An open economy is a type of economy where not only domestic factors but also entities in other countries engage in trade of products (goods and services). Trade can take the form of managerial exchange, technology transfers, and all kinds of goods and services. (However, certain exceptions exist that cannot be exchanged; the railway services of a country, for example, cannot be traded with another country to avail the service.)
The act of selling goods or services to a foreign country is called exporting. The act of buying goods or services from a foreign country is called importing. Exporting and importing are collectively called international trade.
There are a number of economic advantages for citizens of a country with an open economy. A primary advantage is that the citizen consumers have a much larger variety of goods and services from which to choose. Additionally, consumers have an opportunity to invest their savings outside the country. There are also economic disadvantages of an open economy. Open economies are interdependent on others and this exposes them to certain unavoidable risks.
If a country has an open economy, that country's spending in any given year need not equal its output of goods and services. A country can spend more money than it produces by borrowing from abroad, or it can spend less than it produces and lend the difference to foreigners. As of 2014 there is no totally-closed economy.
In a closed economy, all output is sold domestically, and expenditure is divided into three components: consumption, investment, and government purchases.
Y = C + I + G
where Y is the national income, C is the total consumption, I is the total investment and G is the total government expenditure. In an open economy, some output is sold domestically and some is exported to be sold abroad. We can divide expenditure on an open economy's output Y into four components: Cd, consumption of domestic goods and services, Id, investment in domestic goods and services, Gd, government purchases of domestic goods and services, X, exports of domestic goods and services. The division of expenditure into these components is expressed in the identity
Y = Cd + Id + Gd + X.
The sum of the first three terms, Cd + I d + Gd, is domestic spending on domestic goods and services. The fourth term, X, is foreign spending on domestic goods and services (the value of exports). Since total domestic spending is a sum of spending on domestic as well as foreign goods and services, we can say that,
C = Cd + Cf, I = I d + I f, G = Gd + G f.
We substitute these three equations into the identity above: Y = (C - Cf ) + (I - I f ) + (G - G f ) + X. We can rearrange to obtain
Y = C + I + G + X - (Cf + I f + G f).
The sum of domestic spending on foreign goods and services (Cf + I f + G f) is expenditure on imports (IM). We can thus write the national income accounts identity as
Y = C + I + G + X - IM.
Since the value of total imports is a part of domestic spending and it is not a part of domestic output, it is subtracted from the total output. This gives us the value of Net Exports (NX = X - IM), the identity becomes
Y = C + I + G + NX.
In closed economy: National savings = Investment. Closed economy countries can increase its wealth only by accumulating new capital.
If output exceeds domestic spending s, we export the difference: net exports are positive. If output falls short of domestic spending, we import the difference: net exports are negative.
Begin with the identity
Y = C + I + G + NX.
Subtract C and G from both sides to obtain
Y - C - G = I + NX.
Y - C - G is national saving S, which equals the sum of private saving, Y - T - C, and public saving, T - G, where T stands for taxes. Therefore,
S = I + NX.
Subtracting I from both sides of the equation, we can write the national income accounts identity as
S - I = NX.
This shows that economy's net exports must be equal to the difference between savings and investment. Another name for net exports is the trade balance, as it tells us the difference between imports and exports from being equal.
The left-hand side of the identity is the difference between domestic saving and domestic investment, S - I, known as net capital outflow. Net capital outflow is equal to the amount that domestic residents are lending abroad minus the amount that foreigners are lending to home country. If net capital outflow is positive, the economy's saving exceeds its investment, and lending the excess to foreigners. If the net capital outflow is negative, the economy is experiencing a capital inflow: investment exceeds saving, and the economy is financing this extra investment by borrowing from abroad.
The national income accounts identity shows that net capital outflow always equals the trade balance. That is, Net Capital Outflow = Trade Balance
S - I = NX.
If S - I and NX are positive, we have a trade surplus. In this case, since our exports are higher than our imports, we are net lenders in world financial markets. If S - I and NX are negative, we have a trade deficit. In this case, we are importing more goods than we are exporting. And hence we are net borrowers in the world markets. If S - I and NX are exactly zero, we are said to have balanced trade because the value of imports exactly equals the value of our exports.
In case of a small open economy, perfect capital mobility is often assumed. By "small" it is understood that an economy has very small share in the world markets. Things that happen within the economy are thus assumed to have a negligible effect on interest rate. By perfect capital mobility, it is often meant that residents of a country have full access to goods and services and specifically financial markets of the world.
The assumption of perfect capital mobility, together with the very strong assumption of a perfect equilibrium, causes the interest rate in the small open economy, r, to equal the world interest rate r*, the real interest rate prevailing in world financial markets: r = r*.
This means that people in this small open economy will never borrow at more than rate r in the small open economy. They will shift to international markets to borrow or invest, in case r > r*. Because of the popularity of the small open economy model, it is often said that, the interest rates in a small open economy are determined by the world markets. The world interest rate is determined in another way, and often economists choose to model this through an equilibrium between world interest and world savings.