5.4 Large Versus Small Open Economies


In this chapter we have seen how a small open economy works. We have examined the determinants of the international flow of funds for capital accumulation and the international flow of goods and services. We have also examined the determinants of a country’s real and nominal exchange rates. Our analysis shows how various policies—monetary policies, fiscal policies, and trade policies—affect the trade balance and the exchange rate.

The economy we have studied is “small’’ in the sense that its interest rate is fixed by world financial markets. That is, we have assumed that this economy does not affect the world interest rate, and that the economy can borrow and lend at the world interest rate in unlimited amounts. This assumption contrasts with the assumption we made when we studied the closed economy in Chapter 3. In the closed economy, the domestic interest rate equilibrates domestic saving and domestic investment, implying that policies that influence saving or investment alter the equilibrium interest rate.

The small-open-economy specification is directly applicable to Canada. But which analysis should we apply to an economy like the United States? The answer is a little of both. The United States is neither so large nor so isolated that it is immune to developments occurring abroad. The large U.S. trade deficits since 1980 show the importance of international financial markets for funding U.S. investment. Hence, the closed-economy analysis of Chapter 3 cannot by itself fully explain the impact of policies on the U.S. economy.

Yet the U.S. economy is not so small and so open that the analysis of this chapter applies perfectly either. First, the United States is large enough that it can influence world financial markets. For example, large U.S. budget deficits were often blamed for the high real interest rates that prevailed throughout the world in the 1980s. Second, capital may not be perfectly mobile across countries. If individuals prefer holding their wealth in domestic rather than foreign assets, funds for capital accumulation will not flow freely to equate interest rates in all countries. For these two reasons, we cannot directly apply our model of the small open economy to the United States.

When analyzing policy for a country like the United States, we need to combine the closed-economy logic of Chapter 3 and the small-open-economy logic of this chapter. The results, not surprisingly, are a mixture of the two polar cases we have already examined. Consider, for example, a reduction in national saving due to a fiscal expansion. As in the closed economy, this policy raises the real interest rate and crowds out domestic investment. As in the small open economy, it also reduces net capital outflow, leading to a trade deficit and an appreciation of the exchange rate. Hence, although the model of the small open economy examined here does not precisely describe an economy like the United States, it does provide approximately the right answer to how policies affect the trade balance and the exchange rate.