CHAPTER 5
SAVING AND INVESTMENT
IN THE OPEN ECONOMY
Lecture Outline:
I.
Balance of Payments Accounting
II.
Goods Market Equilibrium in an
Open Economy
III.
S and I in a Small Open Economy
IV.
S and I in Large Open Economies
V.
Fiscal Policy and Current Account
I. Balance of Payments Accounting

Balance of Payments Accounts
— are the record of a country’s
international transaction

Current Account
— measures a country’s trade in currently
produced goods and services, along with
net transfers between countries.
2. The Capital Account

Capital and Financial Account
It
records trade in existing assets, either real
(direct investment) or financial (portfolio
investment).
a). Financial Inflow:
Canada sells assets to foreign country
b). Financial Outflow:
Canada buys assets from foreign country
2. The Capital Account
Official Reserve Assets
It
— are assets, other than domestic money or
securities, that can used in making
international payments

Official Settlements Balances ( or the
Balance of Payments):
— is the net increase (domestic less foreign)
in a country’s official reserve assets.
3. The Relationship Between The Current
Account and The Capital Account
CA  KA  0
Why?
Every international transaction involves a
swap of goods, services or assets between
countries.
The two sides of the swap has offsetting
effects.
4. Net Foreign Assets

Net Foreign AssetsI t
= Foreign assets – Foreign liabilities

Net amount of new foreign assets
= a country’s current account surplus
II. Goods Market Equilibrium in
an Open Economy

Equilibrium Condition:
S
d
Assume

 I  C A  I  ( N X  N FP )
d
d
NFP  0
,
S
d
 I  NX
d
Alternative way to express:
Y  C  I  G  NX
d
d
III. S and I in a Small Open Economy

Small Open Economy:
— too small to affect the world real
interest rate.
World Real Interest Rate ( r w )
— the real interest rate that prevails in the
international capital market.


Assume: financial markets are fully
accessible to all savers and borrower.
4. Effects of Economic Shocks

At a given r w , any change that desired
national saving relative to desired
investment will net foreign lending, CA
and NX.

Examples:
(i) A Temporary Adverse Supply Shock
(ii) An Increase in M PK f
CA
IV. S and I in a Large Open Economy

Large Open Economy:
— large enough to affect the world real
interest rate.

Two large economies:
(i) home economy (ii) foreign economy

r will be such that:
Desired international lending
w
= Desired international borrowing
IV. S and I in a Large Open Economy

Alternative equilibrium condition:
lending country’s CA surplus
= borrowing country’s CA deficit

Any factor that desired international
lending relative to desired international
borrowing
r
w
V. Fiscal Policy and the Current
Account
Q: Does government budget deficit cause a CA
deficit?
A: It could — through the response of
national saving.
budget deficit
S
D
CA
V. Fiscal Policy and the Current
Account

A deficit caused by
G

S
D
G
CA
A deficit resulting from a tax cut
(i) If Ricardian Equivalence holds:
no effect on CA
D
(ii) If consumers C :
S
D
CA