THE GLOBAL BUSINESS ENVIRONMENT:
INTERNATIONAL MACROECONOMICS AND FINANCE
Professor Diamond Class Notes: 5
SAVING AND INVESTMENT IN THE LONG RUN IN A SMALL OPEN ECONOMY AND A LARGE OPEN ECONOMY
THE IMPACT OF GOVERNMENT POLICIES IN A SMALL AND A LARGE OPEN ECONOMY IN THE SHORT RUN
SAVING AND INVESTMENT IN A SMALL OPEN ECONOMY
IN THE LONG RUN
As we have observed the U.S. economy since the 1960's has increasingly become a more open economy. Moreover, due to its size, its major impact on world financial markets and the role of the U.S. dollar as the world's major reserve currency, it is a dominant large open economy. A large open economy is one that can influence its domestic interest rates, has a substantial impact on world markets and, in particular, on the world interest rate. In contrast, small open economy takes its interest rate as given by world financial markets, and by virtue of its size, has a negligible impact on world markets.
A model of a Small Open Economy in the Long Run. The U.S. is clearly a large open economy. Nevertheless, we find it useful to begin (as if often the case in constructing economic models) with the somewhat simpler small open economy case. We can the utilize the insights gained to develop the large open economy model. Moreover, we will find that although the U.S. is not a small open economy, it will provide approximately the correct answer as to how government policies affect the trade balance, exchange rates, and the level of output.
We begin by restating the national income accounts identity:
Y = C + I + G + NX
And recall that by algebraic manipulations it can be written as:
S-I =NX
Let us now develop a long run small open economy model that reflects this relationship between saving and investment (net foreign investment) and net exports (the trade balance).
The model makes the following assumptions:
1. We are dealing with a small open economy
2. There is perfect capital mobility. The government does not impede international lending or borrowing. Residents have full access to world financial markets.
3. The interest rate in a small open economy equals the world interest rate r*. The equilibrium of world saving and investment determines the world interest rate.
The model further assumes:
1. Y = YF(K,L). The output Y of the economy is fixed by the factors of production and the production function.
2. C = (Y-T). Consumption is positively related to disposable income Y-T.
3. I = I (r*). Investment is negatively related to the interest rate.
4. NX = (Y-C-G) - I
NX = S-I
Substituting the above three assumptions into number 4:
The equation shows what determines saving and investment and thus, the trade balance. Budgetary fiscal policy determines saving. High government expenditures and low tax rates result in sizeable deficits (G-T) and lower national saving. Lower government expenditures accompanied by higher tax rates yield budget surpluses and raise the level of national saving. Investment depends on the world interest rate r*. High interest rates decrease the number of profitable projects; low rates increase the number of profitable projects. The Trade Balance NX is determined by the difference between saving and investment at the world interest rate -- see Figure 8-2.
Government Policies and the Trade Balance. Assume the economy begins with balanced trade: NX = O and S = I. What would be the effects of government fiscal policy at home and abroad? First, let us examine the impact of increase government purchases to expand domestic spending as follows:
1. The increase in G reduces national saving since S = Y-C-G.
2. With an unchanged world interest rate I remains the same. Thus, S falls below I and some investment must be financed by borrowing from abroad.
3. Since NX = S-I, the decline in S implies a reduction in NX. The economy now has a trade deficit.
A decrease in taxes has the same effects although its overall impact on national saving is somewhat muted since a portion of the tax cut finds its way into private saving - see Figure 8-3. Thus, starting from balanced trade a fiscal policy that reduces national saving leads to a trade deficit.
Let us now examine what occurs when foreign governments increase their government purchase. If these countries are a small part of the world economy these changes have a negligible impact on other countries. However, if these foreign countries are a large part of the world economy, their increase in government spending reduces world saving and causes the world interest rate to rise. This in turn, reduces investment in the domestic economy. With no changes in domestic saving, saving S now exceeds investment I. Since NX = S-I, the reduction in I must also increase NX - the trade balance. Thus, fiscal expansion abroad, which increases the world interest rate, leads to a trade surplus - see Figure 8-5.
A change (shift) in the investment schedule (curve) in the domestic economy will also affect the trade balance. Assume that a change in the tax law, which provides an investment tax credit, shifts the investment curve (to the right). At a given world interest rate investment is now higher. Since saving is unchanged, increased investment must be financed by borrowing from abroad. Since NX = S-I, the increase in I leads to a decrease in NX. An outward shift in the investment schedule causes a trade deficit - see Figure
8-6.
SAVING AND INVESTMENT IN A LARGE OPEN ECONOMY
IN THE LONG RUN
We begin as we did in the small open economy with the relationship between saving and investment and net exports:
S-I=NX
We recall that S-I is called net foreign investment (NFI). It is the amount that domestic investors lend abroad minus the amount that foreign investors lend to the U.S. It may be positive or negative.
In a small open economy, investment (capital) flows in and out of a country freely at a fixed world interest rate. In the large open economy model the interest rate r is largely a function of the domestic economy and central bank monetary policies. If a nation's interest rate is higher than those available abroad for investments of comparable risk, then domestic investors will favor securities in their home country. The higher the interest rates one can earn domestically, the less attractive will be investment abroad. Investors overseas will act in a similar manner. They also have a choice between domestic and foreign investments. The higher the interest rate in their home country, the less they will be investing in the U.S. and other foreign countries. Conversely the lower the interest rate in their own country the more they will favor overseas investments.
Thus, net foreign investment is negative related to the domestic interest rate r. As the domestic interest rate rises, less U.S. savings flow abroad and larger amounts of foreign capital funds flow to the U.S.:
NFI=NFI(r)
The equation states that net foreign investment is a function of the domestic interest rate. NFI varies inversely with r. As r rises, NFI declines and as r declines, NFI increases. Note that NFI can be either positive or negative depending on whether the economy is a lender (has a NX surplus) or a borrower (has a NX deficit) in a world financial markets - see Figure 8-15.
A model of a Large Open Economy. We can now proceed to develop the model for a large open economy. To do so we need to consider two markets: the market for loanable funds and the market for foreign exchange.
The Market for Loanable Funds. An open economy’s saving is used in two ways: to finance domestic investment and to finance net foreign investment. Thus we rewrite the national income identity as follows:
S = I (r) + NFI(r)
The interest rate equilibrates the supply of loanable funds (saving and the demand for loanable funds (domestic investment and net foreign investment) see Figure 8-17.
The Market for Foreign Exchange. Next we consider the relationship between net foreign investment and the trade balance. We have observed previously that the national income identity can be expressed as:
NX = S – I
Since the trade balance (NX) is a function of the exchange rate and NFI = S – I we can state:
NX(e) = NFI
The real exchange rate e is the price that equilibrates the trade balance and net foreign investment – see Figure 8-18.
Lastly, we need to recall that the nominal exchange rate e is equal to the real exchange rate e times the ratio of the price levels in the foreign countries and the home country:
e = e X P* / P
Government Policies and the Trade Balance. We are now in a position to determine how economic policies influence a large open economy. To do this we need to utilize a three-step process:
1. how the market for loanable funds determines the equilibrium interest rate;
2. how the interest rate determines the amount of net foreign investment, which in turn determines the supply of dollars to be exchanged into foreign currency; and
3. how the real exchange rate adjusts the supply of dollars and the demand for dollars emanating from net exports – see Figure 8-19.
Fiscal Policy at Home. A policy of fiscal expansion – an increase in government expenditures or a reduction in taxes reduces national saving, thereby reducing the supply of loanable funds and raising the equilibrium interest rate. The higher interest rate reduces both domestic investment I and net foreign investment NFI. In turn, the decline in NFI decreases the supply of dollars causing the exchange rate to rise (appreciate). This in turn causes net exports to fall and a resulting trade deficit – see Figure 8-20.
A fiscal contraction by reducing government expenditures or raising taxes, increases savings and thus will cause the exchange rate to fall (depreciate) and net exports to rise.
Note that the impact of fiscal policy in a large open economy combines the impact of the closed economy with that of a small open economy. As in the closed economy, a fiscal expansion reduces saving, causing interest rates to rise and crowding out investment. As in the small open a fiscal expansion causes a rise in the exchange rate and a trade deficit.
Shifts in Investment Demand. Assume that the government institutes an investment tax credit, which shifts the investment demand schedule outward. The demand for loanable funds increases, causing a rise in the interest rate. The higher rate reduces net foreign investment as we make fewer loans abroad and foreigners invest more here. The decline in net foreign investment reduces the supply of dollars in the foreign exchange market causing the exchange rate to rise and net exports to fall – see Figure 8-21.
Trade Policies. Protectionist policies such as increases in tariffs or the imposition of import quotas reduces the demand for imports causing an outward shift in the net export schedule. Since the market for loanable funds is unaffected the interest rate is unchanged as is foreign investment. The shift in the net export schedule causes the exchange rate to rise. The rise in the exchange rate makes U.S. goods more expensive relative to foreign goods causing exports to fall and imports to rise. Thus, negative trade restrictions do not change the trade balance – see Figure 8-22.
Shifts in Net Foreign Investment. Changes in fiscal policy abroad may also affect the exchange rate and net exports. A European Union (EU) policy decision to reduce government deficits would increase the saving of the euro zone countries. This would cause a decline in the interest rate in EU counties and stimulate euro nations lending to the U.S. causing net foreign investment to decline. The exchange rate would appreciate and net exports would fall – see Figure 8-23.
THE IMPACT OF GOVERNMENT POLICIES IN A SMALL OPEN ECONOMY IN THE SHORT RUN UNDER FLOATING AND FIXED EXCHANGE RATE SYSTEMS
THE MUNDELL FLEMING MODEL
We now turn our attention to the short run. Again we begin with a small open economy. The principal paradigm for analyzing the impact of government policies in the short run is the Mundell-Fleming model. Robert Mundell and J. Marcus Fleming were economists at the International Monetary Fund in the 1960’s. They extended the Keynesian closed economy IS/LM model to predict the impacts on monetary, fiscal and trade restriction policies under floating vs. fixed exchange rate systems. Robert Mundell was the 1999 Nobel Laureate in Economic Science. In addition to the Mundell-Fleming model he was recognized for his work on optimal currency areas. The latter research has been influential in moving the European Union to a common currency. Indeed, he is referred to as the “euro godfather”.
The Mundell-Fleming Model. The model has the following characteristics:
1. Like the closed economy IS-LM model, it initially assumes that the price level is fixed.
2. Also, like the closed IS-LM model it shows the interaction between the goods market and the financial (money) market.
3. It shows that the behavior of an economy depends on the exchange rate system it has adopted.
4. It begins by assuming a floating exchange rate system – the nation’s central bank allows the exchange rate to adjust to changing economic conditions.