III. Open economy macroeconomics
C. Foreign sector geometry
1. Basic setup

NX-NFI equilibrium is stable

Works like supply and demand:     RH > Ra     --> Excess S$ --> $depr back down to Ra     RL < Ra     --> Excess D$ --> $appr back up to Ra     Note: a country's trade balance = 0 unless savers want to shift their savings into or out of the country.     Without capital mobility, NFI is vertical at NX=0

2. The determinants of NFI

    Recall the equation for NFI:  

The fundamental open economy relationship:

        NX º NFI (which = Y - C+I+G)

    NFI consists of 4 components: Y,C,I,G
    Based on this relationship, there are exactly 4 things a borrowing country can do to stop borrowing so much
    ? What are they?
    increase Y, decrease C, I, and/or G

    no magic bullet: must produce more or spend less
    lower spending => austerity
    part of conditional loan packages (Examples: IMF, EU)

3. Long-run NFI

    Hypothetical situation--a steady-state situation.
    Abstract from temporary cyclical events, and consider how a country can be a chronic borrower or lender
    Example: Foreign-direct investment (FDI) falls into this category

a. Characteristics of the long run

(1) Fully adjusted output markets             (LR S&D elasticities (e))     (2) Y = Yf (full employment)     (3) Rsp = Rfwd = RLR (stable ER)     (4) rdom = rwld (equal internal and external i-rates)

b. Net lenders and net borrowers

NFI = NX = external balance     LR location:      NFIf = Yf - (C+I+G)r=rwld     Note: NFIf determines RLR

c. Providing a favorable investment climate

    Recall: Macroeconomic goal: to provide an environment that promotes investment and growth
    A big part of that is good governance

    Source: Worldwide governance indicators 6 indicators tracked by World Bank
    Governance Indicators: Country data (select "Country" for time series back to 1996)

    The indicators (see definitions for details):

1. Voice and Accountability
2. Political Stability
3. Government Effectiveness
4. Regulatory Quality
5. Rule of Law
6. Control of Corruption

    Investment and growth

    (1) NBER, Bekaert, Geert, and Campbell R. Harvey, Spring 2001
    Financial liberalization g ir, hI, hgrowth
    Samples of 30 and 95 countries: the most likely estimated range for the resulting increase in annual growth = 1.5-2.3%

    Why?
    More overall savings and financial investment (including portfolio diversification by locals)
    More efficient financial sector (insider trading laws, transparency, etc.)

    "It is not just the existence of capital markets that is important for growth prospects--it is crucial that these capital markets be liberalized to allow foreign investors to participate and local investors to diversify their portfolios across borders. Our research shows that the financial liberalization effect is not subsumed by economic reforms or proxies for the development of capital markets and financial intermediation."

    (2) NBER 8084: Robert Lipsey, June 2001: FDI vs portfolio investments
    FDI more likely to ride out crises: 1982, 1994, 1997
    1982: FDI fell to only 40% of 1982 level, but did not turn negative
    1994: FDI fell 15%, and exceeded 1994 level by 1997-98, while portfolio investments turned negative and recovered only slightly
    1998: FDI fell slightly and recovered by 1999
    Why? Subsidiaries can survive downturns by turning to exports