IC

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}{Home} + S^{d}{Foreign} = I^{d}{Home} + I^{d}{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)