Composition of Open Economy Macroeconomics

What is an Open Economy?

An open economy is one that deals with other nations across borders in terms of trade of commodities, financial assets, and human workforces. In the modern world, almost all economies are open in nature. There are actually no closed economies because closing the border from international trade blocks the economy from thriving.

There are three basic ways to illustrate the composition of open economies which are the following:

Output Market

An open economy can trade with other economies in services, commodities, and products. This relationship broadens the idea that a country’s manufacturers and consumers can choose between domestic and foreign goods. Therefore, we can clearly see the advantage that an open economy increases the competition among the manufacturers of different products and services. As consumers choose the best option, the best producer of a commodity or item gets the upper hand in the competition and is preferred by consumers.

Financial Market

Open economies also allow and interact with cross-border financial transactions. So, in an open economy, foreign participants can also invest and buy financial assets. In modern economies, there are financial establishments, such as stock markets that help in making financial transactions by both domestic and foreign players.

Labor Market

Apart from services, commodities, and financial assets, open economies also allow entities to choose the location and workforce. So, companies can establish manufacturing facilities according to their choice in open economic countries. This helps companies and industries become more competitive as they can choose less costly manufacturing locations and provide customers with products at a cost-effective rate.

Key Terms Related to Open Economy Macroeconomics

• Trade deficit − As mentioned above, a trade deficit in an open economy refers to the loss in international trade that is related to imports and exports. When imports exceed exports, a trade deficit occurs.

• Trade surplus − A trade surplus is the opposite of a trade deficit. When an economy earns more in export than the amount it spends on imports, it is said to have a trade surplus.

• Gross Domestic Product (GDP) − The GDP of a nation refers to all the products the nation produces within a given timeframe. In simpler words, GDP measures the monetary value of final goods produced in a country within a chosen period of time. The value of final goods is taken in measuring GDP because taking intermediate values may lead to double entry. GDP is considered the most important aspect in measuring the growth of an economy as it shows the power of the economy that is concerned with the calculation.

• Exchange Rate − The exchange rate is related to the relative value of the currency of a nation. It is the relative measure of the strength of the currencies of nations. Usually, the value of the currency is determined with respect to the value or strength of a foreign currency in comparison to domestic currency.

  There are two ways to measure the value. In the direct quotation method, the unit of foreign currency is measured in terms of domestic currency while in the case of indirect quotation, the domestic currency is measured in terms of foreign currency. The idea here is to check the strength of the currency in comparison to a foreign currency which shows whether the value of the currency is higher than the foreign currency in order to determine the value of the domestic currency that can be used by other nations and exporters to adjust the price of their products.

• Exchange Rate (international experience) − In general, the exchange rate of a country is related to the demand and supply of the currency in a particular nation.

  Internationally, the exchange rate is divided into two types - floating and fixed rates. In the case of a floating rate, the value of the currency is allowed to move freely in comparison to foreign currencies. It is a process that takes place in international currency markets. In the case of fixed rate, the central bank of a nation and/or the government fixes the price of its currency. The price is usually based on gold and currency reserves available with the nation.

Balance of Payment in Open Economies

Balance of payments is one of the most important and critical aspects in the case of open economies. Balance of payments is a term related to import and export. As modern open economies produce the best item for export they can produce and buy or import items they need, and there occurs a net trade deficit or surplus. A trade deficit occurs when a country’s net value of imports is more than the value of exports it makes. In other words, it is the loss a country makes in international trade. On the other hand, if a country earns more in exports than it spends in imports, it makes a trade surplus.

It is important to have a knowledge of the Balance of Payments because it shows the strength of the economy. Usually, the net BoP of a nation should be equal to zero which shows that imports are equal to exports. Though, most countries look to have a positive BoP which shows that the country earns more in exports than the amount it spends in imports.

It is important to note that to be a strategically richer nation, the country’s trade must earn a surplus. This means that the exports made by the nation must exceed the imports. That is why governments offer extreme focus on generating revenues through exports and try to become self-reliant in terms of imports.

However, it has been noticed that no country is 100% self-reliant when it comes to imports as different nations have different advantages in terms of resources. For example, the Gulf nations have supremacy in terms of their crude oil resources but they lack resources of metals and other industrial products.

Key Note − Open economy macroeconomics deals with the economies of the nations in distinct methods. Presently, the concept is not discussed much because it is given that most nations, except only a few, are open in nature.

Conclusion

Open economies are the backbone of economic and financial systems in the modern world. It is considered to be more advantageous than closed ones because modern economies let nations leverage their superiorities to income more than what it can achieve as a closed economy. It is impossible to think about a world that is closed in terms of economic boundaries in the present day. That is why it is important to learn about open economies and their features.

FAQs

Qns 1. What are the three markets via which open economies operate?

Ans. Open economies operate via output, financial, and labor markets.

Qns 2. What is meant by trade deficit?

Ans. When there is a deficit caused by the international trade of a nation, it is known as a trade deficit. In the case of a trade deficit, the value of imports exceeds the value of exports of a nation.

Qns 3. What is the floating exchange rate of a currency?

Ans. When the rate of the currency is determined automatically by the international markets instead of getting fixed by the central bank, it is known as the floating exchange rate.