118-1Saving and Investmentin the Open Economy,Part 218-2Agenda• Globalization and the U.S. Economy• Saving and Investment in Large Open Economies (LOE)• The U.S. Current Account Deficit• Fiscal Policy and the Current Account¾ The Twin Deficits18-3Globalization and the U.S. economy• World’s economies have become increasingly interdependent, with more international trade, finance and investment.18-4Globalization and the U.S. economy• Exports and imports have grown significantly as a percent of GDP over the past 50 years and particularly over the last 20 years.218-5Exports and imports18-6Globalization and the U.S. economy• U.S. investments abroad and foreigners’investments in U.S. have also grown significantly as a percent of U.S. GDP over past 20 years.¾ The U.S. is now the world’s largest international debtor.18-7International ownership of assets18-8Globalization and the U.S. economy• Costs of globalization for the U.S.: ¾ U.S. imports increase.• This displaces some domestic production and jobs.• This increases competitive pressures and reduces profit margins in import-competing sectors.¾ U.S. foreign direct investment might displace domestic investment.• If so, this reduces domestic production and jobs.318-9Globalization and the U.S. economy• Benefits of globalization for the U.S.: ¾ U.S. imports increase.• This may mean are wider variety of goods and services.• Prices of imported goods and services and prices of goods and services in import-competing sectors decline.• Generates production and jobs in import-complementary sectors.18-10Globalization and the U.S. economy• Benefits of globalization for the U.S.: ¾ U.S. exports increase.• Domestic production and employment expand in the export and export-complementary sectors.• This increases pricing power and profit margins in these sectors.¾ Foreign direct investment in the U.S. increases domestic investment.• This increases domestic production and jobs. 18-11Globalization and the U.S. economy• Recently, big changes in the business services industry.¾ The most visible sub-sector has been call centers.• Substantial offshoring has resulted in domestic job losses.¾ However, the U.S. is the world leader in exporting business services.• Far more is done in U.S. and sold abroad than vice versa.¾ U.S. benefits more than it “loses” from such activity.18-12International trade in business services418-13Saving and Investment in LOE• A large open economy, LOE, is an economy that is large enough to affect the world real interest rate.¾ Suppose there are just 2 economies in the world.• The home or domestic economy.– Saving = S, investment = I.• The foreign economy, representing the rest of the world.– Saving = SFor, investment = IFor.18-14Saving and Investment in LOE• The world real interest rate, rw, will adjust to equilibrate desired international lending by one country with desired international borrowing by the other.¾ The equilibrium world real interest rate is determined such that a current account surplus in one country is equal in magnitude to the current account deficit in the other.18-15Determination of rwwith two LOEs18-16Saving and Investment in LOE• Economic shocks in a LOE:¾ Anything that increases desired national saving, or• Output rises, future output falls, G falls, etc.¾ Anything that increases desired investment.• MPKfrises, τfalls, etc.518-17An increase in Sdwith LOEs18-18Saving and Investment in LOE• Economic shocks in a LOE:¾ An increase in desired saving in one LOE will:• Reduce that country’s current account balance,• Reduce that country’s net foreign lending, and– Or increase that country’s net foreign borrowing.• Cause the world real interest rate to decline.18-19An increase in Idwith LOEs18-20Saving and Investment in LOE• Economic shocks in a LOE:¾ An increase in desired investment in a LOE will:• Increase that country’s current account balance,• Increase that country’s net foreign lending, and– Or decrease that country’s net foreign borrowing.• Cause the world real interest rate to rise.618-21The U.S. current account deficit• The current account deficit has deteriorated significantly over the past 20 years.¾ Why has the current account deteriorated so much?¾ Is a huge current account deficit sustainable?¾ If not, what will happen to cause it to adjust?18-22The U.S. current account balance18-23The U.S. current account deficit• Why has the U.S. current account deficit deteriorated so much?¾ Weaker growth in foreign demand.¾ Better international investment opportunities.¾ Higher oil prices.¾ Increased saving by developing countries.18-24The U.S. current account deficit• Lower foreign demand:¾ Economic growth in Japan and Europe has been much weaker than in the U.S. since the early 1990s.• People there are saving more, investing in the U.S. more, but buying fewer U.S. goods.718-25The U.S. current account deficit• Better international investment opportunities:¾ U.S. investors are diversifying their investments internationally.¾ Foreign investors are investing heavily in the U.S.18-26Net international ownership of assets18-27The U.S. current account deficit• Higher oil prices:¾ U.S. imports much of its oil consumption.• Doubling of oil prices recently led to decline in current account balance of over 1% of GDP.18-28Petroleum net exports818-29The U.S. current account deficit• Increased saving by developing countries:¾ Many developing nations changed from being international borrowers to being international lenders.• They want to invest in safe places like U.S., rather than borrowing and getting into financial crises.18-30The U.S. current account deficit• Is a huge current account deficit sustainable?¾ Most economist do not think so.• If not, what will happen to cause it to adjust?¾ A decline in the foreign exchange value of the dollar will increase import prices and decrease export prices.• This will lead to lower imports and higher exports and reduce current account deficit.18-31Fiscal policy and the current account• Are budget deficits and current account deficits necessarily related? ¾ This is the “twin deficits” argument.18-32Fiscal policy and the current account• Are budget deficits and current account deficits necessarily related? ¾ This depends on the response of national saving.• An increase in the government budget deficit raises the current