An open economy has alternative sources of investment and alternative outlets for saving. We show this situation in Figure 3().8 for a small open economy with a high degree of mobility of financial capital. A small open economy must equate its domestic interest rate with the world real interest rate, r””: It is too small to affect the world interest rate, and because capital mobility is high, financial capital will move to equilibrate interest rates at home and abroad.
Figure 3().8 helps explain the determination of saving, investment, and net exports in the open economy. At the prevailing world interest rate, domestic investment is shown at point A, which is the intersection of the investment schedule and the interest rate. Total national saving is given at point B on the total saving schedule, S + T- G. The difference between them-given by the line segment AJJ-is net exports. (This equality is shown by the saving-investment identity in the box on page 645.)
Integration of a country into the world financial } tern adds an important new dimension to economic performance and economic policy. The foreign sector provides another source for domestic investment and another outlet for domestic saving.Higher saving at home-whether in the form of private or public saving to a combination of higher investment at home and higher net exports. A country’s trade balance is primarily a reflection of its national saving and investment .rather than of its productivity or wealth. Adjustments in a country’s trade accounts require a change in domestic saving or investment, and in the long run the adjustments will be brought about by movements in the country’s relative prices, often through exchange-rate changes.
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