Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Saving and investment in an open economy

You may be concerned that savings only equals investment in a closed economy. This is a reasonable concern, because most countries engage in large amounts of international trade. In an open economy, the correct relationship between savings and investment is:

NX is net exports and so, in words, savings less investment must exactly equal net exports.

This simple expression has a rather ‘deep’ interpretation: if a country has more savings than investment (S – I > 0), the excess savings flow abroad, which is why S – I is called net capital outflow. You can think of this net capital outflow as the country lending money to the rest of the world.

Interestingly, the money lent abroad is exactly equal to net exports: that is, the net demand for goods and services from abroad. For example, if the UK’s net capital outflow is equal to £1 billion, all that money would be used by foreigners to buy UK exports. In return, people in the UK effectively receive a claim on (that is, ownership of) £1 billion

worth of capital stock abroad.

So what determines the real interest rate in an open economy? Answer: the global market for loanable funds. The interest rate adjusts to ensure that global savings is exactly equal to global investment. This isn’t surprising, because the world economy as a whole is a closed economy (at least until humans find alien life and begin trading with them!).

Call r* the equilibrium world interest rate. Then for a small open economy (small relative to the world economy as a whole) the following must apply:

That is, the domestic real interest rate (r) must exactly equal the world interest rate. If not, arbitrageurs could make a riskless profit. For example, if r

• 
  r*, arbitrageurs could borrow domestically at rate r and then lend abroad for rate r*. Doing so would increase the demand for domestic savings (increasing r) and increase the supply of savings in the global market (reducing r*). Arbitrage would continue until r = r*. You can apply a similar argument for r < r*.