Many of our macro models

deal with what's called a closed economy.

We assume that

there aren't any other countries

to trade with,

but in the real world of course

both goods and money flow back and forth

between countries.

How do we account for that?

First, let's think about

the most basic way

the economies

of two different countries interact

by selling goods and services to one another.

Let's back up and remember some definitions.

Exports are the total value

of goods and services

produced in a country

that are sold to buyers

from a different country.

Examples of exports from the United States

would include Iowa wheat

bought by a South Korean food distributor,

and American-made movie watched in Spain

or even a German tourist

paying for a hotel in Arizona.

Meanwhile, imports are the

total value of goods and services

produced in other countries

that are sold to organizations or people

in this country.

Examples of imports to the United States

include T-shirts made in Bangladesh,

oil produced in Saudi Arabia,

or even American tourists

paying for a hotel in Canada.

For a given country

it's useful to think about net exports.

A country's total exports

minus its total imports.

If a country's exports

are greater than its imports

net exports are positive.

On the other hand

if a country's exports

are lower than its imports

net exports are negative.

The starting point

for our closed economy macro model

is our GDP identity.

To consider the open economy,

the first step is to adjust our GDP identity

to reflect net exports.

For example,

if a country is spending $2 trillion

on consumption,

$1 trillion on investment,

$1.5 trillion on government purchases

is exporting $0.7 trillion

and is importing $1.2 trillion.

Then it's net exports

will be negative $0.5 trillion

and its GDP will be $4 trillion.

One way to think about net exports

is to rearrange our open economy identity.

We can call net exports

the difference between

what a country is producing, Y

and what its consumers, businesses,

and government are purchasing,

C+I+G.

So for example

suppose Pangea

is producing $4 trillion in output

and consumption, investment,

and government purchases

add up to $3.5 trillion.

That means

that there's $0.5 trillion of output

that is produced

but not purchased by domestic actors.

That extra output gets sold abroad.

So exports will exceed imports

by that $0.5 trillion

giving Pangea a net exports

of the positive $0.5 trillion.

Likewise, suppose Laurasia is producing

$4 trillion in output

and consumption, investment,

and government purchases

add up to $4.5 trillion.

That means that domestic actors

are purchasing a $0.5 trillion more output

than is being domestically produced.

That extra output

will have to come from other countries.

So imports will exceed exports

by that $0.5 trillion

giving Laurasia a net exports

of $-0.5 trillion.

Next we take net exports

and add in something

called net investment income.

This is the difference between

interest payments

or other returns on investment

paid by foreign borrowers

to U.S. lenders

and the payments flowing

in the other direction

from U.S. borrowers to foreign lenders.

Net exports

plus those investment income flows

is called the current account.

Let's go back to Pangea and Laurasia.

Laurasia was producing $4 trillion in output

but was purchasing $4.5 trillion.

As we saw that meant

that $0.5 trillion more goods

needed to be imported than exported.

For a net exports of $-0.5 trillion.

If there is no net investment income

the net gives a current account deficit

of $0.5 trillion

but since output equals income

Laurasia also needs to borrow $0.5 trillion

to pay for those extra imports.

That net borrowing

falls under a different category

called the capital account.

Laurasia has to borrow $0.5 trillion

more than it lends

so that it will be able to pay

for the $0.5 trillion in extra imports.

We say that Laurasia has a positive

$0.5 trillion surplus

in its capital account.

Meanwhile, Pangea had $4 trillion in output

but was only purchasing $3.5 trillion.

That means that it has $0.5 trillion

in unused goods piling up in warehouses.

Again if there is no net investment income

that means Pangea has a current account

surplus of $0.5 trillion

and since output equals income

and Pangeans have a total of $0.5 trillion

that they have earned but not spent

sitting around in their bank accounts.

As we've seen those unused Pangean goods

gets sold abroad

as a positive $0.5 trillion in net exports

and the $0.5 trillion in unspent Pangean money

will be loaned abroad

in the form of $-0.5 trillion

in the Pangean capital account.

Adding up a country's current account

and capital account will give

what's called the balance of payments.

In theory the current account

and the capital account

should wipe each other out.

For example,

Pangea has a current account net exports

of a positive $0.5 trillion

and a capital account

net borrowing of $-0.5 trillion.

So its balance of payments

should be zero.

And now you can see

how these two countries fit together.

Laurasia wants to buy

$0.5 trillion more goods

than its producing

and needs to borrow

$0.5 trillion more dollars

to pay for them.

Meanwhile, Pangea has produced

a $0.5 trillion more goods than it's using

and it has $0.5 trillion in dollars

sitting in its banks.

The obvious solution is for Pangean citizens

to lenders savings to the Laurasians

who use that extra money

to purchase and import

the extra Pangean output.