Chapter 18. Openness in Goods andFinancial MarketsWe have assumed until now that the economy wasclosed—that it did notinteract with the rest of the world. We had to start this way, to keep thingssimple and build up your intuition for the basic macroeconomic mechanisms.We are now ready to relax this assumption. Understanding the macroeconomicimplications of openness will occupy us for this and the next three chapters.“Openness” has three distinct dimensions:1.Openness in goods markets—the ability of consumers and firmsto choose between domestic goods and foreign goods. In no countryis this choice completely free of restrictions: Even the countries mostcommitted to free trade havetariffs—taxes on imported goods—andquotas—restrictions on the quantity of goods that can be imported—on at least some foreign goods. At the same time, in most countries,average tariffs are low and getting lower.2.Openness in financial markets—the ability of financial investorsto choose between domestic assets and foreign assets. Until recentlyeven some of the richest countries, such as France and Italy, hadcap-ital controls—restrictions on the foreign assets their domestic res-idents could hold and on the domestic assets foreigners could hold.These restrictions are rapidly disappearing. As a result, world financialmarkets are becoming more and more closely integrated.1
3.Openness in factor markets—the ability of firms to choose whereto locate production, and of workers to choose where to work. Herealso trends are clear. Multinational companies operate plants in manycountries and move their operations around the world to take advantageof low costs. Much of the debate about theNorth American FreeTrade Agreement (NAFTA)signed in 1993 by the United States,Canada, and Mexico centered on its implications for the relocationof U.S. firms to Mexico. Similar fears now center around China. Andimmigration from low-wage countries is a hot political issue in countriesfrom Germany to the United States.In the short run and in the medium run—the focus of this and the next threechapters—openness in factor markets plays much less of a role than opennessin either goods markets or financial markets. Thus, I shall ignore openness infactor markets, and focus on the implications of the first two dimensions ofopenness here.Section 18–1 looks at openness in the goods market, the determinants of thechoice between domestic goods and foreign goods, and the role of the realexchange rate.Section 18–2 looks at openness in financial markets, the determinants of thechoice between domestic assets and foreign assets, and the role of interestrates and exchange rates.Section 18–3 gives the map to the next three chapters.