Macroeconomics Chapter 5: Saving & Investment in the Open Economy

Parts of the current account:

1. Net exports of G&S (NX) 2. Net income from abroad (NFP) 3. Net unilateral transfers (NUT)

Net foreign assets

NFAs are a country's foreign assets held by its citizens minus its foreign liabilities - foreign assets are foreign stocks & bonds and real estate - foreign liabilities are domestic physical assets held by foreigners

The effects of economic shocks in a small open economy

- Anything that increases desired national saving (Y rises, future output falls, or G falls) relative to desired investment (MPK falls, rises) at a given world interest rate increases net foreign lending (and vice versa) - temporary adverse supply shock leads to temporary drop in income --> drop in saving, so net foreign lending declines

Net unilateral transfers (NUT)

- Payments made from one country to another that are not for the purchase of a G/S or asset (i.e. foreign aid, gifts) - US has negative NUT b/c it's a net donor to other countries

What is the effect on national savings if there is a deficit resulting from a current tax cut (G & Y are constant at FE)?

- S only falls if C rises (b/c S =Y-C -G) - thus S won't change if Ricardian equivalence holds, as tax cut won't affect consumption & CA won't change) BUT if RE doesn't hold, S will decline as will CA balance & national lending will decrease

What is the effect on national savings if there is a deficit caused by increased government purchases?

- deficit reduces national saving - current account balance declines

What are the possible uses of national savings?

1. Increase the capital stock by domestic investment 2. Increase the stock of net foreign assets by lending to foreigners (CA: funds available for net foreign lending)

Ways in which NFAs can change in value:

1. Value of existing foreign assets can change (ex/ change in stock prices) 2. A country can acquire new foreign assets or incur foreign liabilities

The official settlements balance Also called

AKA the balance of payments - equals the net increase in a country's ORAs - for US, a net increase in official reserve assets means a rise in U.S. government reserve assets minus foreign central bank holdings of U.S. dollar assets

Financial Inflow

Credit item (+) i.e. sale of U.S. assets to foreigners

Financial Outflow

Debit item (-) i.e. purchase of foreign assets by U.S. residents

What is a credit item in balance of payments accounting?

Funds flow into the country - example: exports of goods

What is a debit item in balance of payments accounting?

Funds flowing out of the country - example: imports of goods

What is the relationship between the current account and the capital and financial account

In each period: CA + KFA = 0 - although in practice, measurement problems prevent this from being exactly true (these are recorded as a statistical discrepancy)

How do asset purchases across borders affect the KFA?

Most transactions involving the flow of assets appear in the FA of the KFA: - If USA sells assets to a foreign country, that is a capital inflow for the home country and a credit (+) item in the financial account (i.e. US hotel sold to an Italian investor) - When USA purchases assets from a foreign country, there is a capital outflow from US and a debit (-) item in the financial account (i.e. US citizen opening foreign bank account)

Official reserve assets

ORAs are assets used in making international payments - foreign government securities - foreign bank deposits - SDRs of the IMF - gold Central banks buy (or sell) ORAs with (or to obtain) their own currencies

Goods Market Equilibrium in an Open Economy

S = I + CA = I + (NX + NFP) we are assuming NFP = 0 = NUT

Desired savings in an open economy

S = I + NX

What is a small open economy?

an economy too small to affect the world real interest rate (the changes in S&I aren't large enough) - we assume residents of the small open economy can borrow or lend at the expected world real interest rate

Current Account balance

sum of net exports of goods and services, net income from abroad, and net unilateral transfers CA = NX + NFP + NUT

The capital & financial account (KFA):

sum of the CA and FA balances & net international flow of financial derivatives - but FA balance is by far the biggest of these -> KFA is almost equal to the financial account balance FA records trades in existing assets - assets can be either real (houses) or financial (stocks and bonds) CA records the net flow of unilateral transfers of assets into the country (debt forgiveness, migrants' transfers)

What does having a balance of payment surplus vs deficit mean?

surplus = country is increasing ORAs deficit = country is reduced ORAs

What does it mean for a country if desired savings is less that desired investment?

the country is an international borrower w/ a CA deficit

What does it mean for a country if desired savings is greater that desired investment?

the country is an international lender w/ a CA surplus

World real interest rate

the real interest rate in the international capital market (in which individuals, businesses and governments can borrow across borders)

Financial Account Balance:

value of financial inflows - value of financial outflows