Open Economy

Open Economy Macro Models
Savings – Investment Identity

PvtS = I – GS + NFI

NFI = Current account balance

= Net exports + Net income from abroad

= Receipts from abroad – Payments from abroad

Net exports = X – M = Trade balance

Net income from abroad = Income from foreign assets – income payments to foreign asset owners

Consider country with current account deficit:

Current account
Net exports < 0
Net income < 0 – country is paying interest on accumulated foreign debts from past
Capital account
Accumulating additional foreign debt to finance
Relying on

Borrowing from foreign banks
Sale of bonds or equity to foreigners
Foreign direct investment

Determinants of different components of Savings Investment:

I and PvtS depend on real interest rate
Net exports depend on real exchange rate
Capital flows depend on real interest rate

CLOSED ECONOMY

I(r) = PvtS(r) + GS

Real interest rate = r
No trade or capital flows NFI=0

SMALL OPEN ECONOMY

I(r*) + NFI = PvtS(r*) + GS

I(r*) + (X-M) + net income = PvtS(r*) + GS

Equilibrium world real interest rate = r*
Small economy – too small to effect r*
Integration of world capital markets -- any capital flows forthcoming at r*

For a given fiscal policy -- GS -- and net income (determined by debt position from past) --->
INVESTMENT / SAVINGS balance determines trade deficit.

An increase in govt. deficit leads to a trade deficit.

U.S. in the early ‘80s
Latin American debt crisis in the early ‘80s – govt. deficits financed by sovereign debt (bank borrowing and foreign bond sales. Accumulated debt approached 100% of GDP.

An increase in world interest rates with a given GS leads to a trade surplus.

Japan in the late ‘80s

Investment boom leads to current account deficit

Asian crisis – in order to buy investment goods and keep I > National Savings, rely on the savings of foreigners:

borrow from banks abroad
sell bonds or equity to foreigners
FDI foreign direct investment

Sustainable, as long as new capital produces goods to service debts – easier if investment in TRADEABLE goods sector and borrowing should continue as long as available investment projects profitable.

Now, what maintains equilibrium?

Adjustment of real exchange rate

ereal = e (P/P_foreign)

Increase in real exchange rate –

Foreign goods relatively cheaper
Domestic goods relatively expensive

More imports, less exports AND (X-M) falls

Protectionist trade policy (import restrictions) lead to higher real exchange rate.
Larger government deficit (fall in GS) leads to higher real exchange rate.

What makes Current Account deficit sustainable?

Higher GDP growth rate
More openness – Higher Export/GDP share
Not too large: magic number 5% of GDP
Efficient intermediation

Now,

What happens if financing the current account deficit becomes difficult?
If capital inflows at r* are not forthcoming?
If country risk impedes capital inflows?

Since there is a trade deficit, net exports < 0, payment made for imports leads to the country’s currency accumulating abroad.
Holders begin to sell it and the CURRENCY DEPRECIATES.
LARGE OPEN ECONOMY PvtS = I - GS + NFI

NFI = NX + (net income)

NX = f(ereal)

NFI - (net income) = g(r)

1. Increase in govt deficit leads to an increase in both the real interest rate and the real exchange rate

2. Import restrictions lead to an increase in the real exchange rate.

3. High foreign interest rates OR high savings rates abroad implies that NFI falls and leads to a lower real inerest rate and a higher real exchange rate.