Econ 304 Exam 2 Textbook Notes Outline Chapter 2 pp 40 41 I Relating Saving and Wealth a Stocks and Flows i Flow variables variables that are measured per unit of time 1 Ex GDP various types of expenditures income and saving 2 Often the rate of change in a stock variable 3 Ex bathtub water a The amount of water at any moment is a stock b The rate at which water enters the tub is a flow variable variable c Flows the change of the stock ii Stock variables defined at a point in time contrast to flow variables 1 Ex amount of money in your bank account on a specific date the total value of all houses in the US on a specific date b Wealth and Saving as Stock and Flow i Similar relation to the bathtub example ii Wealth of an economic unit is its assets minus its liabilities 1 Also called net worth 2 Assets things unit owns IOUs from other economic c National Wealth units etc 3 Liabilities what owes to other units 4 Measured in dollars at a point in time 5 Stock variable iii Saving 1 Measured in dollars per unit time 2 Flow variable 3 Accumulation of assets or reduction in liabilities adds to wealth just as water flowing into bathtub i The total wealth of the residents of a country ii Consists of the country s domestic physical assets land physical capital and its net foreign assets NFA iii Net foreign assets foreign assets foreign liabilities 1 Part of national wealth because represent claims on foreigners that are not offset by foreigners claims on the domestic economy 2 Assets owned by US ex Japanese stocks bonds factories loans to Japanese 3 Liabilities US assets owned by foreign country ex US bonds stocks factories owned by Japanese Japanese loans to US iv Domestic financial assets held by domestic residents not part of national wealth value of any domestic financial asset is offset by a domestic financial liability v Can change in two ways over time 1 The value of the existing assets or liabilities that make up national wealth may change a Ex dramatic increase in stock market in 1990s increased US national wealth b Depreciation of physical assets reduces national wealth 2 National saving a Over a period of time each extra dollar of national saving adds a dollar to national wealth b S I CA c National savings has two uses i ii Increase the stock of domestic physical capital through investment Increase the nations stock of net foreign assets by lending to foreigners or acquiring foreign assets in an amount equal to the current account balance CA d Increases in national saving increase national wealth by the same amount e The more rapid the flow of national saving the more quickly the stock of national wealth rises vi National saving and investment in US compared to other countries 1 US is low saving compared with other industrialized countries Investment is also relatively low Investment rates are generally higher than savings rates 2 3 4 US current account has been in deficit basically since 1980 negative a S I CA if investment saving CA must be 5 High saving countries China have saving rates higher than investment rates consistently positive CA balance Chapter 5 pp 180 197 I Goods Market Equilibrium in an Open Economy a National income accounting identity i S I CA I NX NFP ii Version of the uses of saving identity iii States that nation saving has two uses 1 2 Increase nation s stock and capital by funding investment Increase the nation s stock of NFA by lending to foreigners 3 Current account CA is the sum of net exports NX and net factor payments from abroad NFP iv For the economy to be in goods market equilibrium actual v national saving and investment must also equal their desired levels If actual and desired levels are equal 1 Sd Id CA Id NX NFP 2 The goods market equilibrium condition for an open 3 economy In goods market equilibrium in an open economy Sd must equal Id plus the amount lent abroad CA 4 Closed economy equilibrium condition CA 0 vi For simplicity we assume that NFP 0 1 Sd Id NX 2 We can refer to NX as net exports or as the current account balance synonymously vii As for the closed economy we can also write the goods market equilibrium condition for the open economy in terms of AS and AD viii Alternative condition for goods market equilibrium 1 Y Cd Id G NX a Y output Cd desired consumption spending G government purchases 2 Rewritten a NX Y Cd Id G i States that in GME the amount of NX a country sends abroad equals the country s total output minus total desired spending by domestic residents absorption b Sd Y Cd G c NX Exports X Imports M ix Absorption 1 An economy in which output exceeds absorption will send goods abroad NX 0 current account trade surplus 2 An economy that absorbs more than it produces will be a net importer NX 0 current account trade deficit x Trade deficit 1 Ex Our US trading partner Japan has a trade deficit X M a Japan finances this by selling stocks bonds or obtain loan from US b Japan is selling assets borrowing US is lending c NFA owned by US increases US has increased foreign assets and the change in their NFA is positive 2 Ex US has a trade deficit that must be financed a Sell assets to trading partner Japan or borrow loans increase b NFA decreases because our foreign liabilities c Change in NFA is negative we are selling our assets to our trading partner II Saving and Investment in a Small Open Economy a Small open economy an economy that is too small to affect the world real interest rate b World real interest rate the real interest rate that prevails in the international capital market the market in which individuals businesses and governments borrow and lend across national borders c Can describe the GME in a small open economy by using the saving i Fixed in this economy investment diagram d New assumption residents of the economy can borrow or lend in e the international capital market at the expected world interest rate rw If the world real interest rate is rw the domestic real interest rate must be as well no domestic borrowers with access to the international capital market would pay more than this rate to borrow no domestic saver with access to the international capital market would accept less than this rate to lend either f Desired national saving does NOT need to equal desired investment at equilibrium in contrast to in a closed economy If rw is above the closed market equilibrium Sd Id g i This excess in saving can be used to buy foreign assets ii This outflow uses up the excess national saving so there is no iii