Saving, Investment, in the Open Economy

1
Saving, Investment, in the Open Economy
2
Closed economy

• Y C I
• Y C S
• S I

3
Analysis of Saving, Investment, and Current
Account

• Closed economy

S
r
I
S,I
4
Open economy

• Saving does not have to equal investment
• National output that is not consumed is exported

5
Current account

• in a closed economy the current account is always
  0
• current account surplus--domestic economy lends
  more to foreigners than borrowed
• current account deficit--domestic economy borrows
  more from foreigners than lent

6
Balance of Payments

• Current Account
• Net exports
• Net income from abroad
• Net unilateral transfers
• Capital and Financial Account (KFA)
• Capital account net flows of assets unilaterally
  transferred into the country
• Financial Account when a country sells an asset
  to another country, it is recorded as a financial
  inflow
• Statistical discrepancy

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CA KFA 0
8
Current Account
9
Net International Investment Position of the US
10
Shock on savings

• An increase in income results in an increase in
  saving

S
r
S
I
S,I
11
Shock on Saving Investment

• An increase in saving and investment

S
r
S
I
I
S,I
12
An Open economy

• CA B - B-1
• where CA current account, and B represents the
  claim on foreign output
• CA is the change in net foreign assets
• B - B-1 Y NFP - C - I
• Household income (GNP GDP (Y) net income
  from abroad)

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S and the CA

• S Spvt SG
• Spvt Y NFP TR INT T C
• SG T G INT - TR
• S Y NFP TR INT T C T G INT - TR
• S Y NFP C G
• S I NFP NX
• S I CA

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• CA S - I
• Hence, S need not equal I. If I exceeds S, CA is
  in deficit, implying an decrease in claims on
  foreign output (or an increase in foreign claims
  on domestic output)
• Examples
• US during the 1980s sustained a fall in S
• Thailand in early and middle 1990s sustained an
  increase in I greater than S

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Expressing CA in terms of demand

• CA NX NFP
• CA Y NFP - (C I G)
• Ad C I G spending on domestic economy by
  residents (domestic absorption)
• CA Y NFP - Ad
• current account is in deficit when countries
  spend more than they earn, or I gt S

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Saving, Investment, and Current Account
CA
S
r
I
CA
0
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CA and International Trade

• Y Ad X - IM output produced must be absorbed
  domestically or exported
• NX X - IM
• Y - Ad
• trade balance equals output less domestic
  absorption
• CA Y- Ad NFP
• A Ad IM
• CA Y A NFP

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Absorption/GDP and the C/GDP
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Determination of the CA

• Assume a small country and a world interest rate

CA
S
r
I
CA
0
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Investment shock

• Example Norway in the 1970s

S
r
I
I
S,I
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Output Shock

• Example output drops owing to poor weather
• People wanting to maintain their level of
  consumption reduce their saving

S
r
S
I
S,I
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Terms of Trade shock

• Terms of trade (TT)--price of a countrys exports
  relative to the price of its imports Px/Pm
• An increase in Px increases output, increases
  saving, leads to a CA surplus

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• Transitory change in TT--allow CA to adjust
• Permanent change in TT--allow consumption to
  adjust

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Intertemporal budget constraint

• Assume the country starts with no foreign assets
• B1 Y1 - C1 - I1 CA1
• B2 - B1 Y2 rB-1 - C2 - I2
• C1 C2/(1r) (Y1 - I1) Y2/(1r)

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Implications

• what is true for households is true for
  individual
• a country cannot run a permanent CA deficit
• if a country runs a deficit the first year, it
  runs a surplus the second
• if a country runs a surplus the first year, it
  runs a deficit the second

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Limitations on Foreign borrowing

• Administrative controls--restrictions on
  borrowing, lending, etc.
• domestic savings cannot be used to purchase
  foreign financial assets
• this would cause the domestic interest to differ
  from the world interest rate, in this case r
  would fall leading to an increase in investment
  and an increase in Y1 (but not Y1)

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• result of capital controls is that the nation is
  at a lower level of welfare see p. 174)

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Large country effects on world interest rates

• In a world economy, rw is such that Iw Sw
• I(r) I(r) S(r) S(r)
• S(r) - I( r) S(r) - I(r)
• CA( r) - CA(r)

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• Under capital mobility interest rates will
  equalizeUnder capital restrictions interest
  rates will differa change in S or I in a large
  country may have profound changes in the CA

S
r
r
S
I
I
I,S
0
I,S
30
Fiscal Policy and the CA

• Increases in government deficit reduce the CA if
  national saving falls

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Government deficit and national saving

• Deficit caused by government purchases reduce CA
• CA Y Ad
• Ad C I G
• Deficit caused by tax cut
• Reduces CA only if C rises
• Ricardian equivalence CA remains unchanged