Small and Large Open Economies

Macroeconomic Theory I

ECON222

Fall 2017

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 1 / 18
The Small Open Economy (SOE) Model

The real interest rate is exogenous for a SOE

,! nancial ows are too small to aect rate set in international markets

Financial markets are open to savers and borrowers wherever they live
=) the domestic real interest rate adjusts to equal the world interest rate

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 2 / 18
Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 3 / 18
Implications of the SOE model

Desired national saving need not equal desired investment

Higher values of the world real interest rate (r w ) imply:

,! lower levels of desired consumption (people save more)
,! lower desired investment (higher uc).

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 4 / 18
 r
S(r)

rw

I(r)

I1d S1d Sd, I d

Figure: SOE running a CA surplus

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 5 / 18
 r
S(r)

w
r
I(r)

d d
S1 I1 Sd, I d
Figure: SOE running a CA decit

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 6 / 18
 r
S(r)

w
r2
w
r1
I(r)

d d
S1 Sd2 I2
d
I1 Sd, I d
Figure: Eect of rise in world interest rate

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 7 / 18
Example 1: A temporary adverse income shock

A severe drought when the CA is in surplus will cause:

,! income to fall
,! saving to fall at every r (the saving curve shifts left)
,! net foreign lending and current account to shrink.

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 8 / 18
 r
S1(r)
S2(r)

rw

I(r)

d
I 1d S2 S1d Sd, I d
Figure: Eect of a decline in current income

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 9 / 18
Example 2: permanent positive productivity shock

A technological innovation, when the CA is in surplus will cause;

,! the expected MPK f to increase
,! the desired capital stock to increase
,! desired investment to rise at every r
,! net foreign lending and the CA to shrink

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 10 / 18
 r
S(r)

rw

I2(r)

I1(r)

I1d I 2d S1d Sd, I d

Figure: Eect of rise in expected TFP

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 11 / 18
A large open economy model

Large open economies can aect the world real interest rate

Suppose there are only two large economies: home and foreign
,! idea can be extended to mutiple countries

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 12 / 18
Goods market equilibrium with large open economies

Now the world real interest rate is endogenous

,! adjusts so that that desired lending by one country equals desired
borrowing by the other

The lending countrys CA surplus equals the borrowing countrys CA

decit

World desired saving equals world desired investment:

SHd + SFd = IHd + IFd

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 13 / 18
 Home Foreign
r r
S(r) S(r)

a b c d
rw

I(r)
I(r)
d d d d d
I Hd SH
d S, I SF I Fd S, I

Figure: World nancial market equilibrium (ab=cd)

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 14 / 18
 Home Foreign
r r
S(r) S(r)

r0

I(r)
I(r)
d d d d d d d
IH
d
SH S, I SF IF S, I

Figure: Disequilibrium: supply of savings exceeds demand

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 15 / 18
Why is Canadas real interest rate so low?

The supply of global savings is high ("savings glut")

,! demographics
,! China and other emerging economies

Global investment is relatively low recently

,! "secular stagnation"?
,! recent global recession
,! on-going uncertainty in Europe

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 16 / 18
 Figure: National Savings as % of GDP

Macroeconomic Theory I (ECON222) Savings & Investment in an Open Economy Fall 2017 17 / 18
6
e-Brief

Figure 4: United States Non-Residential Private Investment as a Percentage of GDP

16

14

12

10
Percent

0
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
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00
01
02
03

05
04

06
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09
10
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13
19
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19
19
19
19
19
19
19
20
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20
20

20
20
20
20
20
20
20
20
Source: United States Bureau of Economic Analysis.

While new investment opportunities may be around the corner, they are not yet apparent. And the secular
decline in investment demand over the last three decades or so is unlikely to be significantly reversed over the
next several years given the very long cycles such demand is subject to. A reasonable assumption is therefore that
the intensity of business investment in the developed world will likely remain below its pre-financial crisis peaks
for the next three to 10 years. Continued low desired investment will therefore exacerbate the effects of high
desired savings on interest rates.

Conclusion
Over the next two to five years, central banks in most developed countries will likely need to raise rates as
economic conditions improve; the Bank of Canada expects the Canadian economy to return to full capacity by
the second half of 2015 (Bank of Canada 2013). There is disagreement about when, and the extent to which,
interest rates will need to rise as the economy returns to its potential. As we have argued in this E-Brief, the
normal or neutral rate, in Canada and elsewhere, is likely lower than that suggested by historical averages,
due to fundamental shifts in the determinants of desired saving and desired investment. The Bank of Canada will
therefore likely only need to take small, incremental steps on its way to normalcy.

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