2.1 Basic Categories in an Open Economy

A. Closed to Open
We developed, in Section 1.2, a framework for a closed economy that looked like this:

It can be characterized by several equations showing what equals what.  The top part of the picture

Shows us that

   C + I + G = Y = Yd + T = C + S + T

Moving down, we can also see that:

    G = T + government borrowing

with government borrowing being the little flow in red.  This means that all government spending (G) is funded either by taxes or by borrowing from the financial sector.

Finally, moving down to the financial sector,

    government borrowing + I = S

Which means that savings is divided between lending to government and lending to private firms.

All this is just review of how our closed-economy framework fit together.  Now we open it up.  Openness means two things: We can import and export goods, and we can borrow and lend abroad.  In other words this part

is going to change because some of total output goes to foreigners, and some of the goods that end up with C, I, and G can come from foreigners.  Moreover, total national output, and the total amount of goods ending up with C, I, and G, don't have to be the same.

And this part

has to change because domestic savers can lend to foreigners, and foreigners can lend to domestic borrowers.  Below, we introduce the new flows.

B. Absorption
We're trying not to use any more jargon than necessary.  But it gets tiresome saying, as we did above, "the goods that end up with C, I, and G."  So we're  going to use the term "domestic absorption" or just "absorption" for C + I + G.  Think of it as all the goods that the domestic economy absorbs.  For some reason absorption is traditionally represented with a capital E.  You won't have to memorize this, but it will be used from time to time.

C. Imports and Exports
Some part of domestic absorption (E) comes from nationally-produced goods and the rest comes from imports.  Some part of domestic output (Y) is sold to foreigners and some part is sold within the country.  Here's how we'll start to adjust our diagram:

    C + I + G = Y = C + S + T

now looks like

    C + I + G + (X - M) = Y = C + S + T

Note that absorption can be bigger than output, as it is here.  It can also be smaller.  If it's bigger, the difference between absorption and output has to be the difference between imports and exports.  If absorption is less than output, our picture would look like

and the difference between output and absorption would be the difference between exports and imports.

D. Foreign Savings and Foreign Investment
Domestic savers can purchase domestic financial assets, but they can also purchase foreign financial assets.  Foreigners can also buy our financial assets.

Total foreign purchases of financial assets from us will be called Gross Foreign Saving.  Total purchases by our savers of foreign financial assets will be called gross foreign investment.

So let's adjust this bit of our diagram:

 to something like:

 

in which gross foreign saving exceeds gross foreign investment, or:

I have included a fiscal deficit in both pictures because most countries run one.  What's important is that the financial sector is also a little accounting unit: We have total purchases of financial assets on the right hand side, and total sales of financial assets on the left hand side.  So we have government, domestic business, and foreigners all lining up on the left to borrow in this case, and both foreign and domestic savers lining up to lend.

The words describing these flows are hard to keep straight.  For one thing, a term like "gross foreign investment" may not bring a picture to your mind's eye as quickly as "import" does.  For another thing, words like "investment" and "saving" are used in hopelessly confused ways in ordinary conversation, and even "gross" versus "net" may take a minute to sort out.  All we can do is apologize for the state of the English language, promise to keep the terms as straightworward as possible, and urge you to pay close attention to this material.

Remember that borrowing means that you sell a security.  Lending means that you buy a security.   Think of the security as a simple IOU that the borrower sells to the lender.

E. The Rest of the World
We now have a new unit to think about.  The Rest of the World receives our exports, sends us imports, lends to us, and borrows from us.  Its flows have to add up too.

or

On the left side we have things foreigners sell to us: theor goods, and their securities.  On the right side we have things foreigners buy from us: our goods and our securities.  The two sides must add up to the same amount.

This is a simple version of the balance of payments.  On the right hand side of this box is everything we do as a nation to earn foreign exchange: we either sell goods to foreigners, or we sell securities.  On the left hand side is everything we spend foreign exchange on: foreign goods, and foreign assets.