Saving and Investment in the Open Economy

Learning Objectives

• Explain how the balance of payments is calculated

• Discuss goods market equilibrium in an open economy

• Describe the factors that affect saving and investment and determine the current account balance in small and large open economies

• Analyze the relationship between government budget deficits and current account deficits

Balance of Payments Accounting

Overview of Balance of Payments

The balance of payments is a systematic record of a country’s international transactions over a period, typically reported quarterly. It consists of three main accounts: the current account, the financial account, and the official reserve account.

• Current Account: Records trade in goods and services, net income from abroad, and net transfers.

• Financial Account: Records transactions in existing assets (real and financial), such as stocks, bonds, and real estate.

• Official Reserve Account: Tracks changes in central bank holdings of foreign assets (e.g., gold, foreign currency, SDRs).

Current Account

• Includes exports and imports of goods and services, net factor income (such as interest and dividends), and net transfers (such as foreign aid).

• Example: In 1991, the U.S. received over $31 billion in transfers from foreign countries to cover Gulf War expenses.

Financial Account

• Records capital inflows and outflows.

• Capital inflow: Home country sells assets to foreigners (financial account balance increases).

• Capital outflow: Home country buys assets from foreigners (financial account balance decreases).

• Balance formula:

Official Reserve Account

• Central banks manage official reserve assets to facilitate international payments.

• For the U.S., the Federal Reserve Bank of New York handles these transactions.

• Balance of payments surplus: Increase in official reserve assets.

• Balance of payments deficit: Decrease in official reserve assets.

Net Foreign Assets

• Defined as a country’s foreign assets minus its foreign liabilities.

• Changes in net foreign assets can result from asset value changes or acquisition/disposal of assets/liabilities.

• Relationship:

• Current account surplus implies financial account deficit (net foreign asset holdings rise).

• Current account deficit implies financial account surplus (net foreign asset holdings decline).

Types of Foreign Investment

• Foreign Direct Investment (FDI): Foreign firms buy/build capital goods in the home country.

• Portfolio Investment: Foreigners acquire securities (stocks, bonds) in the home country.

Application: The United States as International Debtor

• The U.S. has become the world’s largest international debtor since the early 1980s.

• Net foreign debt relative to GDP is significant but not extreme compared to some countries.

• Direct foreign investment by the U.S. abroad is roughly equal to foreign investment in the U.S.

• Key concern: If net foreign debt rises faster than national wealth, it may pose economic risks.

Goods Market Equilibrium in an Open Economy

Equilibrium Condition

In an open economy, goods market equilibrium occurs when aggregate demand equals aggregate supply, considering both domestic and foreign transactions.

• Key equation:

• Where is output (GDP), is consumption, is investment, is government purchases, and is net exports.

Saving and Investment in a Small Open Economy

Small Open Economy Characteristics

A small open economy takes the world real interest rate as given and can borrow or lend freely in international markets.

• National saving and investment are determined by domestic factors and the world interest rate.

• Net exports equal the difference between national saving and investment:

• If saving exceeds investment, the country lends abroad (current account surplus).

• If investment exceeds saving, the country borrows from abroad (current account deficit).

Effects of Shocks and Policy

• Temporary adverse supply shocks reduce income and saving, decreasing net foreign lending.

• Government budget deficits can reduce national saving, shifting the saving curve left and increasing the current account deficit.

International Capital Market Functioning

• Research shows small economies can borrow/lend internationally with little effect on real interest rates.

• Larger economies have a closer relationship between saving and investment, affecting the real interest rate.

Default and Reputation

• Sovereign governments may default under unexpected circumstances, yet can regain access to international lending if reputation is maintained.

Saving and Investment in Large Open Economies

Large Open Economy Characteristics

Large open economies influence the world real interest rate through their saving and investment decisions.

• Equilibrium world real interest rate is set so that the sum of current account surpluses and deficits across countries is zero.

• Integrated capital markets allow free flow of funds, but restrictions (e.g., capital controls) can alter equilibrium.

• Factors increasing desired international lending relative to borrowing cause the world real interest rate to fall.

Effects of Policy and Shocks

• Changes in government purchases or taxes affect national saving, investment, and current account balances in both home and foreign countries.

• Capital controls restrict international borrowing/lending, affecting domestic and world real interest rates.

• Supply shocks in one country can impact saving, investment, and current account balances globally.

Application: Globalization and the U.S. Economy

• Globalization increases interdependence through trade and investment.

• Benefits include job creation and economic growth; costs include job losses in certain sectors.

• Government policy can help mitigate adverse effects on workers.

• Recent trends show a large U.S. current account deficit, partly due to increased saving by developing countries seeking safe investments.

• Bilateral trade balances can be misleading; tariffs and retaliation reduce overall welfare.

Fiscal Policy and the Current Account

Twin Deficits Hypothesis

The "twin deficits" hypothesis suggests that government budget deficits are often accompanied by current account deficits, but this relationship depends on the effect of fiscal policy on national saving.

• If a government budget deficit reduces desired national saving, the current account deficit increases.

• In a small open economy, a reduction in national saving shifts the saving curve left, decreasing the current account balance.

• In a large open economy, similar effects occur, but changes also impact the world real interest rate and foreign countries’ balances.

Application: U.S. Twin Deficits

• Historical data show periods where U.S. government budget and current account deficits moved together (e.g., 1980s, early 1990s).

• At other times, such as during World Wars, budget deficits increased while the current account balance improved.

• Evidence is mixed for both the U.S. and other countries.

Key Formulas and Relationships

• Goods Market Equilibrium:

• National Saving:

• Current Account Balance:

• Net Foreign Assets:

• Financial Account Balance:

Example Table: Types of International Transactions

Below is a table summarizing how various transactions enter the U.S. balance of payments accounts:

Summary

• The balance of payments provides a comprehensive record of a country’s international transactions.

• Goods market equilibrium in open economies depends on the interplay between saving, investment, and net exports.

• Small open economies are price takers in the world capital market, while large open economies influence the world real interest rate.

• Fiscal policy can affect the current account, but the relationship is not always straightforward.

• Globalization has increased economic interdependence, with both benefits and costs for national economies.