasing-Power Parity (PPP)

The simplest theory of exchange rates, based on the Law of One Price: a good must sell for the same price everywhere to prevent arbitrage.

Implies that a unit of currency should buy the same quantity of goods in all countries. Thus, the real exchange rate should be 1.

$1=\frac{e\times P}{P^{\ast }}⟹e=\frac{P^{\ast }}{P}$

Prediction: The nominal exchange rate reflects differences in price levels. If a country has high inflation, its currency must depreciate to maintain parity.

The Big Mac Index

A Swiss Big Mac costs CHF 7.20. A US Big Mac costs $\mathrm{6.01.}Withanexchangerateof1.25$/CHF, the real exchange rate is 1.5.

• Meaning: A Swiss Big Mac costs 1.5 times a US Big Mac.
• Conclusion: The Swiss Franc is “overvalued” by PPP standards.

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A Macroeconomic Theory of the Open Economy

To analyze open-economy dynamics, two markets are modeled simultaneously.

1. The Market for Loanable Funds

Coordinates saving and investment + NCO.

$S=I+NCO$

• Supply: National Saving ($S$). Depends positively on the real interest rate ($r$).
• Demand: Domestic Investment ($I$) + Net Capital Outflow ($NCO$). Depends negatively on $r$.
• Equilibrium: Determines the real interest rate ($r$).

2. The Market for Foreign-Currency Exchange

Coordinates the exchange of domestic currency for foreign currency.

$NCO=NX$

• Supply: Net Capital Outflow ($NCO$). Vertical curve (determined by $r$ from the other market, not by the exchange rate).
• Demand: Net Exports ($NX$). Downward sloping (higher exchange rate makes exports expensive/imports cheap $\to$ lower NX).
• Equilibrium: Determines the real exchange rate ($E$).

Policy Analysis

Effect of a Budget Deficit

1. Loanable Funds: $S$ falls (Shift Left). Interest rate ($r$) rises.
2. Link: Higher $r$ reduces Investment ($I$) and reduces Capital Outflow ($NCO$).
3. FX Market: Lower NCO means reduced supply of domestic currency. Exchange rate ($E$) appreciates.
4. Result: Twin Deficits, Budget deficit leads to Trade deficit ($NX$ falls).

Effect of Capital Flight

(Large sudden exit of assets due to instability)

1. Loanable Funds: $NCO$ demand increases (Shift Right). Interest rate ($r$) rises.
2. FX Market: Supply of domestic currency increases (massive selling). Exchange rate ($E$) depreciates.
3. Result: Currency crash + Interest rate spike.

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Continue here: 09 Business Cycles