Chapter 5 Saving and Investment in Open Economy

Balance of Payments Accounting

Record of a country’s international transactions

A Credit Item

A flow of funds into Canada+

A Debit Item

A flow of funds out of Canada-

Current Account

Measures a country’s trade currently produced goods and services, along with net transfers between countries

Components of current account

Net exports of g&s, investment income from assets abroad, and current transfers

Merchandise Trade

A component of net exports which involves a trade in goods. Exports-Imports.

Debit, Credit

A car bought from Japan is a ______ item for Japan, and a ______ for Canada

Credit, Debit

Timber bought by the USA is a _____ item for The USA, and a _______ item for Canada

Trade in Services

A component of net exports which Internationally Traded services. It includes tourism, transportation, insurance, education, and financial services

Example of merchandise trade

Canada buying from Japan is an _______

Example of trade in services

USA buying from Canada is an _____

Investment Income

Interest Payments, dividends, and royalties a country’s residents receive from assets owned abroad

Credit Item

Interest received from abroad is a ______

Debit Item

Payments of income investment to foreigners is a ______

Net Investment Income from Assets Abroad

Income Investment received from abroad- payments of investment income paid to foreigners

Current Transfers

Payments from one country to another that do not correspond to the purchase of any good, service, or asset

Examples of Current Transfers

Foreign Aid, Pension Payments, MonetaryGifts to Family Living Internationally

Debit

A Transfer by a Canadian abroad is a _____ item for Canada

Current Transfers=

transfers received by a country-transfers flowing out of country

Current Transfer Balance

Taking all the credit items in a country and subtracting them by the debit items of said country

Current Account Balance=

net exports of goods and services+ net investment income from assets abroad + current transfers

Capital Account

Trades in existing assets(ex: house) or financial assets (ex: stocks & bonds)

The Financial Account

One part of capital account. It involves recording direct and portfolio investment. This accounts for most of the capital account.

The Capital Account

One part of capital account. It involves recording migrants’ funds and inheritances

Capital Account Balance

The value of capital inflows minus the value of capital outflows

Official Reserve Assets

Assets, other than domestic money and security, used to make international payments

Assets in Official Reserve Assets

Foreign Government securities, gold, bank deposits, Special Drawing Rights of the IMF

Currency

Central Banks buy official reserve assets with their own ______

A Net Increase in Official Reserve Assets

Rise in Canadian Government reserve assets minus foreign central bank holding of Canadian dollar assets

Equal zero at the each period

Current Account Balance(CA) + Capital Account Balance(KA) must _____

Statistical Discrepancy

Amount added to Current Account Balance and Capital Account Balances to reach zero

Net Foreign Assets

A Country’s foreign assets minus its foreign liabilities

Goods Market Equilibrium

S^d=I^d+CA=I^d+(NX+NFP)

Open-Economy Goods Equilibrium

Assuming NFP is Zero

S^d=I^d+NX

Absorption- total spending by residents

(C^d+I^d+G^d)

Small Open Economy

Economy too small to affect the world real interest rate

The World Real Interest Rate(WRIR)

The real interest rate that prevails in international capital market

Assumptions of small open economy

WRIR is fixed, markets of financial capital are open to all savers and borrowers, can borrow or lend at the expected WRIR

Need not equal

Desired National Saving _______ desired investment

High values of world real interest rate(r^w)

Lower levels of desired consumption, lower direct investment

Shifts in the saving curve

Changes in desired national saving result in

Shifts in the investment curve

Changes in determinants of desired national investment results in ______

A temporary adverse supply shock in a small open economy

A severe drought when CA is in surplus will cause the investment curve to remain unaffected, income falls, saving to fall at every r, net foreign lending and current account will fall

A Permanent Positive Supply Shock in small open economy

Technological innovation when CA is in surplus will cause expected future MPK to rise, saving curve to be unaffected, domestic capital stock to increase, desired investment to rise at every rate of r, net foreign lending and current account to fall

Large Open Economy

Economy is large enough to affect world real interest rate

World Interest Rate moves to set equal

Desired International ending by one Country with Desired International Borrowing by the other

Equilibrium World Real Interest Rate

Interest rate at which desired international lending by one country equals desired international borrowing of another

Changes in the equilibrium world Interest Rate

Any Factor that increases desired international lending of a country relative to desired international borrowing causes world nterest rate to fall

Twin Deficits

Economies that have both a fiscal deficit and a current account deficit

Increase in Government Budget Deficit

Raises current account deficit only if budget deficit reduces desired national saving. Reduces desired national saving, saving curve shifts left, reducing current account balance.