We often hear the term open economy referred to in international trade discussions. However, what is the open economy? For an exchange rate to be determined between two countries, both countries must have a similar fiscal structure. If one country has a pro-cyclical fiscal policy, characterized by falling deficits over time, while the other has a fiscally constrained but pro-interventionist policy (large trade surpluses), then the exchange rate will be negatively correlated with the other country’s policy, causing a gap in the exchange rate.
Open economy is also known as the ‘exchange value’ of a nation’s goods and services. Open economy is a political philosophy that believes that exchange rates between nations are determined by the domestic policies of the governments rather than foreign-policy driven factors. Open economy philosophy believes that domestic policies govern international trade more than foreign-policy driven factors. For instance, if a country has a free-trade environment, then the exchange rate between its goods and services is subject to changes at the hands of politically motivated national policies. For an open economy, there is no problem solving disputes among countries over trade imbalances.
For an open economy, foreign investments are allowed and domestic resources are utilized if they are complementary to domestic resources. Thus, if domestic resources are insufficient to satisfy the needs of an economy, foreign assets can be utilized to fill the gap. In other words, for an open economy, domestic resources play a bigger role in satisfying the external demand requirements. This means that a country with abundant domestic resources is not restricted to exporting those resources in excess to achieve higher foreign trade share.
On the other hand, for an open economy, a policy of low inflation and low interest rate changes are conducive to a domestic monetary policy that is accommodative of domestic supply. An appreciating monetary policy allows the expansion of the monetary base (with negative interest rate), which in turn, stimulates more investment. The more investment is created, the more goods and services are purchased, creating employment. In addition, as more money is circulating, the purchasing power of the currency increases. This, in effect, decreases the value of the local currency.
In both Japan and the United States, the open economy succeeded in overcoming the problems of deflation through the intervention of the central bank. In Japan, this was done by the Bank of Japan’s unlimited monetary policy, which allowed it to intervene to stabilize the economy. In the US, the widespread use of the monetary transmission mechanism and the loose exchange rates between various currency pairs served as an indirect remedy to deflationary conditions.
Another area where an open economy successfully functions is in the realm of international trade. In fact, international trade is the cornerstone of an open economy. When there is a regular flow of investment and trading between different countries, a powerful economic network is formed. The degree of integration between different nations’ monetary systems depends largely on the degree of freedom offered by the system. Openness also ensures that trade remains localized.
Finally, the openness of an open economy encourages the transfer of technologies, as well as innovations. Advanced computer systems, for example, can be accessed and used by people anywhere in the world. This makes possible the efficient and inexpensive transport of goods and services, which can ultimately increase national income. As globalization continues to grow, the benefits offered by trading networks will be more significant. As these open markets expand, the regional differences that existed before will disappear, providing the global market with a much greater pool of producers and consumers.
In the end, any open economy is dependent on its net exports. If the value of the dollar goes down, so does the value of the country’s net exports. A successful economy depends on the ability to successfully sell and buy, to reinvest, and to leverage its forex transactions.