Question

Explain in detail. Use graphs to explain your answer wherever necessary:

A small open economy that is a net lender

Answer 1

To answer this question lets begin with the model of international capital flows & trade balance. From the model we know that - S-I=NX.

The lhs of the equation tells us the net capital outflow while the rhs is the trade balance. So at equilibrium NCO equals the trade balance. Now a country is net lender to the world only when it saves more then its invests (i.e. its trade balance is positive). When the nation saves more it has extra funds to lend out to the rest of the world making it a net lender. Also note that if I>S that country is net borrower (and has trade deficit).

Next consider the fact that a small open economy cannot influence the world's real interest rate. Hence the net capital outflow (S-I) is determined by the world interest rate. Now a small open economy can become net lender only when its savings exceed its investment. To understand when will happen - this lets consider the graph drawn below. Initially the world interest rate is at r1 and at this level the NCO is 0 (as S=I) and this much means NX=0 and there is trade balance. The small open economy is neither lender nor borrower. Now for country to be a net lender there must be a external factor which alters the interest rate. This can happen when a large open economy raises government spending (without changing taxes) and this depletes the world savings and raises world interest rate to r2. This change in world interest rate does not impact savings and investment graphs of domestic economy as the changes happen outside the small economy. So at this higher interest rate, the investment demand decreases along the I(r) curve. Observe that at r2 there is positive gap between S and I which denotes positive NCO (and hence NX). As for the small open economy savings is more than its investment at the new world interest rate r2 - the small economy can lend out the excess funds to the world and this makes it a net lender.