Module 10 Notes: Saving, Investment, and Capital Flows

Module 10: Impacts of Saving, Investment, and Capital Flows

Learning Objectives

• Use the loanable funds market model to predict how various factors influence interest rates and investment levels.
• Predict how differences in return on investment impact global capital flows.
• Describe the influence of net capital outflow and net exports on exchange rates using a demand and supply model.
• Combine models to predict how changes in financial markets and global investment returns impact exchange rates.
• Predict how changes in trade policies, exchange rates, or other global conditions alter macroeconomic outcomes.

Integrated Model of Capital Flows

• Build upon Modules 8 and 9 to create a comprehensive model.
• Module 8: Market for loanable funds, national savings, investment, and financial markets.
• Module 9: Trade benefits, demand and supply models, exchange rates, balance of payments, current account balanced by capital and financial accounts, and the relationship between net exports and net foreign investment (net capital outflow).

Simplifying Interactions

• Relate the loanable funds market and the market for foreign exchange.
• Use the domestic real interest rate as an interaction mechanism with net capital outflow.
  • Discuss each market, the interaction mechanism, and then integrate them.

Key Concepts

• Real Interest Rate: Nominal interest rate minus inflation.
  • Represents the real return on capital after adjusting for inflation.
• Real Exchange Rates: Nominal exchange rates adjusted for price effects.
  • Represents the rate at which one country's goods trade for another's after adjusting for price differences.
• The real interest rate and real exchange rate equilibrate the quantity of loanable funds, net capital outflow, and the quantity of dollars exchanged for foreign currency.

Relationship Between Domestic Real Interest Rate and Net Capital Outflow

• Recall the circular flow model from Module 8, $Y = C + I + G + NX$, where:
  • $Y$ = GDP (income and output).
  • $C$ = Consumption.
  • $I$ = Investment.
  • $G$ = Government Expenditures.
  • $NX$ = Net Exports.

Income Allocation

• Income goes to consumption (c), taxes (taxes go to government).
• Government spends money (g) or saves (public savings).
• Households save (private savings).
• Firms access loanable funds for investment (I) and may also save.
• Government can dis-save, borrowing to increase expenditure.
• National Saving = Private Saving + Public Saving.
• National saving is the supply curve in the market for loanable funds.
• Demand for loanable funds is characterized as the demand for investment.

Including International Trade

• In an open economy, net exports (NX) are included in GDP calculation.

Algebraic Representation

• Starting with $Y = C + I + G + NX$
• Subtracting $C$ and $G$: $Y - C - G = I + NX$
• Adding taxes: $Y - C - T$ (private saving) + $T - G$ (public saving) = National Saving

Budget Balance

• Balanced Budget: Taxes = Government Spending (Public Savings = 0).
• Budget Surplus: Taxes > Government Spending (Public Savings > 0).
• Budget Deficit: Government Spending > Taxes (Public Savings < 0, reduces national savings).
• National Savings = Domestic Investment + Net Exports.

Balance of Payments

• Exports not paid for with imports must be paid for with financial or capital assets from the importing country.
• If NX > 0, then Y > C + I + G.
• Excess value produced is sent to foreign markets and paid for with capital or financial assets.

Saving, Investment, and Net Exports

• If a country saves more than it invests domestically, the excess capital is invested overseas.
• Net Capital Outflow (NCO) = Capital saved and invested overseas.
• $NX = NCO$
• $National Savings = Investment + NCO$
• Supply of Loanable Funds = Demand for Loanable Funds (Investment + NCO).

Investment Decisions

• Comparison of domestic vs. overseas investment opportunities.
• Investors seek the greatest risk-adjusted return.
• High domestic return encourages domestic investment.
• Low domestic return encourages foreign investment.

Loanable Funds Market and Capital Flows

• Limited supply of loanable funds leads to high real interest rates, attracting foreign capital.
• High supply of loanable funds leads to low real interest rates, causing capital to flow out.

Real Interest Rate and Net Capital Outflow Relationship

• High real interest rates attract foreign investment, resulting in more capital flowing in (negative NCO).
• Low real interest rates encourage domestic savings to seek higher returns in foreign markets, increasing net capital outflow (positive NCO).
• Capital flows to where it gets the highest risk-adjusted return.

Impact of Global Interest Rates

• Changes in international real interest rates shift the demand for net capital outflow.
• Increased real return on capital outside the country leads to more capital outflow.

Summary

• Global investors have global investment options.
• Capital flows to the highest risk-adjusted return.
• $National Savings = Investment + Net Capital Outflow$
• Positive NCO: More money flowing out than in.
• Negative NCO: More money flowing in than out.
• Higher interest rates attract capital inflow and reduce outflow.
• Lower interest rates increase capital outflow and reduce inflow.