Savings Or Investments: Open Economy, Open Question

In an open economy, the amount saved is directly linked to the amount invested. This relationship, known as the savings-investment identity, is a fundamental macroeconomic concept. It states that the amount of money available for investment, which includes economic activities like building a university or R&D, must be equal to the amount saved. This is because savings are converted into loanable funds, providing the necessary capital for investments.

In an open economy, foreign investment and trade also come into play. The savings-investment identity in this context is expressed as: S = I + G - T + X - M, where S is savings, I is investment, G is government spending, T is taxes, X is exports, and M is imports. This equation highlights that an open economy's savings include both domestic and foreign sources, and that the balance of trade (X-M) can impact the level of investment in the domestic economy.

The relationship between savings and investment is crucial for understanding a country's economic health and growth. It also provides insights into how different sectors of the economy interact and influence each other.

The saving-investment identity

In mathematical terms, the saving-investment identity can be expressed as:

Supply of financial capital = Demand for financial capital

S + (M - X) = I + (G - T)

Here, S represents private savings, T is taxes, G is government spending, M is imports, X is exports, and I is investment. This equation demonstrates that the total quantity of financial capital supplied must equal the total quantity of financial capital demanded.

Y = C + I + G + (X - M)

Where Y is the national income identity, C is consumption, I is investment, G is government spending, and (X - M) is the balance of trade (exports minus imports).

The balance of payments accounting

The balance of payments (BOP) is a country's record of all international transactions (payments and receipts) between its residents and residents of other countries during a specific time period. The BOP is usually calculated quarterly and annually. It is divided into three main accounts: the current account, the capital account, and the financial account. These accounts summarise the economic transactions of an economy with the rest of the world, including exports and imports of goods, services, and financial assets, as well as transfer payments like foreign aid.

The current account records the flow of goods and services in and out of a country, including tangible goods, service fees, tourism receipts, and money sent to other countries as official aid or remittances. The capital account records international capital transfers, including debt forgiveness, the transfer of goods and financial assets, ownership of fixed assets, as well as gift and inheritance taxes, death levies, and uninsured damage to fixed assets. The financial account reflects increases or decreases in a country's ownership of international assets, including private investments in businesses, real estate, bonds, and stocks, as well as government-owned assets like foreign reserves and gold.

The BOP is based on double-entry bookkeeping, where each transaction has a credit and a debit entry. A credit is a transaction that brings money into the country, while a debit is a transaction where money flows out of the country. The BOP should theoretically be zero, with credits (assets) and debits (liabilities) balancing each other out. However, in reality, this rarely happens, and the BOP can indicate whether a country has a deficit or a surplus. A surplus indicates that a country is a net creditor to the world, while a deficit indicates that it is a net debtor.

The BOP is an important indicator of an economy's health and can provide insights into a country's economic outlook and strategies. It is particularly relevant for 'open' economies that engage in international trade, such as Australia. By examining the BOP, we can understand the flow of resources between a country and its trading partners, as well as the net change in ownership of assets and liabilities.

Net foreign assets

The NFA metric can be influenced by changes in asset prices and exchange rates. For instance, an appreciation of a country's currency will decrease the value of both assets denominated in foreign currency and the burden of liabilities denominated in foreign currency.

The NFA position indicates whether a country is a net creditor or debtor to the rest of the world. A positive NFA balance means the country is a net lender, while a negative NFA balance means it is a net borrower.

The World Bank offers an alternative definition of "net foreign assets", describing it as the sum of foreign assets held by monetary authorities and deposit money banks, minus their foreign liabilities.

The current account

• Net exports of goods and services
• Net investment income from abroad
• Net unilateral transfers

Net exports of goods and services refer to the trade of merchandise and services. Net investment income from abroad includes interest payments, dividends, royalties, and other returns on assets owned by domestic individuals in a foreign country. Net unilateral transfers are payments from one country to another that do not correspond to the purchase of a good or service, such as foreign aid.

> First, it is worth remembering that in a closed economy, we assume that saving = investment. (S=I). For a firm to invest, it needs savings to be able to finance the investment.

> A fall in savings means people are spending more (higher consumption) therefore, this would tend to suck in imports as we buy goods and services from abroad. But, also, if domestic savings fall – how will the domestic investment be financed? The investment must be financed by capital inflows from abroad.

Thus, a fall in domestic savings will lead to a current account deficit, as the country will need to import more goods and services than it exports, and will need capital inflows from abroad to finance its investment. Conversely, a country with excess savings will have a current account surplus.

The capital and financial account

The Capital Account

The capital account records the net flow of investment into a country's economy. It reflects the net change in ownership of a country's assets, including foreign investments, loans, and the transfer of financial assets. The capital account also covers specific types of asset transfers and non-financial assets. It includes:

• Debt forgiveness
• The transfer of goods and financial assets by migrants entering or leaving a country
• The transfer of ownership of fixed assets and funds received for the sale or acquisition of fixed assets
• Gift and inheritance taxes
• Death levies, patents, copyrights, and royalties
• Uninsured damage to fixed assets

A surplus in the capital account means money is flowing into the country, representing the borrowing or sale of assets. A deficit indicates money flowing out of the country, suggesting an increase in ownership of foreign assets.

The Financial Account

The financial account measures the increase or decrease in a country's ownership of international assets. It deals with money related to:

• Private investments in businesses, real estate, bonds, and stocks
• Government-owned assets, such as special drawing rights at the International Monetary Fund (IMF)
• Private sector assets held in other countries
• Local assets held by foreign governments and individuals
• Foreign direct investment

The financial account can be divided into two sub-accounts: domestic ownership of foreign assets and foreign ownership of domestic assets. If the former increases, the overall financial account increases, and vice versa.

An open economy supports free trade and is characterised by a large volume of imports and exports. In an open economy, the capital and financial accounts reflect investment and capital market regulations. Positive capital and financial accounts indicate that a country has more debits than credits and is a net debtor to the world. Conversely, negative capital and financial accounts make the country a net creditor.

Frequently asked questions