[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

domestic economy is borrowing more from foreigners than it is lending to foreigners.
In 2002, for example, national saving in the United States totaled $1.54 trillion (of which
private saving was $1.57 trillion and government saving was –$30 billion), while private
investment was $1.93 trillion. The difference between investment and national saving
was $390 billion, which was financed by a net capital inflow. Because this investment
was financed by borrowing from abroad, it represents the amount that foreigners
have invested in the United States, and so it is also called net foreign investment.
When the capital market in an open economy is in equilibrium, national saving
plus net capital inflows equals private investment. National saving plus capital flows
from abroad can be thought of as the “sources” of funds, and investment can be
thought of as the “use” of these funds.
The reaction in the capital market is different if the country is a small open
economy rather than a large open economy. A small open economy is one that is too
small to affect the rest of the world with shifts in its domestic saving or investment;
it can borrow or lend internationally at the world rate of interest. A large open economy
can also borrow and lend in the international capital market. However, domestic
shifts in saving or investment in such an economy are substantial enough to affect
that market’s equilibrium world rate of interest.
The Capital Market in the Small Open Economy Capital
market equilibrium requires that national saving plus net capital inflows
equal private investment. The implications this has for the economy
will depend on the relationship of the supply of funds from both domestic
and foreign sources to the real interest rate. A small open economy
like Switzerland faces a perfectly elastic supply curve of funds at the
world real interest rate. If borrowers in Switzerland were to pay a
slightly higher interest rate than that paid in other countries, those
with financial capital to lend would divert their funds to Switzerland.
If Switzerland were to pay slightly less than the interest rate available
in other countries (adjusted for risk), it would not obtain financial capital.
Those who have financial investments in Switzerland can take
their funds and invest them abroad to earn higher interest rates. These
flows of international financial capital play an important role in the
global economy. For a small country, the interest rate is determined
by the international capital market. Effectively, such a country takes the
interest rate as fixed. This is shown in Figure 26.1, where the interest
rate is fixed at r*. A fixed interest rate, in turn, means that the level of
investment is fixed, at I* in Figure 26.1. Any shortfall between the level
of domestic national saving and the level of domestic investment is
funded by borrowing from abroad. In Figure 26.1, if the level of national
saving is given by S 0 , the amount of funds borrowed from abroad is
B 0 . A reduction in the amount of domestic saving increases the amount
of foreign borrowing (B 1 ) but leaves investment unaffected.
This result contrasts with our earlier result for a closed economy,
one in which there is no foreign borrowing or lending. There, we noted
that lower national saving (a shift to the left in the saving curve) results in
less investment. The effect of an increase in government expenditures
REAL INTEREST RATE (r )
r *
Figure 26.1
B 1
B 0
National
saving
curves
S 1
S 0
I*
SAVING (S) AND INVESTMENT (I )
SUPPLY OF SAVING IN A SMALL OPEN
ECONOMY
Investment
schedule
In a small open economy, the real interest rate, r*, is
determined by the international capital market. That in
turn determines the level of investment, I*. In the figure,
saving is assumed to be fixed, unaffected by the interest
rate. If domestic national saving equals S 0 , the shortfall,
B 0 , is made up by borrowing from abroad. A reduction in
national saving to S 1 , caused, for example, by an increase
in the government’s deficit, leads to increased international
borrowing, B 1 , but leaves investment unchanged.
THE OPEN ECONOMY ∂ 569