I n t h I s c h a p t e r y o u w I l L

part because of increased government budget deficits and in part because of a
fall in private saving. Because this fall in saving did not coincide with a similar
fall in domestic investment, net foreign investment became a large negative
number, indicating that foreigners were buying more assets in the United States
than Americans were buying abroad. Put simply, the United States was going
into debt.
As we have seen, accounting identities require that net exports must equal
net foreign investment. Thus, when net foreign investment became negative,
net exports became negative as well. The United States ran a trade deficit:
This equation shows that a nation’s saving must equal its domestic investment
plus its net foreign investment. In other words, when U.S. citizens save a dollar of
their income for the future, that dollar can be used to finance accumulation of do-
mestic capital or it can be used to finance the purchase of capital abroad.
This equation should look somewhat familiar. Earlier in the book, when we
analyzed the role of the financial system, we considered this identity for the spe-
cial case of a closed economy. In a closed economy, net foreign investment is zero
(
NFI
0), so saving equals investment (
S
I
). By contrast, an open economy has
two uses for its saving: domestic investment and net foreign investment.
As before, we can view the financial system as standing between the two sides
of this identity. For example, suppose the Smith family decides to save some of its
income for retirement. This decision contributes to national saving, the left-hand
side of our equation. If the Smiths deposit their saving in a mutual fund, the mu-
tual fund may use some of the deposit to buy stock issued by General Motors,
which uses the proceeds to build a factory in Ohio. In addition, the mutual fund
may use some of the Smiths’ deposit to buy stock issued by Toyota, which uses the
proceeds to build a factory in Osaka. These transactions show up on the right-
hand side of the equation. From the standpoint of U.S. accounting, the General
Motors expenditure on a new factory is domestic investment, and the purchase of
Toyota stock by a U.S. resident is net foreign investment. Thus, all saving in the
U.S. economy shows up as investment in the U.S. economy or as U.S. net foreign
investment.

---

C H A P T E R 2 9
O P E N - E C O N O M Y M A C R O E C O N O M I C S : B A S I C C O N C E P T S
6 6 7
Imports of goods and services exceeded exports. In 1998, the trade deficit was
$151 billion, or about 1.8 percent of GDP.
Are these trade deficits a problem for the U.S. economy? Most economists
believe that they are not a problem in themselves, but perhaps are a symptom
of a problem—reduced national saving. Reduced national saving is potentially
a problem because it means that the nation is putting away less to provide for
its future. Once national saving has fallen, however, there is no reason to de-
plore the resulting trade deficits. If national saving fell without inducing a trade
deficit, investment in the United States would have to fall. This fall in invest-
ment, in turn, would adversely affect the growth in the capital stock, labor
Percent
of GDP
20
18
16
14
12
10
1960
1965
1995
1990
1985
1980
1975
1970
National saving
Domestic investment
Percent
of GDP
4
4
3
2
1
0
1
2
3
Net foreign
investment
(a) National Saving and Domestic Investment (as a percentage of GDP)
(b) Net Foreign Investment (as a percentage of GDP)
2000
1960
1965
1995
1990
1985
1980
1975
1970
2000
F i g u r e 2 9 - 2
N
ATIONAL
S
AVING
,
D
OMESTIC
I
NVESTMENT
, 
AND
N
ET
F
OREIGN
I
NVESTMENT
.
Panel (a) shows national saving
and domestic investment as
a percentage of GDP. Panel
(b) shows net foreign investment
as a percentage of GDP. You can
see from the figure that national
saving has been lower since 1980
than it was before 1980. This fall
in national saving has been
reflected primarily in reduced net
foreign investment rather than in
reduced domestic investment.
S
OURCE
: U.S. Department of Commerce.

---

6 6 8
PA R T E L E V E N
T H E M A C R O E C O N O M I C S O F O P E N E C O N O M I E S
productivity, and real wages. In other words, given the fact that U.S. citizens are
not saving much, it is better to have foreigners invest in the U.S. economy than
no one at all.
Q U I C K Q U I Z
:
Define 
net exports
and 
net foreign investment.
Explain how
they are related.
T H E P R I C E S F O R I N T E R N AT I O N A L T R A N S A C T I O N S :
R E A L A N D N O M I N A L E X C H A N G E R AT E S
So far we have discussed measures of the flow of goods and services and the flow
of capital across a nation’s border. In addition to these quantity variables, macro-
economists also study variables that measure the prices at which these interna-
tional transactions take place. Just as the price in any market serves the important
role of coordinating buyers and sellers in that market, international prices help co-
ordinate the decisions of consumers and producers as they interact in world mar-
kets. Here we discuss the two most important international prices—the nominal
and real exchange rates.
N O M I N A L E X C H A N G E R AT E S
The