International Capital Markets

from last time
government saving
a small open economy
a large open economy

From Last Time

Expected profitability of capital and the expected real interest rate are two of the factors that influence the amount of business investment.
Any price change (and the interest rate is the price of borrowing money) has two effects: the substitution effect and the income effect. The substitution effect comes about because a rise in the interest rate increases the rewards to saving. So, pe ople save more and spend less. However, the income effect has the opposite effect. A rise in the interest rate means I need to save less to reach a given savings goal because what I do save will earn more interest. Studies have found the substitution e ffect is strong: a rise in the interest rate increase savings.

Government Saving

The government is a net saver when it runs a budget surplus; it is a net borrower when it runs a budget deficit. A government budget deficit reduces the pool of savings available for private borrowing. This decrease in savings raises the interest rate.

However, interest rates will not be affected if Ricardian Equivalence holds. Ricardian Equivalence is the proposition that private savings rises to offset government budget deficits. Households realize that budget deficits must be financed by higher taxes in the future. Household savings will rise in order to have the funds available to pay these higher taxes. The savings curve does not shift. Empirically, however, there is little support for Ricardian Equivalence.

A Small Open Economy

A closed economy neither borrows from nor lends to foreign countries. Foreigners may want to lend funds for investment in the U.S. if the expected returns are higher than in other countries. If investment opportunities outside the U.S. are more promising, savings will go outside of the U.S.

When capital is mobile internationally, we have an open economy. A country's desired total saving is equal to the sum of desired domestic investment and the amount of savings lent abroad.

A small open economy is one whose total saving is too small to affect the world real interest rate. For large and small open economies, the domestic real interest rate must equal the world real interest rate.

A Large Open Economy

A large open economy can affect the world real interest rate. The world real interest rate equates desired international lending by the U.S., for example, with desired international borrowing by the rest of the world.

Equilibrium occurs when the amount the U.S. wants to lend abroad is equal to the amount foreigners wish to borrow from us.

A rise in investment in the U.S. raises the world real interest rate; an increase in saving in the U.S. lowers the world real interest rate.