7. The Open Economy and Trade

In micro, trade between countries was still the equilibrium of one market at a time; in macro, the whole economy's saving and investment decide the trade outcome. Starting from the identity that the trade balance is saving minus investment ($NX = S - I$), this chapter shows why a tariff cannot fix a deficit, and why the exchange rate is the price that moves to keep that identity true.

• The Trade Balance Is Saving minus Investment — In micro, a tariff was a story about one import market. In macro, the whole country's saving and investment set the trade balance. If saving beats investment, the leftover 💰 money flows abroad. If investment beats saving, the country borrows from abroad. The gap always matches, as in the formula below. A tariff moves neither saving nor investment. So the trade balance ends up right back where it started. For example, say your classmates collect 100 🍬 candies. If they eat 70 and save 30, those 30 can be lent to the next class. If they want to eat 120, they must borrow 20 from next door. A country's trade works the same way: it is the gap between what is saved and what is spent.
• The Exchange Rate Closes the Loop — In micro, the exchange rate was one price among many. In macro, it is the very price that adjusts to match the saving-investment gap. When our 💰 money gets pricier, our goods get pricier too. Foreign buyers buy less, and net exports fall. The equilibrium rate is where net exports equal the saving-investment gap. The formula below finds that spot. When government borrowing widens a deficit, the currency rises and net exports worsen by exactly that much. For example, imagine the corner 🏪 shop suddenly charges more for 🍬 candy. Shoppers drift to the shop next door, and the pricey shop sells less. A pricier currency works the same way. Foreign buyers drift away until exports fall enough to restore the balance.