Chapter 5. Saving and Investment in the Open Economy. Copyright 2009 Pearson Education Canada

This Chapter Key change in an open economy: domestic spending need not equal domestic production in every year. International Trade and international borrowing and lending allows countries to break this link. We ll start with some definitional accounting before we can proceed to the analysis Copyright 2009 Pearson Education Canada 5-2

Balance of Payments Accounting The balance of payments accounts are the record of country s international transactions. ti Any transaction that involves a flow of funds into Canada is a credit item (+). Any transaction that involves a flow of funds out of Canada is a debit item (-). Balance of payments is made of two accounts: the current account (CA) and the capital and financial i account (KA). Copyright 2009 Pearson Education Canada 5-3

The Current Account The current account (CA) measures a country s trade in currently produced goods and services, along with net transfers between countries. The components of the current account balance are: Net exports of goods and services; Investment income from assets abroad; Current transfers. Copyright 2009 Pearson Education Canada 5-4

Net Exports of Goods and Services Net Exports are often broken down into two categories: merchandise (goods) and services Merchandise trade is trade in goods. A car brought to Canada from Japan is a merchandise import for Canada. It is a debit item for Canada (-). It is a credit item for Japan (+). Copyright 2009 Pearson Education Canada 5-5

Net Exports of Goods and Services (continued) The trade in services includes, for example, transportation or tourism: A Canadian tourist in Mexico is an import of tourism services for Canada. It is a debit item for Canada (-). It is a credit item for Mexico (+). Copyright 2009 Pearson Education Canada 5-6

Investment Income from Assets Abroad Investment income is interest payments, dividends, and royalties a country s residents receive from assets owned abroad. NFP and net investment income from abroad are equivalent concepts for Canada, (i.e. wages and earnings are small). so they are treated equivalently. Copyright 2009 Pearson Education Canada 5-7

Current Transfers Current transfers are payments from one country to another that do not correspond to the purchase of any good, service or asset. A transfer by a Canadian abroad is adebit item (-) () for Canada. ada E.g. Official foreign aid (payment from one government to another), money gifts from one resident of a country to another. Copyright 2009 Pearson Education Canada 5-8

Current Account Balance The current account balance is obtained by adding all the credit items and subtracting ti all the debit items. A current account surplus is a positive current account balance. A current account deficit is a negative current account balance. The Canadian CA balance in 2006 was $23.6 B, a CA surplus Copyright 2009 Pearson Education Canada 5-9

The Capital Account The capital and financial account (KA) is made up of: The financial account records real (direct) and financial (portfolio) investment. The capital account records migrants funds, inheritances, transaction of intellectual property This is frequently referred to simply as the capital account (KA) Copyright 2009 Pearson Education Canada 5-10

The Capital Account (Continued) If Canada sells an asset to another country it is a financial inflow for Canada; a credit item (+) in the KA. If Canada ada buys an asset from abroad it is a financial outflow for Canada; ada; a debit item (-) in the KA. Copyright 2009 Pearson Education Canada 5-11

The Capital Account Balance The capital account balance equals the value of capital inflows (credit items) minus the value of capital outflows (debit items). If the KA balance >0 then there is a capital account surplus. If the KA balance <0 then there is a capital account deficit. The Canadian KA balance in 2006 was -$18.5 B, a KA deficit i Copyright 2009 Pearson Education Canada 5-12

The Official Settlements Balance The official i settlements balance (or the balance of payments) is the net increase in the entry Official Reserve Assets. Official reserve assets: assets other than domestic money or securities (foreign govt securities, bank deposits, IMF deposits, gold) used in making international payments. Transactions in official reserve assets are different from other KA transactions because they re conducted by central banks of countries. The official i settlements t balance can be in surplus or in deficit. Copyright 2009 Pearson Education Canada 5-13

The Relationship between the CA and the KA In each period, the current account (CA) balance and the capital account (KA) balance must sum to zero: CA + KA = Intuition: by accounting, every transaction involves offsetting effects. But, in practice, measurement problems, recorded as a statistical discrepancy, prevent CA+KA = 0 from holding exactly. 0 Copyright 2009 Pearson Education Canada 5-14

The Current and the Capital Accounts (continued) The statistical discrepancy is the amount to be added to the sum of CA and KA balances to reach its theoretical value of zero. In Canada in 2006, it was estimated to be -$5.1 B! Copyright 2009 Pearson Education Canada 5-16

Net Foreign Assets and the Balance of Payments Net foreign assets (foreign assets foreign liabilities) can change when: the value of existing foreign assets and foreign liabilities changes E.g. Value of stock held in a foreign corporation increases in value the country acquires new foreign assets or incurs new liabilities. The net amount of new foreign assets a country acquires equals its current account surplus (decrease foreign debt) Copyright 2009 Pearson Education Canada 5-17

Goods Market Equilibrium in an Open Economy Recall in Ch 2 we derived d the uses- ofsaving identity: S = I + CA = I + (NX + NFP) Which tells us that national saving (S) has two uses: increase the nation s stock of capital by funding investment (I); increase the nation s stock of net foreign assets by lending to foreigners (CA). Copyright 2009 Pearson Education Canada 5-18

Goods Market Equilibrium in an Open Economy The closed economy goods market equilibrium holds when I and S equal their desired d levels. l In an open economy equilibrium, desired d saving (S d ) equals desired d domestic investment (I d ) plus amount lent abroad (CA): S d = I d + CA = I d + (NX + NFP) Copyright 2009 Pearson Education Canada 5-19

The Goods Market Equilibrium (continued) Assume NFP is zero, then the openeconomy goods market equilibrium condition is: d d S = I + NX d d NX = Y -(C + I + G) (C d +I d +G) is called absorption the total spending by domestic residents An economy in which production exceeds absorption will send goods abroad (NX>0) and have a current account surplus (CA>0), and vice versa for an economy that absorbs more than it produces. Copyright 2009 Pearson Education Canada 5-20

Saving and Investment in a Small Open Economy A small open economy is an economy that is too small to affect the world real interest rate. The world real interest rate (r w ) is the real interest rate that prevails in the international capital market. The market in which economic agents borrow and lend across national borders Canada is an example of a small open economy, so we will take the world real interest rate as fixed Copyright 2009 Pearson Education Canada 5-21

A Small Open Economy: Assumptions of the Model The markets for financial capital are open to all savers and borrowers regardless of where they live. Thus, for a small open economy o the domestic real interest rate will adjust in the long run to the (expected) world interest rate. Copyright 2009 Pearson Education Canada 5-22

The Model of a Small Open Economy In an open economy, desired d national saving need not equal desired investment. Higher values of the world real interest t rate (r w ) imply: lower levels of desired consumption (people save more); lower desired investment (higher uc). ) Our saving and investment model can be used to determine the excess between S and I, the current account balance. Copyright 2009 Pearson Education Canada 5-24

The Model of a Small Open Economy There are 3 equilibrium possibilities: 1. r = > * d > d w r 1 r, then S I World interest rate higher than the one which would clear the domestic savings market. (Savers gain) In a closed economy, r would have to fall, but now savers can lend abroad. Excess of S d over I d is lent internationally (net foreign lending is positive), and CA > 0, KA < 0 Copyright 2009 Pearson Education Canada 5-25

The Model of a Small Open Economy 2. r w = r 2 = r *, then S d = I d World interest rate equal to the one which would clear the domestic savings market. No net foreign lending, and CA =0 3. r * d d w = r 3 < r, then S < I World interest rate lower than the one which would clear the domestic savings market. (Borrowers gain) Excess of I d over S d is financed by borrowing internationally (net foreign lending negative), and CA < 0, KA > 0 Copyright 2009 Pearson Education Canada 5-27

The Model of a Small Open Economy Apart from the interest rate, other factors affect the expected rate of return on international investments: transaction costs tax rates on interest income exchange rate risk political risk Copyright 2009 Pearson Education Canada 5-29

Economic Shocks in a Small Open Economy The S-I diagram can be used to determine the effects of economic disturbances that affect desired d S or I Anything that increases desired national saving ( Y, future Y, G) relative to desired national investment ( MPK f, t) at a given world real interest rate (r w ) will: increase net foreign lending; increase the current account balance; increase net exports. Copyright 2009 Pearson Education Canada 5-30

E.g. A Temporary Adverse Supply Shock A severe drought when the CA is in surplus will cause: Current income to fall, so savings will fall at every r (the saving curve shifts left) as people reduce their saving to smooth consumption (C d ); The investment curve to be unaffected; Shock is temporary; doesn t affect MPK f Net foreign lending and current account to shrink since the country saves less Copyright 2009 Pearson Education Canada 5-31

E.g. A Permanent Positive Supply Shock A technological innovation, when the CA is in surplus will cause; S d unaffected Expected future MPK f increases I d rises at every r (shifts right) Domestic K increases Net foreign lending increases, CA shrinks, absorption increases (C d + I d +G) since building K more profitable domestically Copyright 2009 Pearson Education Canada 5-33

A Large Open Economy: Assumptions of the Model A large open economy is an economy large enough to affect the world real interest rate. To illustrate how the model now works, suppose the world consisted of only two large economies: the domestic and the foreign economy. The world real interest t rate is determined d within the model. It is not fixed. The world interest rate will be such that desired international lending by one country equals desired international borrowing by the other country. Copyright 2009 Pearson Education Canada 5-37

A Large Open Economy: the Equilibrium The lending country s CA surplus will be equal the borrowing country s CA deficit. The world desired d saving will be equal to the world desired investment. Changes in the r w : for example, any factor that increases desired international lending of a country relative to desired international borrowing causes the world real interest rate to fall. Copyright 2009 Pearson Education Canada 5-38

A Large Open Economy: The World Real Interest Rate Large open economy: changes in desired saving and desired investment t affect r w With only two economies: Home economy (S d, I d ) and Foreign economy, Rest of the World (S Fd, I Fd ) Shocks to the home economy are going to have spill-over effects on the R-o-W, and vice-versa Copyright 2009 Pearson Education Canada 5-41

Fiscal Policy and the Current Account Are government budget deficits necessarily accompanied by CA deficits? That is, are there twin deficits? it We know that an increase in the government budget deficit will raise the CA deficit only if this increase reduces S d. Then, less saving would be sent abroad and the current account would fall. How can the budget deficit increase? Either by increasing G or decreasing T. Copyright 2009 Pearson Education Canada 5-42

The Government Budget Deficit and National Saving The deficit caused by increased government purchases reduces desired national saving S d = Y - C d -G The CA balance declines. We have a twin deficit. In contrast, if the increase in the budget deficit has no effect on the national saving, the CA is also unaffected: there is no twin deficit. Copyright 2009 Pearson Education Canada 5-43

The Budget Deficit and National Saving (continued) The deficit caused by cuts in current taxes will cause S d to fall only if it causes desired consumption to rise. Cuts in current taxes do not raise desired consumption when the Ricardian equivalence holds. The empirical evidence on the Ricardian equivalence is mixed (cf. Barro, Poterba & Summers, etc.) Hence, twin deficit logic might still hold. Copyright 2009 Pearson Education Canada 5-45