Econ 291
Canadian Macroeconomic Policy
Chapter 5 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
Econ 291
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Chapter 5 1).
Net exports (NX) of goods and services a).
Merchandise trade is trade in goods Merchandise trade balance = Exports minus Imports
b).
Internationally traded services: Eg.
transportation, tourism, insurance, education, financial services, etc.
c). 2).
Export (EX) is a credit; Import (IM) is a debit.
Investment income from assets abroad Investment income is interest payments, dividends and royalties. A country’s residents receive from assets owned abroad. a).
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.
b).
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
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Chapter 5 a).
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.
b).
A transfer by a Canadian abroad is a debit item for Canada.
c).
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. a).
Positive current account balance implies current account surplus.
b).
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). a).
The financial account records direct and portfolio investment.
b).
Capital inflow: the purchase of domestic assets by foreigners and it is a credit item in the capital account. 3
Econ 291
Canadian Macroeconomic Policy
Chapter 5 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 a).
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.
b).
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
Econ 291
Canadian Macroeconomic Policy
Chapter 5 ● Summary: Debit (–)
Credit (+)
Current Account 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
Econ 291
Canadian Macroeconomic Policy
Chapter 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 Id, so the excess of desired saving over desired investment is lent internationally (net foreign lending is positive) and CA > 0.
b).
If rw = r2 then Sd = Id, so there is no net foreign lending and CA = 0.
c).
If rw = r3, then Sd < Id, so the excess of desired investment over desired saving is financed by borrowing internationally (net foreign lending is negative) and CA < 0. rw
S d , Id 4).
Alternative interpretation: in terms of output and absorption
►
NX equals net foreign lending equals the CA balance (assume net factor payments and net unilateral transfers are zero).
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Canadian Macroeconomic Policy
Chapter 5 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 (MPKf falls, τ rises) at a
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Canadian Macroeconomic Policy
Chapter 5 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 rw
S d , Id 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
Econ 291
Canadian Macroeconomic Policy
Chapter 5 rw
S d , Id
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: a).
The home or domestic economy (saving S, investment I)
b).
The foreign economy, representing the rest of the world (saving SFor, investment IFor)
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Chapter 5
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
Econ 291
Canadian Macroeconomic Policy
Chapter 5 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 (Sd = Y – Cd – G).
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Canadian Macroeconomic Policy
Chapter 5
B. The government budget deficit and national saving 1).
2).
A deficit causes by increased government purchases a).
No question here: The deficit definitely reduces national saving
b).
Result: The current account balance decreases.
A deficit resulting from a tax cut a).
Sd falls only if Cd rises
b).
So Sd 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
