Open Economy — International Trade and Finance

• The Balance of Payments (BOP) is the complete record of a country's international transactions over a given period. It splits into two accounts that must always balance.

The Current Account (CA)

The Current Account records:

• Net exports (the Balance of Trade) — exports of goods and services minus imports.
• Net income from abroad — investment income (interest, dividends) received from foreign investments, minus income paid out to foreign investors.
• Net unilateral transfers — one-way flows like foreign aid or remittances.

The Capital and Financial Account (CFA)

• The Capital and Financial Account (CFA) records the buying and selling of financial assets across borders — stocks, bonds, CDs, currency holdings — plus direct foreign investment, like a company building a factory in another country.

The key identity

• CA + CFA = 0. Money that leaves a country in one account must be matched by an offsetting flow in the other — if a country runs a current account deficit (spending more abroad than it earns from trade/income/transfers), it must be financed by a capital and financial account surplus (a net inflow of foreign investment), and vice versa.
• Credits vs. debits: a credit means money is flowing into the country (an export, a foreign purchase of a domestic asset); a debit means money is flowing out (an import, a domestic purchase of a foreign asset).

• An exchange rate is the price of one currency stated in terms of another.
• A currency appreciates when it becomes more valuable relative to another currency (it now buys more of the other currency than before); it depreciates when it becomes less valuable (it buys less).
• Exchange rates are reciprocals of each other: if Currency A buys X units of Currency B, then Currency B buys 1 ÷ X units of Currency A.

• Currencies are traded in a market just like any other good, with a supply and demand curve — take the market for Japanese Yen (priced in US Dollars) as an example:
• The supply of Yen slopes upward: as the dollar price of Yen rises, holders of Yen are willing to supply more of it, since each Yen now trades for more dollars.
• The demand for Yen slopes downward: as the dollar price of Yen rises, buyers want less of it, since Japanese goods and assets become relatively more expensive for dollar-holders.
• Equilibrium in this market sets the exchange rate — the price at which the quantity of Yen supplied equals the quantity demanded.

Determinants that shift the entire supply or demand curve for a currency

These change a currency's equilibrium value:

• Changing tastes/preferences for a nation's goods and services.
• Relative income changes between countries.
• Relative price-level (inflation) changes between countries.
• Relative interest rates between countries.
• Speculation about a currency's future value.

• Fiscal and monetary policy affect the foreign exchange market through a consistent chain of reasoning: a policy or economic change → interest rates change → international capital flows respond → currency demand/supply shifts → the exchange rate changes.
• Example chain — contractionary monetary policy: the central bank raises interest rates to fight inflation → higher rates attract foreign investors seeking better returns → capital flows in → demand for the domestic currency increases → the currency appreciates.
• Example chain — expansionary fiscal policy: larger deficit spending raises domestic interest rates (via crowding out, from Unit 5) → this also attracts foreign capital seeking better returns → the currency appreciates — reinforcing the same mechanism as above, just triggered by fiscal rather than monetary policy.

• Once the exchange rate changes, it feeds directly into net exports (Xn), a component of Aggregate Demand (from Unit 3).
• Depreciation: the domestic currency buys less foreign currency, making domestic goods relatively cheaper for foreigners and foreign goods relatively more expensive for domestic buyers — exports rise, imports fall, and net exports increase.
• Appreciation: the reverse — domestic goods become relatively more expensive for foreigners, foreign goods become relatively cheaper at home — exports fall, imports rise, and net exports decrease.
• This is the mechanism by which flexible exchange rates can help correct trade imbalances over time: a trade deficit tends to depreciate a currency, which then makes that country's exports more competitive.

• This topic formalizes the mechanism used throughout 6.4 and 6.5: financial capital moves toward the countries offering the best real (inflation-adjusted) return.
• If a country's real interest rate rises relative to other countries, it becomes a more attractive place to invest. Foreign financial capital flows in, increasing demand for that country's currency and causing it to appreciate.
• This connects the Loanable Funds Market (Units 4–5) directly to the foreign exchange market: anything that raises a country's real interest rate — a shrinking government deficit, a smaller trade deficit, tighter monetary policy — also tends to attract foreign capital and appreciate its currency.