Wednesday, September 30, 2009

Economists do it with models! Part 1

The last time we used a model we were looking at a hypothetical closed-economy. The model previously proposed was the market for loanable funds and now we can do the same analysis again with the new tools that we built in the preceding posts.

So now we go back to our Savings and Investment identity, S = I and add on NCO. Therefore,
S = I + NCO

Remember what S (national savings) consists of, which is public and private savings or

(Y - t - C) + (t - G) = S = I + NCO
Private Savings + Public Savings = National Savings = Investment and Net Capital Outflow

As we discussed last time NCO should be affected by real interest rates which behaves in the following fashion. As the real interest rate rises this encourages more people to save and less people to invest. The higher rates cost people & businesses more money to borrow to finance a project so instead they can just earn a rate of return by saving it. The higher borrowing costs create a hurdle rate that makes businesses take on the fewer projects that can meet this barrier.

Now though we have the added variable of real interest rates worldwide. So we should consider how those rates will affect financial flows. Note that this is a model and may not explain what currently happens in all places at all times. In fact what I am about to say next does not at all reflect the reality in America for the past 30 years.

So you have capital either located at home (I) or abroad (NCO). Savings will then purchase capital in either places. However, NCO can be positive or negative and will thus have an affect on the market for loanable funds in the following manner (usually): When NCO > 0, NX is greater than zero and we purchase capital abroad which increases the demand for loanable funds thus keeping real interest rates down. Conversely, when NCO <> 0, while NX < 0. How can this be so? Well as the nations that export to the US garner a bunch of dollars the countries then use their US Dollars to buy US debt.

Let's dig a little deeper into this and introduce a time differential. So in a closed economy the only way for a country to increase its investment is to increase savings. That is because S = I. In an open economy because S = I + NCO the domestic citizens do not have to raise their savings to fund investment. So if the US decides to build a nuclear plant it could import the parts from France and also borrow the funds in Euros. This will increase America's Investment (I) while increasing its NCO as well. We could also term NCO as the current account, as in the current account deficit. The reason this works is because the French have decided to save more so that the resources to build the plant are freed up for America. This is a time differential or in the jargon of economists it is an intertemporal trade, in that America imports present consumption (borrowing from the French) and exports future consumption (when it pays off the French.)

This is how the American consumer was able to spend so prolifically over the past 30 years because we kept buying present consumption and paying for it with IOUs (Treasury securities) that Asia snapped up. Because of the perceived weakness of the political and economic systems the Asians were willing to save more than their American counterpart and give up higher returns for two reasons: A) their economies relied upon the US consumer buying their goods, that is their own economies could not consume as much per capita as Americans because of the lack of a social safety net & B) the US dollar is a store of wealth and unit of exchange in the global economy.

I'll end here and begin again with the model.

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