Introducing the Open Economy

This chapter extends the closed economy framework developed in previous chapters to describe two economies which trade merchandise with one another. Our methodology differs from the usual textbook approach, according to which models of individual closed economies are eventually ‘opened’, but which give no consideration to what other countries must be held to be doing and how a full set of interactions between all countries might be characterized. The excuse is that the open economy under study is presumed to be small compared to the rest of the world, so that the feedback effects can be assumed to negligible. But then not much can be said about the US economy, the size of which surely guarantees large feedback effects on the rest of the world, nor about the European community or the block of Asian countries including Japan. This partial equilibrium approach is the more surprising because international trade theory is usually treated within a relatively sophisticated two-country and two-good framework. We shall discuss open economy macro-economics using models of an economic system which, taken as a whole, is closed, with all flows and all stocks fully accounted for wherever they arise.1