Chapter 5: Saving and Investment in the Open Economy

Yulei Luo

SEF of HKU

February 25, 2015

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 1 / 26

Chapter Outline

Balance of Payments Accounting.

Goods Market Equilibrium in an Open Economy.
Saving and Investment in a Small Open Economy.
Saving and Investment in Large Open Economies.
Fiscal Policy and the Current Account.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 2 / 26

Balance of Payments Accounting (BPA): Basic Principles

BPA are part of the national income accounts and are the record of a
country’s international transactions. See Table 5.1 for the U.S. BPA
for 2011.
Credit item (+):
Any transaction that involves a ‡ow of funds into the U.S.
Example: exports of goods.
Debit item ( ):
Any transaction that involves a ‡ow of funds out of the U.S.
Example: imports of goods.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 3 / 26

Table 5.1
Balance of
Payments
Accounts of the
United States,
2011 (Billions of
Dollars)

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The current account (CA)

CA measures a country’s trade in currently produced goods and

services, along with unilateral transfers between countries.
Net exports of goods and services (NX ).
Net income from abroad (NIFA): income receipts from abroad minus
payments to residents of other countries.
Income received from abroad is a credit item, since it causes funds to
‡ow into the U.S.
Payment of income to foreigners is a debit item.
Net income from abroad is part of the current account, and is about
equal to NFP. (NFP appears in National Income and Product Account
and NIFA appears in BPA.)
Net unilateral transfers (NUT ):
Payments made from one country to another that do not correspond to
the purchase of any G&S or asset. E.g., o¢ cial foreign aid.
Negative net unilateral transfers for the U.S., since the U.S. is a net
donor to other countries.
Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 4 / 26
 (Conti.) Adding all the credit items and subtracting all the debit
items in the CA yields the CA balance:

CA = NX + NFP + NUT , (1)

Positive CA balance implies CA surplus.

Negative CA balance implies CA de…cit.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 5 / 26

The capital and …nancial account

The capital and …nancial account (KFA) records trades in existing

assets, either real (for example, houses) or …nancial (for example,
stocks and bonds).
KFA consists of a capital account and a …nancial account. The
capital account records the net ‡ow of unilateral transfers of assets
into the country.
Most transactions appear in the …nancial account part of the KFA:
When home country sells assets to a foreign country, that is a capital
in‡ow for the home country and a credit (+) item in the KFA.
When assets are purchased from a foreign country, there is a capital
out‡ow from the home country and a debit ( ) item in the KFA.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 6 / 26

 (Conti.) Financial Account
Financial In‡ow. Credit item (+).
Sale of U.S. assets to foreigners.
Financial Out‡ow
Debit item ( ).
Purchase of foreign assets by U.S. residents.

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The o¢ cial settlements balance (OSB)

Transactions in o¢ cial reserve assets are conducted by central banks

of countries.
O¢ cial reserve assets are assets (foreign gov. securities, bank
deposits, and SDRs of the IMF, gold) used in making international
payments.
Central banks buy (or sell) o¢ cial reserve assets with (or to obtain)
their own currencies.
OSB also called the balance of payments (BOP), it equals the net
increase in a country’s o¢ cial reserve assets.
For the U.S., the net increase in o¢ cial reserve assets is the rise in
U.S. gov. reserve assets minus foreign central bank holdings of U.S.
dollar assets.
Having a BOP surplus means a country is increasing its o¢ cial
reserve assets; a balance of payments de…cit is a reduction in o¢ cial
reserve assets.
Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 8 / 26
The relationship between the CA and the KFA

Current account balance (CA) + capital and …nancial account

balance (KFA) = 0.

CA + KFA = 0 (2)
by accounting; every transaction involves o¤setting e¤ects.
Every international transaction involves a swap of G&S or assets
between countries. The two sides of the swap always have o¤setting
e¤ects on the sum of the CA and KFA.
In practice, measurement problems, recorded as a statistical
discrepancy, preventing CA + KFA = 0 from holding exactly.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 9 / 26

 Table 5.2 Why the Current Account Balance and the
Capital and Financial Account Balance Sum to Zero: An
Example
(Balance of Payments Data Refer to the United States)

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Net foreign assets and the balance of payments accounts

Net foreign assets are a country’s foreign assets minus its foreign
liabilities:
Net foreign assets may change in value (example: change in stock
prices).
Net foreign assets may change through acquisition of new assets or
liabilities.
The net increase in foreign assets equals a country’s CA surplus.
A CA surplus implies a KFA de…cit, and thus a net increase in
holdings of foreign assets (a …nancial out‡ow).
A CA de…cit implies a KFA surplus, and thus a net decline in holdings
of foreign assets (a …nancial in‡ow).

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 (Conti.) Foreign direct investment (FDI): a foreign …rm buys or builds
capital goods.
Causes an increase in the KFA.
Portfolio investment: foreigners acquire U.S. securities; also increases
KFA balance.
Summary: Equivalent measures of a country’s international trade and
lending.
CA surplus = KFA de…cit = net acquisition of foreign assets = net
foreign lending = net exports (if NFP and net unilateral transfers are
0).

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 11 / 26

 Summary 7

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Application: The U.S. as international debtor

The rise in foreign liabilities by the U.S. since the early 1980s has
been very large (Figure 5.1).
The U.S. has become the world’s largest international debtor.
But the net foreign debt of the U.S. relative to U.S. GDP is relatively
small (27%) compared to other countries (some of whom have net
foreign debt of over 100% of GDP).
Despite the large net foreign debt, the U.S. has direct foreign
investment (companies, land) in other countries about equal in size to
other countries’foreign direct investment in the U.S.
What really matters is not size of net foreign debt, but country’s
wealth (physical and human capital):
If net foreign debt rises but wealth rises, there’s no problem.
But U.S. wealth isn’t rising as much as net foreign debt, which is
worrisome.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 12 / 26

 Figure 5.1 International ownership of
assets relative to U.S. GDP, 1982-2011

Sources: International
ownership of assets: Bureau
of Economic Analysis,
International Economic
Accounts, International
Investment Position, Table 2,
available at www.bea.gov/
international/xls/intinv11_t2.
xls.GDP: Bureau of Economic
Analysis, National Income
and Product Accounts,
available at
research.stlouisfed.org/fred2
/series/GDPA.

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 Table 5.3 Foreign Holdings of U.S.
Treasury Securities

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Goods Market Equilibrium in an Open Economy

S = I + CA = I + (NX + NFP ), (3)

which is a version of the uses-of-saving identity: Saving has two uses:
Increase the capital stock by domestic investment.
Increase the stock of net foreign assets by lending to foreigners.
In this section, we’ll assume NFP = 0 = NUT :

S = I + CA = I + NX . (4)

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 13 / 26

 (Conti.) To get goods market equilibrium, actual national saving and
investment must equal their desired levels:

S d = I d + CA = I d + NX . (5)

Alternative method:

Y = C d + I d + G + NX , (6)
NX = Y (C d + I d + G ), (7)

which means that net exports equal output (Y ) minus absorption

(total spending by domestic residents, C d + I d + G ).

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 14 / 26

Saving and Investment in a Small Open Economy

Small open economy (SOE): an economy too small to a¤ect the

world real interest rate (IR).
World real interest rate (r w ): the real IR in the international capital
market.
Key assumption: Residents of the SOE can borrow or lend at the
expected world real IR.
Result: r w may be such that S d > I d , S d = I d , or S d < I d :
If S d > I d , the excess of desired saving over desired investment is lent
internationally (net foreign lending is positive) and NX > 0.
If S d = I d , there is no net foreign lending and NX = 0.
If S d < I d , the excess of desired investment over desired saving is
…nanced by borrowing internationally (net foreign lending is negative)
and NX < 0.
Net exports equals net foreign lending equals the CA balance
(assuming NFP and net unilateral transfers are 0).
Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 15 / 26
 Figure 5.2 A small open economy that
lends abroad

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 Figure 5.3 A small open economy that
borrows abroad

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 Table 5.4 Goods Market Equilibrium in a Small
Open Economy: An Example (Billions of Dollars)

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The e¤ects 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 f falls, τ
rises) at a given world IR increases net foreign lending, and vice versa.
A temporary adverse supply shock:
Temporary drop in income leads to a drop in saving, so net foreign
lending declines; shown in Fig. 5.4.
An increase in the expected future marginal product of capital.
Desired investment rises, so net foreign lending falls; shown in Fig.
5.5.

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 Figure 5.4 A temporary adverse supply
shock in a small open economy

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 Figure 5.5 An increase in the expected
future MPK in a small open economy

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Saving and Investment in Large Open Economies

Large open economy: an economy large enough to a¤ect the world

IR. 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 SFor ,
investment IFor ).
The world real IR moves to equilibrate desired international lending by
one country with desired international borrowing by the other (Fig.
5.6).
The equilibrium world real IR is determined such that a CA surplus in
one country is equal in magnitude to the CA de…cit in the other.
Changes in the equilibrium world real IR: Any factor that increases
desired international lending of a country relative to desired
international borrowing causes the world real IR to fall.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 17 / 26

 Figure 5.6 The determination of the world real
interest rate with two large open economies

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Application: The Impact of Globalization on the U.S.
Economy

World’s economies are increasingly interdependent— more

international trade and investment.
Historical data on trends in trade from 1929 to 2011.
Note large gains in both exports and imports over past 50 years (as %
of GDP).
Costs of globalization: U.S. jobs lost in particular sectors.
Bene…ts of globalization: U.S. jobs gained in particular sectors.
U.S. exports increase.
Cheaper imported goods means more G&S at lower prices— gains from
trade.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 18 / 26

 (Conti.) But loss for jobs from foreign trade is a small fraction of
total job loss in U.S.
Recent years: big changes in business services industry— call centers,
etc.
Critics: moving jobs abroad.
Reality: U.S. is world leader in exporting business services— far more
is done in U.S. and sold abroad than vice versa.
So U.S. bene…ts from such activity far more than it “loses”.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 19 / 26

 Figure 5.7 Exports and imports of goods and
services as a percent of GDP, 1929-2011

Sources: Exports and

imports: Bureau of Economic
Analysis, Trade in Goods and
Services, available at
research.stlouisfed.org/fred2
/series/EXPGSCA and
IMPGSCA. GDP: Bureau of
Economic Analysis, National
Income and Product
Accounts, available at
research.stlouisfed.org/fred2
/series/GDPCA.

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Application: Recent Trends in the U.S. CA De…cit.

U.S. CA de…cit is large (Fig. 5.8).

Why is the U.S. CA de…cit continuing to increase?
Lower foreign demand.
Better international investment opportunities.
Higher oil prices.
Increased saving by developing countries.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 20 / 26

 Figure 5.8 Current account balance as
a percent of GDP, 1960-2012

Sources: Balance on current account: Bureau of Economic Analysis, available on-line at

research.stlouisfed.org/fred2/series/BOPBCA. GDP: Bureau of Economic Analysis, available at
research.stlouisfed.org/fred2/series/GDP.
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 (Conti.) Lower foreign demand
Slower economic growth in Japan and Europe in early 2000s.
People there are saving more and investing in U.S. more, but buying
fewer U.S. goods.
Better international investment opportunities:
U.S. investors are diversifying investments internationally.
Foreign investors are investing more in U.S.
Higher oil prices
U.S. imports much more oil than it exports.
Doubling of oil prices recently led to decline in CA balance of over 1%
of GDP.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 21 / 26

 Figure 5.9 Net international ownership of
assets relative to U.S. GDP, 1982-2011

Sources: Net international investment position: Bureau of Economic Analysis, International Investment
Position of the United States at Yearend, available online at www.bea.gov/international/xls/intinv11_t2.xls;
GDP: Bureau of Economic Analysis, available at research.stlouisfed.org/fred2/series/GDP.

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 Figure 5.10 Petroleum net exports as a
percent of U.S. GDP, 1978-2011

Sources: Petroleum net exports: Bureau of Economic Analysis, U.S. International Transactions Accounts, Tables
2a and 2b, Net Trade in Goods, available at www.bea.gov/international/index.htm. GDP: Bureau of Economic
Analysis, available at research.stlouisfed.org/fred2/series/GDP.

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 (Conti.) Increased saving by developing countries:
Many developing nations want to invest in safe places like U.S., rather
than borrowing and getting into …nancial crises.
They changed from being international borrowers to being international
lenders.
Some people also blame U.S. gov. de…cit— twin de…cits argument
But in late 1990s, U.S. gov. ran surpluses, and CA de…cit got larger.
Other countries with CA surpluses also run larger gov. budget de…cits
than U.S.

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Are government budget de…cits necessarily accompanied by
CA de…cits (“twin de…cits”)?

The critical factor: the response of national saving:

An increase in the government budget de…cit (GBC) raises the CA
de…cit only if the increase in the budget de…cit reduces desired national
saving.
In a SOE, if an increase in the GBC reduces desired national saving,
the saving curve shifts left, thus reducing the CA balance (Fig. 5.11).

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The government budget de…cit and national saving

A de…cit caused by increased government purchases:

No question here: The de…cit de…nitely reduces national saving.
Result: The CA balance declines.
A de…cit 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 a¤ect consumption.
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 CA
balance.

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 Figure 5.11 The government budget deficit
and the current account in a small open
economy

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Application: the twin de…cits

Relationship between the U.S. GBC and U.S. CA de…cit. Fig. 5.12
shows data.
The de…cits appear to be twins in the 1980s and early 1990s, moving
closely together.
But at other times (during World Wars I and II, and during 1975)
government budget de…cits grew, yet the CA balance increased.
The evidence is also mixed for foreign countries.

Luo, Y. (SEF of HKU) ECON2102/2220: Intermediate Macro February 25, 2015 25 / 26

 Figure 5.12 The government budget deficit and
the current account in the United States, 1960-
2011

Sources: Total government and Federal government receipts, current expenditures, interest, and transfers:
BEA Web site, www.bea.gov, NIPA Tables 3.1 and 3.2. GDP: BEA Web site, NIPA Table 1.1.5. Current account
balance: BEA Web site, International transactions accounts Table 1.

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 (Conti.) U.S. experience:
Early and mid 1980s: supports twin de…cits.
Federal tax rebate, 1975: contrary to twin de…cits.
Recent experience: contrary to twin de…cits.
Experience of other countries
Germany: increased CA de…cit and budget de…cit.
Canada, Italy mid 1980s large budget de…cits without severe CA
de…cits.

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