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eco-1002 · Open economy

Open-Economy Macro and the Real Exchange Rate

Trade balance as the mirror of saving minus investment; how the real exchange rate adjusts to keep the two sides equal; what tariffs actually do (and don't do).

⏱ 20 min Tags: open economy, exchange rates, trade balance

Learning objectives

  • State the saving-investment identity for an open economy: S − I = NX.
  • Predict the real exchange rate response to a saving or investment shock.
  • Explain why tariffs don't change the trade balance in this framework.

The fundamental identity

In any open economy, what a country saves and doesn’t invest at home must flow somewhere — by accounting, it flows abroad as a net capital outflow, which is exactly equal to net exports:

S−I=NX.S - I = NX.

If the US saves more than it invests, S−I>0S - I > 0, so NX>0NX > 0: the US runs a trade surplus and accumulates foreign assets. If the US invests more than it saves, NX<0NX < 0: a trade deficit, financed by foreign borrowing.

The real exchange rate is the price that clears trade

The real exchange rate ε\varepsilon is how many units of foreign goods trade for one unit of US goods. A higher ε\varepsilon (a stronger dollar in real terms) makes US exports more expensive and imports cheaper, reducing NXNX.

Equilibrium ε∗\varepsilon^* is whatever value makes NX(ε)=S−INX(\varepsilon) = S - I. If saving rises, the right-hand side rises, so NXNX must rise, which requires ε\varepsilon to fall — a weaker real dollar.

The nominal broad US dollar index, daily, from 2006 to 2024.
The dollar against a basket of major trading-partner currencies since 2006 (index value, not a single bilateral rate). Notable moves: 2008–2009 flight-to-safety surge, 2014–2015 strong-dollar period as the Fed exited ZLB ahead of others, 2022 spike alongside the Fed's aggressive tightening, partial reversal through 2023. The model in this lesson is what determines this index in the long run.Source: FRED, St. Louis Fed (DTWEXBGS)
Saving S
$1600B
Investment I
$1500B
Net capital outflow (S − I)
$100B
Real exchange rate ε*
1.14

A small open economy takes the world real rate as given. Higher domestic saving raises S − I (more capital flowing abroad), which requires a weaker domestic currency (lower ε) to generate the offsetting trade surplus. Tariffs shift the NX curve right but don't change the equilibrium quantity of NX — they just appreciate the currency. Trade balance is set by saving-investment, not by protection.

Try raising the world real rate (slider) and watch what happens. Higher world rr pulls capital out of the US, lowers investment, raises S−IS - I, and weakens the dollar to boost net exports.

Why tariffs don’t work the way people think

Try sliding the tariff lever. A protective tariff shifts the NXNX curve right at any given ε\varepsilon. But the equilibrium quantity of NXNX doesn’t change — it’s still equal to S−IS - I. What changes is ε\varepsilon: the dollar appreciates by exactly enough to offset the tariff. American consumers pay more for imports, but the trade balance doesn’t move.

This is the incidence of tariffs result that surprises non-economists: saving and investment determine the trade balance, and a tariff just changes the prices at which trade happens.

Practice quiz →