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I am reading the book Macroeconomics by Olivier Blanchard.

It states that an alternative way of looking at an goods market equilibrium is investment = saving. In an open economy it states the equilibrium condition is Net Exports = Saving (both private and public) - Investment.

I am struggling a little bit with the intuition of understanding this condition. Would it be because the difference between saving and investment would contribute to the capital account aspect of the balance of payments in some way?

I would be very grateful if someone could help me to gain an understanding of this equilibrium condition.

Thankyou.

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First it should be clear that this is an (ex post) national account equality:

$Y=C+I+G+NX$, the private saving is $S_p=Y-C-T$ and public saving is $S_g=T-G$ thus you have $S_p+S_g-I=NX$.

Later you see in this book that the net exports, which depend on the exchange rate, are exactly equal to the Net Capital Outflow. Why? because an export is like a capital import (and vice versa).

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  • $\begingroup$ I got it now. I never thought to look at it in relation to the income formula. Thankyou for your help. $\endgroup$ – Harkell Apr 11 '15 at 22:52
  • $\begingroup$ Good luck for the next steps :) $\endgroup$ – Yann Apr 12 '15 at 14:20
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Just to add a little more intuition, recall the difference between a small open economy and a closed economy. A closed economy must consume its endowment. A small endowment, however, can borrow and lend from the rest of the world. This allows it to engage in intertemporal trade. When it borrows from the rest of the world, it does so to either increase present consumption or, in the case of a production economy, to increase investment.

Thus, this leads to the equilibrium condition that at any time, the amount saved is equal to the sum of investments plus net exports (foreign money flows in to the economy), $$ NX + I = S. $$

Note, that even if we're not dealing with an endowment economy, i.e., even if the closed economy is a production economy, it is still constrained in its ability to engage in intertemporal trade. The closed economy is constrained to invest only what it saves. Hence, to take advantage of an investment opportunity, it must forgo some present consumption.

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  • $\begingroup$ Thankyou very much for your response. I seem to have a couple of gaps in my knowledge preventing me from fully understanding this. Does foreign investment in domestic assets (i.e. foreign buying of domestic bonds) - and vice versa - come under the Net Exports variable? Which denotation does domestic investment in domestic assets come under? The Investment variable, one would think, however I seem to recall being told that the I variable does not include financial investment, so does it come under saving? $\endgroup$ – Harkell Apr 12 '15 at 1:00
  • $\begingroup$ Also what is meant by endowment and endowment economy in this context? Google doesn't seem to give a clear description of the term. What is the difference between a production economy and endowment economy? I will be extremely grateful if you answer these questions, I understand it is a lot. $\endgroup$ – Harkell Apr 12 '15 at 1:05
  • $\begingroup$ In response to the first comment: those questions seem to be slightly outside of the scope of this question. Please, feel free to ask them in a new question. (We're always happy to increase the number of questions on this site!) Until then, this discussion might be useful to you: gregmankiw.blogspot.com/2006/07/… . $\endgroup$ – jmbejara Apr 12 '15 at 1:15
  • $\begingroup$ In response to the second comment: an endowment economy is one in which each of several countries is endowed with some amount of stuff. They can't increase the total amount of stuff, they can only trade it and at the end of the period consume it. So, total worldwide consumption will in the end just be equal to the total world-wide endowment. A production economy means that a country can use some of that stuff now to produce stuff in the future. Thus, world-wide consumption doesn't necessarily equal total endowment as some of it can now be used for investment. $\endgroup$ – jmbejara Apr 12 '15 at 1:19

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