Foreign lenders demand a risk premium if they

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Unformatted text preview: G). If output exceeds domestic spending, we export the difference (NX > 0). If output falls short of domestic spending, we import the difference (NX < 0). Y – C – G = I + NX. Since Y – C – G = national saving S: S – I = NX Trade balance is another name for net exports that tells us how our trade Page 12 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 in goods and services departs from the benchmark of equal imports and exports. Net capital outflow (sometimes called net foreign investment) is S – I, the difference between domestic saving and domestic investment. It equals the amount that domestic residents are lending abroad minus the amount that foreigners are lending to us. The national accounts identity shows that net capital outflow always equals the trade balance. If (S – I) and NX are positive, we have a trade surplus, meaning that we are net lenders in world financial markets, exporting more goods than we are importing. If (S – I) and NX are negative, we have a trade deficit, we are net borrowers in world financial markets, and we are importing more goods than we are exporting. If (S – I) and NX are exactly zero, we are said to have balanced trade because the value of imports equals the value of exports. The national accounts identity shows that the international flow of funds to finance capital accumulation and the international flow of goods and services are two sides of the same coin. If domestic saving exceeds domestic investment, the surplus is loaned to foreigners. If investment exceeds saving, the extra investment must be financed by borrowing from abroad. Now we do not assume that the real interest rate equilibrates saving and investment. Instead, we allow the economy to run a trade deficit and borrow from foreigners, or run a trade surplus and lend to other countries. In the case of a small open economy with perfect capital mobility (residents have full access to world financial markets, no government intervention), then the interest rate in our small open economy, r, must equal the world interest rate r*, the real interest rate prevailing in world financial markets, plus the risk premium θ associated with that particular economy. We write: r = r* + θ. The small open economy takes the world real rate of...
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