Class Notes. Chapter 5 Saving and Investment in the Open Economy Learning Objectives

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1 1 Chapter 5 Saving and Investment in the Open Economy Learning Objectives A. Explain how the balance of payments is calculated (Sec. 5.1) B. Discuss goods market equilibrium in an open economy (Sec. 5.2) C. Describe the factors that affect saving and investment and determine the current account balance in a small open economy (Sec. 5.3) D. Describe the factors that affect saving and investment and determine the current account balance in a large open economy (Sec. 5.4) E. Analyze the relationship between the government budget deficit and the current account deficit (Sec. 5.5) Class Notes I. Balance of Payments Accounting (Sec. 5.1) A. Balance of payments accounts 1. The record of a country s international transactions 2. Any transaction that involves a flow of money into the United States is a credit ( ) item (enters with a plus sign); for example, exports 3. Any transaction involving a flow of money out of the United States is a debit ( ) item (enters with a minus sign); for example, imports B. The current account 1. Net exports of goods and services 2. Net income from abroad a. Income received from abroad is a credit item, since it causes funds to flow into the United States b. Payment of income to foreigners is a debit item c. Net income from abroad is part of the current account, and is about equal to NFP, net factor payments 3. Net unilateral transfers a. Payments made from one country to another b. Negative net unilateral transfers for United States, since United States is a net donor to other countries 4. Sum of net exports of goods and services, net income from abroad, and net unilateral transfers is the current account balance a. Positive current account balance implies current account surplus b. Negative current account balance implies current account deficit Current Account Net exports Exports of goods Exports of services Imports of goods Imports of services Net income from abroad Income receipts from abroad Income payments to foreigners Net unilateral transfers Debit ( ) Credit ( )

2 Transfers from foreigners Transfers to foreigners Capital and Financial Account Capital account Financial account Increase in foreign-owned assets Increase in U.S.-owned assets abroad C. The capital and financial account 1. The capital and financial account records trades in existing assets, either real (for example, houses) or financial (for example, stocks and bonds) 2. The capital account records the net flow of unilateral transfers of assets into the country 3. Most transactions appear in the financial account part of the capital and financial account a. When home country sells assets to foreign country, that is a capital inflow for the home country and a credit ( ) item in the capital and financial account b. When assets are purchased from a foreign country, there is a capital outflow from the home country 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, it 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. Having a balance of payments surplus means a country is increasing its official reserve assets; a balance of payments deficit is a reduction in official reserve assets D. The relationship between the current account and the capital and financial account 1. Current account balance (CA) capital and financial account balance (KFA) 0 (5.1) 2. CA KFA 0 by accounting; every transaction involves offsetting effects 3. Examples given of offsetting transactions (text Table 5.2) 4. In practice, measurement problems, recorded as a statistical discrepancy, prevent CA KFA 0 from holding exactly E. Net foreign assets and the balance of payments accounts 1. Net foreign assets are a country s foreign assets minus its foreign liabilities a. Net foreign assets may change in value (example: change in stock prices) b. Net foreign assets may change through acquisition of new assets or liabilities 2. The net increase in foreign assets equals a country s current account surplus 3. A current account surplus implies a capital and financial account deficit, and thus a net increase in holdings of foreign assets (a financial outflow) 4. A current account deficit implies a capital and financial account surplus, and thus a net decline in holdings of foreign assets (a financial inflow) 5. Foreign direct investment: a foreign firm buys or builds capital goods a. Causes an increase in capital and financial account balance b. Portfolio investment: foreigners acquire U.S. securities; also increases capital and financial account balance

3 6. Summary: Equivalent measures of a country s international trade and lending Current account surplus capital and financial account deficit net acquisition of foreign assets net foreign lending (if NFP and net unilateral transfers are zero) net exports II. Goods Market Equilibrium in an Open Economy (Sec. 5.2) A. From Ch. 2, S I CA I (NX NFP) (5.2) 1. So national saving has two uses: a. Increase the capital stock by domestic investment b. Increase the stock of net foreign assets by lending to foreigners 2. To get goods market equilibrium, national saving and investment must equal their desired levels: a. S d I d CA I d (NX NFP) (5.3) b. Goods market equilibrium in an open economy c. Assuming net factor payments are zero, then S d I d NX (5.4) 3. Alternative method: a. Y C d I d G NX (5.5) b. NX Y (C d I d G) (5.6) Net exports equal output (Y) minus absorption (C d I d G) III. Saving and Investment in a Small Open Economy (Sec. 5.3) A. Small open economy: an economy too small to affect the world real interest rate 1. World real interest rate (r w ): the real interest rate in the international capital market 2. Key assumption: Residents of the small open economy can borrow or lend at the expected world real interest rate (Figure 5.1) 3. Result: r w may be such that S d > I d, S d I d, or S d < I d a. If r w r 1, then S d > I d, so the excess of desired saving over desired investment is lent internationally (net foreign lending is positive) and NX > 0 b. If r w r 2, then S d I d, so there is no net foreign lending and NX 0 c. If r w r 3, then S d < I d, so the excess of desired investment over desired saving is financed by borrowing internationally (net foreign lending is negative) and NX < 0 4. Alternative interpretation: in terms of output and absorption 5. Net exports equals net foreign lending equals the current account balance (assuming net factor payments and net unilateral transfers are zero) B. The effects of economic shocks in a small open economy 1. Anything that increases desired national saving (Y rises, future output falls, or G falls) relative to desired investment (MPK f falls, rises) at a given world interest rate increases net foreign lending, and vice versa

4 2. A temporary adverse supply shock: Temporary drop in income leads to a drop in saving, so net foreign lending declines; shown in text Figure An increase in the expected future marginal product of capital Desired investment rises, so net foreign lending falls; shown in text Figure 5.5 IV. Saving and Investment in Large Open Economies (Sec. 5.4) A. Large open economy: an economy large enough to affect the world real interest rate 1. Suppose there are just two 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 S For, investment I For ) 2. The world real interest rate moves to equilibrate desired international lending by one country with desired international borrowing by the other (Figure 5.2) 3. 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 4. 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 Application: The impact of globalization on high income economies 1. World s economies are increasingly interdependent more international trade and investment a. Should high income reign in globalization? 2. Costs of globalization: high income economies suffer job losses in particular sectors 3. Benefits of globalization: high income economies gained jobs in particular sectors a. High income economies exports increase b. Cheaper imported goods means more goods & services at lower prices gains from trade 4. Recent years: big changes in business services industry call centers, etc. a. Critics: moving jobs abroad b. Reality: high income economies are world leaders in exporting business services. c. So high income economies benefits from such activity far more than they lose C. Application: Recent trends in the U.S. current account deficit 1. U.S. current account deficit is large (text Fig. 5.8) 2. Why did U.S. current account deficit increase from 1991 to 2005? a. Lower foreign demand b. Better international investment opportunities c. Higher oil prices d. Increased saving by developing countries 3. Lower foreign demand a. Slower economic growth in Japan and Europe in early 2000s

5 b. People there are saving more and investing in U.S. more, but buying fewer U.S. goods 4. Better international investment opportunities (text Fig. 5.9) a. U.S. investors diversifying investments internationally b. Foreign investors investing more in U.S. 5. Higher oil prices a. U.S. imports much more oil than it exports b. Doubling of oil prices recently led to decline in current account balance of over 1% of GDP (text Fig. 5.10) 6. Increased saving by developing countries a. Many developing nations want to invest in safe places like U.S., rather than borrowing and getting into financial crises b. They changed from being international borrowers to being international lenders 7. Some people also blame U.S. government deficit twin deficits argument a. But in late 1990s, U.S. government ran surpluses, and current account deficit got larger b. Other countries with current account surpluses also run larger government budget deficits than U.S. V. Fiscal Policy and the Current Account (Sec. 5.5) Are government budget deficits necessarily accompanied by current account deficits? That is, are there twin deficits? A. The critical factor: the response of national saving 1. An increase in the government budget deficit raises the current account deficit only if the increase in the budget deficit reduces desired national saving 2. In a small open economy, if an increase in the government budget deficit reduces desired national saving, the saving curve shifts left, thus reducing the current account balance (text Fig. 5.11) B. The government budget deficit and national saving 1. A deficit caused by increased government purchases a. No question here: The deficit definitely reduces national saving b. Result: The current account balance declines 2. A deficit resulting from a tax cut a. S d falls only if C d rises b. So S d won t change if Ricardian equivalence holds, since then a tax cut won t affect consumption c. But if people don t foresee the future taxes implied by a tax cut today, they will consume more, desired saving will decline, and so will the current account balance C. Application: the twin deficits 1. Relationship between the U.S. government budget deficit and U.S. current account deficit 2. Text Figure 5.12 shows data 3. The deficits appear to be twins in the 1980s and early 1990s, moving closely together 4. But at other times (during World Wars I and II, and during 1975) government budget deficits grew, yet the current account balance increased