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

The discussion so far has also assumed that the world’s capital markets are fully
integrated. However, this is far from the truth. Individuals know more about what
is going on in their own country than about what is going on abroad. American
investors require slightly higher returns on foreign investments to compensate
for this increased risk. In recent years, as the flow of information has increased,
the magnitude of this risk premium—the extra return they must earn for taking
the risk of investing abroad—has decreased. But because financial capital still
does not flow perfectly freely, interest rates are not equal in all countries, and
a decrease in U.S. saving is not fully made up by an increased flow of capital
from abroad.
While capital from abroad does not fully offset changes in U.S. saving, foreign
saving has been an important source of funds for the United States. In 2002, for
example, foreign capital flows were equal to 20 percent of U.S. private investment
spending. An increase in U.S. interest rates relative to rates in other countries makes
it more attractive for foreigners to lend to American firms and the U.S. government.
Conversely, a decrease in U.S. interest rates relative to rates in other countries
makes such lending less attractive for foreigners. Thus, the total supply of saving
available to finance U.S. investment—the sum of national saving plus net capital
inflows—increases as the U.S. interest rate rises. Even if national saving is unresponsive
to changes in interest rates (as we have often assumed in drawing a vertical
national saving curve), the total supply of funds will increase with the U.S. interest
rate. This means that we should draw the saving curve as having a positive slope
when we take into account both domestic and foreign sources of saving.
What are the implications of a positively sloped saving curve? Suppose the U.S.
investment function shifts to the right. Many economists have argued that this type
of shift occurred in the 1990s as firms increased investment at each interest rate to
take advantage of new technologies. In a closed economy, such a shift would raise the
real interest rate, and investment would be constrained by the availability of domestic
saving. But in today’s integrated world economy, an investment boom in the
United States can be financed by capital inflows. An increase in U.S. investment at
each real interest rate raises world interest rates, but the resulting capital inflow
increases the supply of saving and results in more investment than would occur
when investment must be financed solely from domestic sources.
Wrap-Up
A LARGE OPEN ECONOMY:
THE UNITED STATES
The United States is a large open economy. Reductions in the U.S. national saving
rate are reflected in increases in the real interest rate internationally (and therefore
in the United States also), and reduced levels of investment. But the effects on
investment in the United States are smaller than would be the case if the economy
were closed, because an increase in U.S. interest rates will attract foreign saving (a
capital inflow).
THE OPEN ECONOMY ∂ 571