Reading: Abel, Bernanke, Croushore, Kneebone, Macroeconomics Ch.5 Ch.5: Saving and Investment in the Open Economy Objectives: Develop the idea that a country s spending need not equal its production in every period, due to foreign trade. The fundamental determinants of a country s trade position are its saving and investment decisions. Assuming an open economy. 1. Balance of Payments Accounting A. Balance of payment accounting 1). Definition: The record of a country s international transaction. 2). Any transaction that involves a flow of money into Canada is a credit item. Eg. exports 3). Any transaction involving a flow of money out of Canada is a debit item. Eg. imports 4). In touch with the macro economy: the balance of payments accounts data released quarterly in Canada s Balance of International Payments. B. The current account (CA) The current account measures a country s trade in currently produced goods and services, along with net transfer between countries. It has 3 components. 1
1). Net exports (NX) of goods and services Merchandise trade is trade in goods Merchandise trade balance = Exports minus Imports Internationally traded services: Eg. transportation, tourism, insurance, education, financial services, etc. c). Export (EX) is a credit; Import (IM) is a debit. 2). Investment income from assets abroad Investment income is interest payments, dividends and royalties. A country s residents receive from assets owned abroad. Investment income received from abroad is a credit item, since it causes funds to flow into Canada. Payment of investment income to foreigners is a debit item because they represent funds that flow out of the country. Net investment income from assets abroad is part of the current account, and is about equal to NFP. (Note: most factor payment flows are investment income, but wages and salaries account for a small part of factor payments and thus NFP and net investment income are equivalent concepts.) 3). Current transfers 2
Payments made from one country to another that do not correspond to the purchase of any goods, services or assets. E.g. official foreign aid, pension payments or gift of money from a resident of one country to family member living in another country. c). A transfer by a Canadian abroad is a debit item for Canada. Negative current transfers for Canada, since Canada is a net payer of transfers to other countries. 4). Sum of net exports of goods and services, net investment income from assets abroad, and current transfers is the current account balance. It is obtained by adding all the credit items and subtracting all the debit items. Positive current account balance implies current account surplus. Negative current account balance implies current account deficit. C. The capital account (KA) 1). The capital and financial account records trades in existing assets, either real (eg. direct investment, houses) or financial (eg. portfolio investment, stocks and bonds). The financial account records direct and portfolio investment. Capital inflow: the purchase of domestic assets by foreigners and it is a credit item in the capital account. 3
E.g. a Canadian bond is sold to Italian investors c). Capital outflow: the purchase of foreign assets by domestic residents and it is a debit item in the capital account. E.g. a Canadian obtains a Swiss bank account d). The KA balance or net capital outflow (NCO) = capital outflow capital inflow e). Positive capital account balance implies capital account surplus. Negative capital account balance implies capital account deficit. 2). The official settlements balance The official settlements balance or the balance of payments is the net increase (domestic less foreign) in a country s official reserve assets. E.g. for Canada, the net increase in official reserve assets is the rise in Canadian government reserve assets minus foreign central bank holdings of Canadian dollar assets. Transactions in official reserve assets are conducted by central bank of countries. Official reserve assets are assets used in making international payments. c). Having a balance of payments surplus means a country is increasing its official reserve assets; a balance of payments deficit is a decrease in official reserve assets. 4
Summary: Current Account Debit ( ) Credit (+) Net exports Exports of merchandise Exports of services Imports of merchandise Imports of services Net income from assets Income from foreign investments Investment income paid to foreigners Current transfers Transfers from foreigners Transfers to foreigners Capital Account Increase in foreign-owned assets Increase in domestically owned assets abroad D. The relationship between the current account and capital account 1). Current account balance (CA) + capital account balance (KA) = 0 5
CA + KA = 0 Because every international transaction involves an exchange of one asset for a good or service. When a country is running a trade surplus (NX>0), it is selling more goods and services to foreigners than it is buying from them. What is it doing with the foreign currency it receives from the net sale of goods and services abroad? It must be using it to buy foreign assets. Capital is flowing out of the country (NCO > 0). When a country is running a trade deficit (NX<0), it is buying more goods and services from foreigners than it is selling to them. How is it financing the net purchase of these goods and services? It must be selling assets abroad. Capital is flowing into the country (NCO<0). 2). In practice, measurement problems are recorded as a statistical discrepancy (SD). It is the amount to be added to the sum of CA and KA balances to reach its theoretical value of zero. CA + KA + SD = 0 6
E. Net foreign assets and the balance of payment accounts 1). Net foreign assets are a country s foreign assets minus its foreign liabilities. It is part of a country s national wealth. Net foreign assets can change when: The value of existing foreign assets and foreign liabilities change. The country acquires new foreign assets or incurs new liabilities. 2). The net increase in foreign assets equals a country s current account surplus. 3). A current account surplus implies a KA deficit and thus a net increase in holdings of foreign assets. (Capital outflow). 4). A current account deficit implies a KA surplus and thus a net decrease in holdings of foreign assets. (Capital inflow). 5). Summary: Equivalent measures of a country s international trade and lending. current account surplus = capital account deficit = net acquisition of foreign assets = net foreign lending = net exports (if NFP and net transfers are zero) 7
2. Goods Market Equilibrium in an Open Economy Recall in Ch2, the open-economy national income accounting identity: S = I + CA = I + (NX + NFP) 1). So national saving has two uses: Increase the capital stock by domestic investment Increase the stock of net foreign assets by lending to foreigners 2). To get goods market equilibrium, national saving and investment must equal their desired levels: S d = I d + CA = I d + (NX + NFP) Goods market equilibrium in an open economy is: Assuming NFPs are zero, then. 3). Alternative method: Absorption: the total spending by domestic residents. 8
3. Saving and Investment in a Small Open Economy A. Interest Rate Parity 1) Two assumptions: a) Small open economy = An economy that trades goods and services with other economies and, by itself, has a negligible effect on world prices and interest rates. b) Perfect capital mobility = full access to world financial markets. 2) Interest rate parity = the real interest rate on comparable financial assets should be the same in all economies with full access to world financial markets. r = r w domestic interest rate = world interest rate B. Small open economy: 1). A small open economy is an economy that is too small to affect the world real interest rate. 2). The world real interest rate is fixed for a small open economy. The markets for financial capital are open to all savers and borrowers regardless of where they live. 3). For a small open economy, the domestic real interest rate will adjust in the long run to equal to the (expected) world interest rate. Results: r w may be such that S d > I d, S d = I d, or S d < I d 9
If r w = r 1, then S d > I d, so the excess of desired saving over desired investment is lent internationally (net foreign lending is positive) and CA > 0. If r w = r 2 then S d = I d, so there is no net foreign lending and CA = 0. c). If r w = r 3, then S d < I d, so the excess of desired investment over desired saving is financed by borrowing internationally (net foreign lending is negative) and CA < 0. r w 4). Alternative interpretation: in terms of output and absorption S d, I d NX equals net foreign lending equals the CA balance (assume net factor payments and net unilateral transfers are zero). 10
C. Application: Domestic and foreign interest rates 1). The figure shows that the interest rate paid on an asset in Canada differs from the interest rate paid on a comparable asset in the US. 2). Interest rates will tend to differ on comparable assets if there are considerations other than interest rates that affect the expected rate of return earned on a domestic versus foreign asset. Eg. Transaction costs, tax rates on interest income, exchange rate risk, political risk. D. The effects of economic shocks in a small open economy 1). Anything that increases desired national saving (Y rises, future output falls, or G falls) relative to desired investment (MPK f falls, τ rises) at a 11
given world interest rate increases net foreign lending, the current account balance and net exports and vice versa. 2). Example 1: A temporary adverse supply shock: Temporary drop in income (e.g. a severe drought) leads to: The investment curve to be unaffected Saving to fall at every r (the saving curve shifts left) Net foreign lending and current account to decline r w S d, I d Example 2: A permanent positive supply shock A technological innovation when CA is in surplus will cause: An increase in the expected future marginal product of capital, Desired investment to rise at every r. The saving curve to be unaffected Net foreign lending and the current account to fall. 12
r w S d, I d 4. Saving and Investment in a Large Open Economy A. Large open economy: 1). A large open economy is an economy large enough to affect the world real interest rate. 2). Suppose there are just two economies in the world: The home or domestic economy (saving S, investment I) The foreign economy, representing the rest of the world (saving S For, investment I For ) 13
3). The world real interest rate is determined within the model. It is not fixed. 4). The world real interest rate moves to equilibrate: desired international lending by one country equal to desired international borrowing by the other. 5). The world desired saving will be equal to the world desired investment. 6). Equivalent statement: The equilibrium world real interest rate is determined such that a current account surplus in one country is equal in magnitude to the current account deficit in the other. 14
7). Changes in the equilibrium world real interest rate: Any factor that increases desired international lending of a country relative to desired international borrowing causes the world real interest rate to decrease or vice versa. 5. Fiscal Policy and the Current Account Q: Are government budget deficits necessarily accompanied by current account deficits? That is, are there twin deficits? A. The critical factor: the response of national saving 1). An increase in the government budget deficit raises the current account deficit only if the increase in the budget deficit reduces desired national saving. 2). In a small open economy, if an increase in the government budget deficit reduces desired national saving, the saving curve shifts left, thus reducing the current account balance. E.g. The deficit caused by increased government purchases reduces desired national saving (S d = Y C d G). 15
B. The government budget deficit and national saving 1). A deficit causes by increased government purchases No question here: The deficit definitely reduces national saving Result: The current account balance decreases. 2). A deficit resulting from a tax cut S d falls only if C d rises So S d won t change if Ricardian equivalence holds, since then a tax cut won t affect consumption. c). But if people don t foresee the future taxes implied by a tax cut today, they will consume more, desired saving will decline, and so will the current account balance. 16