CHAPTER 5: SAVING AND INVESTMENT IN THE OPEN ECONOMY
LEARNING OBJECTIVES
A. When an economy is closed then (1) aggregate spending must equal domestic
production, and (2) national saving must equal domestic investment.
B. When the economy is open, these conditions do not have to hold.
a. Aggregate spending does not have to equal domestic production in each
period. Countries can export and import goods and services.
b. National saving does not have to equal domestic investment in each
period. Countries can borrow and lend internationally
c. Real interest rate is determined in the world capital market
d. A country's trade position with other countries depends on its saving
and investment decisions
I. Balance of Payments Accounting
A. Balance of Payments Accounts
1. The record of a country's international transactions (in goods, services,
real and financial assets, transfers,…)
2. Data collected by BEA, Dept. of Commerce, released quarterly in Survey
of Current Business
Recent U.S. Data (Table 5.1)
3. How to read the data?
a. Any transaction that involves a flow of funds into the United States
is a credit (+) item (enters with a plus sign); examples: exports, working
overseas, selling our stocks and bonds and official reserves to overseas
b. Any transaction involving a flow of funds out of the United States
is a debit (-) item (enters with a minus sign); examples: imports, foreign
workers income, buying foreign stocks and bonds and official reserves
from overseas
4. It consists of two major accounts: (1) the current account, (2) the
capital and financial account
B. The Current Account Balance: is a record of a country's net foreign
trade, net foreign income, and its net unilateral transfers with other
countries
1. Net Exports of Goods and Services
a. Merchandise trade balance: Exports of goods minus imports of goods
b. Net exports of services (transportation, tourism, insurance, education,
financial services) are also important
2. Net Income from Abroad
a. Income received from abroad is a credit item (funds flow into the country)
b. Income paid to foreigners is a debit item (funds flow out of the country)
3. Net Unilateral Transfers
a. Payments made from one country to another (official foreign aid, gifts)
b. United States is a net donor to other countries (negative number)
4. Current Account Balance = Net Exports of g&s + Net Income from
Abroad + Net Unilateral Transfers
a. Positive current account balance implies current account surplus
b. Negative current account balance implies current account deficit
Data Application:
The contrast between our trade balance, net exports, and the current account
balance is pretty dramatic, as we tend to import a lot of goods but export
many services.
1981 1998
Trade Balance -$28 B -$247 B
Net Exports -$15 B -$164 B
Current Account Balance +$5 B -$220 B
C. The capital and financial account
1. The capital and financial account records trades in real and financial
assets between U.S. and other countries.
2. The capital account records the net flow of unilateral transfers of
assets into the country
(Ex. debt forgiveness, immigration)
3. The financial account records the net flow of funds due to trade in
real and financial assets.
a. When we sell an asset to a foreign country, that is a capital inflow
for the U.S. and a credit (+) item in the capital and financial account
b. When we purchase an asset from another country, there is a capital
outflow from the U.S. and a debit (-) item in the capital and financial
account
4. The official settlements balance
a. Transactions in official reserve assets are conducted by central banks
of countries
b. Official reserve assets are assets (foreign government securities,
bank deposits, and SDRs of the IMF, gold) used in making international
payments
c. Central banks buy (or sell) official reserve assets with (or to obtain)
their own currencies
d. Official settlements balance
(1) Also called the balance of payments, equals the net increase in a
country's official reserve assets
(2) For the United States, the net increase in official reserve assets
is the rise in U.S. government reserve assets minus foreign central bank
holdings of U.S. dollar assets
e. A balance of payments surplus means a country is increasing its official
reserve assets;
a balance of payments deficit means a reduction in official reserve assets.
D. The relationship between the current account and the capital account
1. CA + KFA = 0 by accounting; every transaction involves offsetting effects
2. Examples given of offsetting transactions (text Table 5.2)
E. Net foreign assets and the balance of payments accounts
1. Net foreign assets refer to a country's foreign assets minus its foreign
liabilities
2. Net foreign assets increase when the current account is in a surplus,
or the capital and financial account is in a deficit (financial outflow)
3. Similarly, net foreign assets falls when there is a current account
deficit or a capital and financial account surplus (a financial inflow)
4. Current account surplus = capital and financial account deficit = net
acquisition of foreign assets = net foreign lending = net exports (if
NFP and net unilateral transfers are zero)
F. Application: The United States as international debtor
1. The U.S. foreign liabilities has increased drastically since the early
1980s
2. The U.S. has become the world's largest international debtor in absolute
terms
3. However, its debt relative GDP is only 18%, which is small compared
to other countries
II. Goods Market Equilibrium for an Open Economy
A. NIPA for open economy (1) S = I + CA = I + (NX + NFP)
and (2) Y = C+I+G+NX
1. National saving has two uses:
a. To finance domestic investment
b. To increase net foreign assets (lend to other countries)
2. Aggregate output [GNP (= GDP+NFP)] has four uses:
a. For domestic consumption
b. For domestic investment
c. For government use
d. For net exports to other countries
2. Goods market equilibrium in an open economy can be represented in
two ways:
a. Desired national saving = desired domestic investment+ foreign investment:
Sd = Id + CA = Id + (NX + NFP)
If we assume NFP = 0, then Sd = Id + NX
b. Aggregate output supplied = aggregate output demanded Y = Cd + Id +
G + NX
c. The two approaches are equivalent.
III. Relation between Saving, Investment, foreign trade, and foreign lending
Case 1. In a Small Open Economy
A. Small open economy: an economy which its saving/investment activities
have no effect on the world real interest rate
1. World real interest rate (rw) is determined in the international financial
market
2. Residents of the small open economy can borrow or lend at the world
real interest rate
3. Result: rw may be such that Sd > Id, Sd = Id, or Sd < Id
a. If rw = 6%, then Sd > Id, so the excess saving is lent internationally
(net foreign lending is positive) and NX > 0
r
Foreign lending = 4 Saving curve
rw = 6%
rd = 4% A
Investment curve
1 3 5
b. If rw = rd=4%, then Sd = Id, so there is no net foreign lending and
NX = 0
r
Saving curve
rw = rd = 4% A
Investment curve
1 3 5
c. If rw = 2%, then Sd < Id, so the excess of desired investment is
financed by borrowing internationally (net foreign lending is negative)
and NX < 0
r
Saving curve
rd = 4% A
rw = 2%
Net foreign borrowing Investment curve
1 3 5
d. Net exports = net foreign lending = current account surplus (assuming
NFP= net unilateral transfers=0) = net increase in foreign assets
B. The effects of economic shocks on S, I, foreign trade and capital flows
in a small open economy
Definition: Economic shock: any factor that causes S and I curves to shift.
Case 1. A temporary adverse supply shock (drought) which causes a temporary
drop in income:
Result: a drop in national saving, and a decline in foreign lending
r
S1 S0
rw = 6%
I
1 3 5
Case 2: An increase in the expected future marginal product of capital:
Results: an increase in desired investment, so net foreign lending falls;
r
S1 S0
rw = 6%
I1
I0
Case 3. An increase in desired national saving (due to a rise in Y, a
fall in future Y, or a fall in G) at a given world real interest rate
Result: Increase in foreign lending and net exports.
r
CA = NX = net lending = 4 S0 S1
rw = 6%
I
1 3 5 7
Summary:
1. Any change that increases desired national saving relative to desired
investment at a given world real
interest rate, will increase net foreign lending, the current account
balance, and net exports.
2. Any change that reduces desired national saving relative to desired
investment at a given world real interest rate, will reduce net foreign
lending, the current account balance, and net exports.
Case 2: Large Open Economies
Large open economy: Its saving and investment decisions affect the world
real interest rate
1. Suppose there are only two large economies in the world
a. The home or domestic economy (saving S, investment I)
b. The foreign economy, representing the rest of the world (saving SFor,
investment IFor)
c. The world real interest rate moves to equilibrate desired international
lending by one country with desired international borrowing by the other
S Sfor
rw
I Ifor
Equivalent statement: The equilibrium world real interest rate is determined
such that a current account surplus in one country is equal in magnitude
to the current account deficit in the other
Changes in the equilibrium world real interest rate:
Any factor that increases desired international lending of a country relative
to desired international borrowing causes the world real interest rate
to fall
IV Fiscal Policy and the Current Account
Do government budget deficits necessarily cause current account deficits?
"twin deficits"?
A. The critical factor: the response of national saving
c A budget deficit causes a current account deficit only if desired national
saving falls
B. The government budget deficit and national saving
Case 1. A deficit caused by increased government purchases
The deficit definitely reduces national saving: S = Y - C - G
Result: The current account balance declines
Case 2. A deficit resulting from a tax cut
d. Sd falls only if Cd rises
e. Sd won't change if Ricardian equivalence holds, since then a tax cut
won't affect consumption
f. But if people don't foresee the future taxes implied by today's tax
cut, they will consume more, desired saving will decline, and so will
the current account balance
C. Application: the twin deficits
1. U.S. data suggests that for the periods of 1980s and early 1990s, budget
deficit and current account deficit move together.
2f Other times (during World Wars I and II, and during 1975) budget deficits
grew, yet the current account balance increased
3. No conclusive evidence
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