Question

Comment on the following statements:

a)In an open economy the only source of domestic investment is domestic savings.

b)If domestic investment is smaller than domestic saving, there is a positive net export of capital and a surplus on the current account.

c)Small open economy will become a net creditor if the domestic real interest rate that it would create under autarky is smaller than the international real interest rate.

d)Liberalization of capital movements has an unambiguously positive effect on national income per capita in the long-run but ambiguous effect on factor incomes.

Answer 1

a) In an open economy, the domestic savings basically denotes the overall or total savings by the domestic households, private companies or business organizations, and the government which is referred to as domestic public savings. Hence, the chief sources of the domestic savings or domestic supply of financial capital or funds are domestic households, private companies or business organizations, and the government. On the other hand, domestic investment refers to domestic financial investment by domestic private companies or business organizations. It is one of the components of the domestic demand for financial capital in the economy along with government spending or expenditure. These two components constitute the overall domestic demand for financial capital which is fulfilled by the domestic aggregate savings or the domestic supply of financial capital or funds from the domestic households, private companies or business organizations, and the government savings or the public savings. Now, based on the expenditure method of calculating national output or GDP in an open economy, private domestic investment also depends on the net export level or specifically, the trade balance calculated as the difference between the total or overall export and the overall or total import level registered by the economy. As the trade balance decreases or the economy experiences trade deficit indicated by a higher total or overall import level of goods and services compared to the overall export of goods and services, the private domestic investment also increases accordingly or proportionately. Hence, another important source of private domestic investment in an open economy is also the net export or specifically, trade deficit registered by the economy.

b) Again based on the Expenditure Method of computing the GDP or national output of an open economy, the private domestic investment is basically equal to the difference between the national output or GDP and the government spending/expenditure, aggregate consumption expenditure, and the overall or total net export. The net export or the trade balance is ideally determined by the interaction between the national savings and national investment level in the economy. As stated in parts), in an open economy, aside from the national or domestic savings another important source of domestic investment is the trade deficit or the difference between the overall export level and import level registered by the economy and furthermore, the trade deficit is calculated as the difference between the domestic or national investment and domestic or national savings in an open economy. Therefore, if the domestic investment is less than the domestic or national savings, it essentially implies a reduction in the trade deficit or an improvement in the trade balance as well as the overall current account balance, implied by a lower trade deficit.

c) It can be customarily stated that the domestic interest rate in any small open economy adjusts accordingly with the international or foreign interest rate implying that the domestic interest rate in the economy is usually equal to the international or foreign interest rate. Even if there is a discrepancy, the international arbitrage conditions will adjust the domestic interest rate accordingly or proportionately with the international or foreign interest rate. Hence, in a small open economy, the domestic interest rate is determined exogenously by the international interest rate and not by the interaction of nations or domestic savings and investment such as in a big open economy. Therefore, if the domestic interest rate of any small open economy is higher than the international interest rate, demand for domestic assets and investment will increase among foreign or international investors as the rate of return on domestic assets and investment is now relatively higher than any foreign investment and asset. Higher demand for domestic assets by the foreign investors and financial speculators will consequently increase the price or value of the domestic assets and investments or the domestic interest rate, holding everything else as constant. Hence, it will adjust the domestic interest rate to the point where it becomes equal to the international interest rate.

d) The liberalization of capital movements essentially refers to free capital movement in the global or international market among the respective countries. Based on the concept of capital liberalization as stipulated by IMF and OECD, it implies the removal of any restrictive policies or market impediments that might inhibit the free flow of capital among the respective nations across the world. Hence, under the notion of free capital movement in the international market, the countries can freely and autonomously engage in capital or financial investment and trading activities which can practically entail higher foreign investments, commercial business establishments, capital or financial trading, commercial exchange of financial assets and portfolios and so forth. All of these possible outcomes of free capital mobility can potentially lead to higher employment generation, better sources of income for domestic residents of any economy, higher per capita income, and further capital or foreign reserve generation in the economy. However, freedom of capital movement can have a mixed and diversified impact on the factor income across the world as the demand and flow of the factor inputs would practically vary in the global or international market. The flow of factor inputs in the global market practically depends on the direction and movement of demand for goods and services in the global economy and the subsequent direction or flow of businesses and commercial or financial investments. Hence, the demand and supply conditions of both goods and services and financial assets or investments essentially determine the demand and supply of factors or inputs of production in the global economy, and such impacts will evidently vary and cannot be observed clearly and unambiguously. It is also evidently contingent on the demand and supply conditions in the international labor market.