Open Economy: International Trade and Finance
This domain covers international trade and finance: comparative advantage and trade policy, the balance of payments, exchange rate determination, and how currency movements affect net exports and aggregate demand. Questions often ask you to classify a transaction in the balance of payments or predict the effect of appreciation.
Balance of payments
- Current account: goods, services, primary income, and secondary income.
- Financial account: direct investment, portfolio investment, and other flows. The capital account is small.
- Current account + financial account + capital account + statistical discrepancy = 0. A current account deficit is matched by net financial inflows.
- Debits use foreign exchange; credits supply foreign exchange.
Exchange rates
- Appreciation: the currency buys more foreign currency. Exports become dearer abroad and imports cheaper at home, so net exports fall, all else equal.
- Depreciation has the opposite effect.
- Floating rates are determined by supply and demand; higher domestic interest rates can attract financial capital and appreciate the currency.
- Fixed rates require central bank intervention and reserves.
Trade policy
- Tariffs and quotas raise the domestic price, reduce imports, and create deadweight loss; domestic producers gain and consumers lose.
- Comparative advantage still predicts gains from trade, even when one country is more productive in everything.
Worked example
If $1 = 0.80 euro, a 400-euro European good costs $500 because 400 / 0.80 = 500. If the dollar appreciates to $1 = 1.00 euro, the same good costs $400. U.S. imports become cheaper, but U.S. exports to Europe become more expensive at the old euro price. The change affects net exports and aggregate demand.
Traps that cost marks
- The current account includes services and income, not just goods.
- Appreciation is not automatically bad; it lowers import prices and can reduce inflation.
- A trade deficit is not the same as a bad economy; it reflects saving, investment, and capital flows.
- Tariffs do not necessarily improve the current account and may invite retaliation.
- Watch the exchange-rate quotation direction: "dollars per euro" and "euros per dollar" move oppositely.