National economies are interconnected through trade in goods and services, through migration flows and through international capital markets. We refer to such economies as open economies. In fact all economies are open to a significant degree. The only truly closed economy is the global economy.
Openness has three important dimensions:
1. Openness in goods markets—the ability of consumers and firms to choose between domestic goods and foreign goods. In no country is this choice completely free of restrictions: Even the countries most committed to free trade have tariffs—taxes on imported goods—and quotas— restrictions on the quantity of goods that can be imported—on at least some foreign goods. At the same time, in most countries, average tariffs are low and getting lower.
2. Openness in financial markets—the ability of financial investors to choose between domestic assets and foreign assets. Until relatively recently even some of the richest countries in the world, such as France and Italy, had capital controls—restrictions on the foreign assets their domestic residents could hold and the domestic assets foreigners could hold. These restrictions have largely disappeared, with the exception of China and other emerging economies. As a result, world financial markets are becoming more and more closely integrated.
3. Openness in factor markets—the ability of firms to choose where to locate production, and of workers to choose where to work. Here trends are also clear. Multinational companies operate plants in many countries and move their operations around the world to take advantage of low costs. Much of the debate about the North American Free Trade Agreement (NAFTA) signed in 1993 by the United States, Canada, and Mexico centered on how it would affect the relocation of U.S. firms to Mexico. Similar fears now center around China. In addition, immigration from low-wage countries, is a hot political issue in countries from Germany, France, the United Kingdom and other countries in the European Union, to the United States.
An open economy can borrow or lend resources to the rest of the world. In contrast to a closed economy, domestic investment may thus differ from national savings. The difference determines the balance of payments.
In addition, transactions among open economies are in many currencies. The relative prices of those currencies, exchange rates, are constantly changing in the current system of floating exchange rates. However, many countries have adopted regimes of fixed or managed exchange rates.
The largest part of international transactions among open economies takes place through international financial and capital markets. These markets allow households and firms to exchange cash and securities (promises of future payment) in different currencies, allow countries to finance deficits in their balance of payments and firms to engage in foreign direct investment.
There are three main points that need to be clearly understood is relation to open economies:
First, in an open economy domestic expenditure can differ from domestic output. Their difference determines the trade balance. The trade balance, plus other net current inflows from the rest of the world define the current account of the balance of payments.
Second, the relationship between the current account, the fiscal balance and the balance of private savings and investment. The current account is, by definition, equal to the sum of the fiscal balance and the balance of private savings and investment.
Thirdly, the important distinction between Gross Domestic Product (GDP) and Gross National Income (GNI or GNP). Whereas GDP measures the volume of domestic output, GNI (or GNP) measures the income of domestic nationals, both from within the country and the rest of the world.
The international monetary systems is the set of internationally agreed rules, conventions and supporting institutions, that facilitate international trade, cross border investment and generally the reallocation of capital between nation states.
It provides for means of payments acceptable between buyers and sellers of different nationality, including means of deferred payments (debt instruments).
To operate successfully, it must inspire confidence, provide sufficient liquidity for fluctuating levels of trade and provide means and rules by which global imbalances can be corrected.
The international monetary system can develop organically, as the collective result of numerous individual agreements between international economic factors spread over several decades, or it can arise from a single architectural vision, as happened with the post World War II system agreed at Bretton Woods in 1944.
For about forty years before World War I (1879-1914) the main economies operated under an international monetary system called the international gold standard. This was a system of fixed exchange rates, based on gold, and the dominant international reserve currency of the time, the pound sterling.
The interwar period was characterized by a variety of exchange rate regimes ranging from floating exchange rates in the first part of the 1920s, to a brief restoration of the international gold standard (1926-1931), to managed exchange rates and capital controls in the 1930s. This period is considered as one of international monetary instability, and is also marked by protectionism in international trade and the onset of the Great Depression.
Between the end of World War II and 1973 the industrial countries operated a system of fixed but adjustable exchange rates, the Bretton Woods system, based on the US dollar (and partly gold), which was also underpinned by capital controls.
From 1973 until today, the US, the Euro Area, Japan, the United Kingdom and Switzerland have chosen free capital mobility, and domestic monetary autonomy, resulting in a system of floating exchange rates. Other countries have chosen a variety of exchange rate regimes, ranging from floating to unilaterally fixed exchange rates.
The international monetary system today is basically tripolar, with a dominant role for the US dollar ($). The other two major currencies are the Euro (€) and the Japanese Yen (¥).
In addition, the pound sterling (£), the Swiss franc and the Chinese renmimbi, or yuan, are significant international currencies.
A country that can borrow in its own currency has significant advantages over countries which cannot do this. It can continue servicing its loans, even if it has to resort to issuing money in order to pay its creditors. So it does not run the risk of default. This option is not available to developing economies which borrow in foreign currency.
The inability of less developed economies to borrow in their own currency, is often called the original sin. On the other hand, the ability of the US to borrow in dollars, and in this way to reduce the real value of its international obligations, is often referred to as the exorbitant privilege of the US.
Blanchard Ch. 17
Macroeconomics 