Saving and Investment in the Open Economy

Balance of Payments (BOP)

• Two main sub-accounts:
  • Current Account (CA): $CA = NX + NFP + NT$
    • $NX$: net exports of goods & services
    • $NFP$: net factor payments from abroad (interest, dividends, royalties)
    • $NT$: net current transfers (e.g., foreign aid)
  • Capital & Financial Account (KA/FA): records trade in existing real & financial assets (direct, portfolio, reserve assets)
  • Accounting identity: $CA + KA = 0$ (measurement errors → statistical discrepancy)
  • Official settlements balance: change in official reserve assets

Net Foreign Assets (NFA)

• $NFA =\text{foreign assets} - \text{foreign liabilities}$
• Change in $NFA$ equals $CA$ (surplus ↑ → net foreign lending / asset acquisition)
• Equivalent statements for a $10$ bn CA surplus:
  • $KA = -10$ bn
  • Net acquisition of foreign assets = $10$ bn
  • Net foreign lending = $10$ bn
  • $NX = 10$ bn if $NFP = NT = 0$

Goods-Market Equilibrium (Open Economy)

• National saving use: $S = I + CA = I + (NX + NFP)$
• With $NFP = 0$ → $NX = Y - (C^d + I^d + G)$ (absorption)

Small Open Economy (price-taker in world capital market)

• World real interest rate fixed: $r = r^w$
• Domestic $r$ adjusts to $r^w$ → $S^d$ and $I^d$ determine CA:
  • If S^d > I^d → net lender, CA > 0
  • If S^d < I^d → net borrower, CA < 0

Comparative-static shocks

• ↑ Desired saving at $r^w$ → ↑ foreign lending, ↑ $CA$, ↑ $NX$
• Temporary adverse supply shock (↓ output) or ↑ expected $MPK_f$ → ↓ $CA$ (graphs shift $S$ or $I$)

Large Open Economy (affects $r$)

• World consists of two large economies; $r$ determined where:
  $S^{d}<em>{Home} + S^{d}</em>{Foreign} = I^{d}<em>{Home} + I^{d}</em>{Foreign}$
• Lending country’s $CA$ surplus = borrowing country’s $CA$ deficit

Twin Deficits (Budget vs Current Account)

• Government deficit ↑ → $S^d = S^p - (G - T)$ falls → $CA$ falls if private saving doesn’t fully offset (no Ricardian Equivalence)
• In small open economy, drop in $CA$ equals fall in national saving; investment unchanged if $r^w$ fixed
• Outcomes: lower foreign lending, higher foreign borrowing, and/or lower domestic investment

Key Identities & Terms (quick recall)

• $CA = NX + NFP + NT$
• $CA + KA = 0$
• $S = I + CA$
• Absorption: $A = C^d + I^d + G$
• Twin deficits: $\Delta (G-T) \uparrow \Rightarrow \Delta CA \downarrow$ (unless fully offset by $\Delta S^p$)