ECON5002 · Macroeconomic Theory
Open Economy Macroeconomics
This chapter re-opens the economy to trade and capital flows, adding two things the closed models leave out: net exports in aggregate demand and a second asset market — foreign currency — whose price is the exchange rate. Two identities anchor everything: the balance of payments, where a current-account deficit is exactly a capital-account surplus, and open (uncovered) interest parity, which ties a small economy's interest rate to the world rate once capital is mobile. The headline exam result is that policy effectiveness flips with the exchange-rate regime — the Mundell-Fleming model and the policy trilemma — and the quantitative core is the smaller open-economy multiplier and the twin-deficit identity (S − I) + (T − G) = NX.
What this chapter covers
- 011. Three dimensions of openness — goods/services, financial, and factor markets; Australia as a small, commodity-export-sensitive economy with a floating dollar
- 022. Balance of payments — current account (trade balance + net income + transfers) vs capital/financial account; CA + KA = 0
- 033. Current-account deficit ⇔ capital-account surplus — a deficit nation is a net seller of assets, funded by foreign capital inflow
- 044. Nominal vs real exchange rate — ε = E·P/P* measures competitiveness; bilateral vs the trade-weighted (effective) index
- 055. Open-economy multiplier — k = 1/(1 − c + ct + m); the import leakage m makes it smaller than the closed multiplier, and a boom worsens the trade balance
- 066. Twin-deficit identity — (S − I) + (T − G) = NX links private saving-investment, the budget, and the external balance
- 077. Uncovered interest parity — i ≈ i* + expected depreciation; a lower domestic rate implies an expected appreciation, limiting monetary independence
- 088. Mundell-Fleming, fixed vs flexible, and the trilemma — monetary policy is strong under floating and impotent under a peg; the Marshall-Lerner caveat on depreciation
Open-economy multiplier, budget and trade balance
- +2Multiplier: k = 1/(1 − c + ct + m) = 1/(1 − 0.8 + 0.8·0.25 + 0.10) = 1/(0.2 + 0.2 + 0.10) = 1/0.5 = 2. Both the tax leakage (ct) and the import leakage (m) sit in the denominator.
- +1Autonomous spending A = C0 − c·T0 + I + G + X − M0 = 120 − 0.8(50) + 180 + 240 + 180 − 80 = 600, so equilibrium income Y = k·A = 2 × 600 = 1200.
- +1Budget balance BB = T − G = (50 + 0.25 × 1200) − 240 = 350 − 240 = +110 — a budget surplus.
- +1Trade balance TB = X − M = 180 − (80 + 0.10 × 1200) = 180 − 200 = −20 — a trade (current-account) deficit.
- +1Identity: (S − I) = NX − (T − G) = −20 − 110 = −130, so I − S = +130. Despite the budget surplus, the nation still runs a current-account deficit of 20 and borrows abroad, because private investment outstrips private saving; the public surplus only partly offsets the private gap.
Key terms
- Balance of payments
- The record of all transactions between residents and the rest of the world, split into the current account and the capital/financial account, which must sum to zero (CA + KA = 0).
- Current vs capital account
- The current account covers the trade balance plus net investment income and transfers; the capital/financial account covers net asset flows. By construction a current-account deficit equals a capital-account surplus (net capital inflow).
- Nominal vs real exchange rate
- The nominal rate E is the relative price of two currencies; the real rate ε = E·P/P* adjusts for relative price levels and is what governs competitiveness. A rise in ε is a real appreciation that worsens net exports.
- Trade-weighted index (TWI)
- A multilateral or effective exchange rate that averages bilateral rates against major trading partners by trade share — the right gauge of overall competitiveness, since a currency can rise against one partner while falling against another.
- Open-economy multiplier
- k = 1/(1 − c + ct + m). The marginal propensity to import m is an extra leakage, so the open multiplier is smaller than the closed one, and a domestic boom pulls in imports and worsens the trade balance.
- Uncovered interest parity (UIP)
- The arbitrage condition i ≈ i* + expected depreciation: expected returns are equalised across currencies, so a lower domestic interest rate implies an expected currency appreciation. It limits a small economy's monetary independence.
- Mundell-Fleming model
- Open-economy IS-LM with perfect capital mobility, where the exchange rate is set by capital flows via interest parity. Monetary policy then works both directly on interest-sensitive spending and indirectly through the exchange rate on net exports.
- Policy trilemma / Marshall-Lerner
- The trilemma: with free capital mobility a country cannot have both a fixed exchange rate and independent monetary policy. The Marshall-Lerner condition (|ηX| + |ηM| > 1) is what a depreciation needs to actually raise net exports.
Open Economy Macroeconomics FAQ
Is open-economy macroeconomics on the ECON5002 exam?
Yes — it is Topic 8, examined only in the 50% closed-book final, which covers Topics 4–8 (not the mid-semester test). Expect a quantitative item on the open multiplier and the twin-deficit identity, plus a Section-B essay on Mundell-Fleming and the exchange-rate regime, where a labelled diagram is rewarded.
Why is the open-economy multiplier smaller than the closed one?
Because imports are an extra leakage from the spending stream: M = M0 + mY rises with income, so each extra dollar of demand partly leaks abroad. The multiplier becomes 1/(1 − c + ct + m), and the marginal propensity to import m enlarges the denominator, shrinking k.
What does a current-account deficit really mean?
By the balance-of-payments identity it equals a capital-account surplus — a net inflow of foreign capital. Through (S − I) + (T − G) = NX, a current-account deficit means the nation invests plus spends more than it saves plus taxes, and the gap is financed by foreigners. It is not automatically a problem.
Why does a higher domestic interest rate imply an expected depreciation?
Under uncovered interest parity, holders of a higher-yielding currency must expect a currency loss that offsets the extra yield — otherwise everyone would crowd into it. So i > i* signals that the market expects the domestic currency to depreciate (or appreciate less), not to strengthen.
How does the exchange-rate regime change policy effectiveness?
Under a flexible rate monetary policy is strong (a rate cut depreciates the currency and raises net exports) while fiscal policy is weakened by appreciation. Under a fixed rate with perfect capital mobility monetary policy is impotent (i is tied to i* to defend the peg) while fiscal policy is strong. This is the policy trilemma — get the pairing the right way round.
Is this guide official or affiliated with the University of Sydney?
No. This is an independent AskSia study resource created to help students revise. It is not produced, endorsed by, or affiliated with the University of Sydney. Always check Canvas and the official unit outline for current dates, weights and rules.
Exam move
Treat this topic as two linked stories — the goods side and the financial side — and make each exam-drawable from memory. On the goods side, drill the open-economy multiplier 1/(1 − c + ct + m) against the clock and always finish a numerical question by reading the external balance through the identity (S − I) + (T − G) = NX, stating explicitly that a current-account deficit is foreign saving funding the nation's excess of investment over saving. On the financial side, memorise uncovered interest parity (i ≈ i* + expected depreciation) and rehearse its counter-intuitive reading that a lower domestic rate implies an expected appreciation. For the Mundell-Fleming essay, build a one-page plan that leads with a labelled open IS-LM diagram, pairs each regime with the potent policy (flexible ⇒ monetary strong, fiscal weak; fixed ⇒ fiscal strong, monetary lost), and closes with the one-line policy trilemma — free capital mobility plus a fixed exchange rate leaves no room for independent monetary policy. Add the Marshall-Lerner caveat whenever you claim a depreciation raises net exports, and state the US$/A$ convention so the direction of an appreciation is never ambiguous.
