A Macroeconomic Theory OF The Open Economy
Over the past two decades, the United States has persistently imported more goods and services than it has exported. That is, U.S. net exports have been negative. Although economists debate whether these trade deficits are a problem  for the U.S. economy, the nation’s business community has a strong opinion. Many business leaders claim that the trade deficits reflect unfair competition: Foreign firms are allowed to sell their products in US. markets, they contend, while foreign governments impede US. firms from selling US. products abroad.
Imagine that you are the president and you want to end these trade deficits. What should you do? Should you try to limit imports, perhaps by imposing a quota on the import of cars from Japan? Or should you try to influence the nation’s trade deficit in some other way? To understand the factors that determine a country’s trade balance and how government policies can affect it, we need a macroeconomic theory that explains how an open economy works. The preceding chapter introduced some of the key macroeconomic variables that describe an economy’s relationship with other economies, including net exports, net capital outflow, and the real and nominal exchange rates. This chapter develops a model that identifies the foreces that determine these variables and shows how these variables are related to one another. To develop this macroeconomic model of an open economy, we build on our previous analysis in two ways. First, the model takes the economy’s GDP as given. We assume that the economy’s output of goods and services, as measured by real GDp, is determined by the supplies of the factors of production and by the available production technology that turns these inputs into output. Second, the model takes the economy’s price level as given. We assume that the price level adjusts to bring the supply and demand for money into balance. In other words, this chapter takes as a starting point the lessons learned in previous chapters about the determination of the economy’s output and price level. The goal of the model in this chapter is to highlight the forces that determine the economy’s trade balance and exchange rate. In one “sense, the model is simple: It applies the tools of supply and demand to an open economy. Yet the model is also more complicated than others we have seen because it involves

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