Small open economies explained
What are small open economies? Every country participates in the exchange of goods, services and capital in a global marketplace. Jamaica, for example, exports bananas, sugar and bauxite, among other products, to other countries in the world, while we import a variety of products from abroad, including oil, apples, grapes, etc.
When we save our money in the bank, the bank might use it to invest abroad, or if the savings rate is low, a bank might borrow money from abroad to lend to us here in Jamaica. All countries interrelate and play a part in the international flow of goods, services and capital. This flow determines the price of domestic goods relative to foreign goods and the price of foreign currency relative to domestic currency (exchange rate).
A country like Jamaica is too small to influence global prices, income, output or interest rates, thus known as a small open economy (SOE). As a result, small open economics tend to be very vulnerable to change to global market conditions. How does it function?
An SOE is characterised by imperfect capital mobility where the flow of international capital or investment between countries is not accessible to everyone at every point in time. In small open economics, the interest rates which represent the price of investment is determined in the international financial market. The trade balance is determined by the difference between savings and investment. If domestic interest rates are less than world interest rates, the country is in trade surplus, and vice versa. How is the international flow of capital and goods?
In an open economy, a country's local savings need not equal local investment. A country is able to invest more than it saves if it borrows the rest from abroad, or it if saves more than it invests domestically, it can lend the rest to foreigners. If saving is less than investment, such is the case in Jamaica, the difference has to be borrowed from foreigners. Jamaica purchases more goods, services and capital from the rest of the world than what it supplies, so it has to borrow the remainder. In this case, Jamaica has a trade deficit and is a net borrower to the rest of the world.
LENDING to JAMAICA
On the contrary, a country that saves more than it invests locally can invest the remainder abroad by lending it to Jamaica, for example. In this case, the country produces more than it spends domestically and exports the rest to foreigners. This country has a trade surplus and is a net lender to the rest of the world. Such that economics assume that when a country operates a trade deficit, they also receive loans to pay for the extra goods they purchase, and when a country is in a trade surplus, they lend to the rest of the world to buy back the extra goods they have supplied to them.
What is the difference between real and nominal exchange rate?
The nominal exchange rate measures the relative price of one currency in terms of another. For example, US$112 to J$1 is the nominal exchange rate. When you hear about exchange rate in the news, for example, the dollar has depreciated or devalued against the US dollar, they are usually referring to the nominal exchange rate.
Real exchange rate
The real exchange rate is the relative price of a good between two countries. In other words, the real exchange is the price at which you can trade one country's goods for another. Let us assume that a T-shirt cost US$1 in the USA, but J$250 locally. If we compare prices using Jamaican dollars, the T-shirt would cost J$112 in the US compared to J$250 here. One T-shirt in Jamaica values two T-shirts in the USA. Therefore, the real exchange rate is a combination of the nominal exchange rate and comparative prices. If prices in Jamaica increases, it worsen the real exchange rate and foreign goods are cheaper relative to domestic goods, so demand for foreign goods should increase, which increases imports. How does policy affect the price of goods between countries?
Expansionary fiscal policy at home reduces national savings; a fall in savings reduces the amount of Jamaican dollar we have to exchange for the US, thus reduces the price of the US dollar, such that the exchange rate falls. Expansionary fiscal policy abroad increases global interest rates relative to domestic interest rates, the increase in global interest rates reduce investment at home and increases investment abroad. This increases the supply of Jamaican dollars to the rest of the world, such that as the exchange rate falls, Jamaican dollar values less.
Dr Andre Haughton is a lecturer in the Department of Economics on the Mona campus of the University of the West Indies. Follow him on twitter @DrAndreHaughton; or email firstname.lastname@example.org.