134
ADDITIONAL CASE STUDY
6-2 Saving and Investment in Open Economies
Our theory of the small open economy suggests that there should be no simple link between the level of
saving and the level of investment. With perfect capital mobility, the level of investment depends
primarily on the world interest rate, whereas the level of saving depends on the level of domestic output.
Source: M. Feldstein and C. Horioka, “Domestic Saving and International Capital Flows,” Economic Journal 90
(June 1980): 319.
Feldstein and Horioka’s work has been updated and modified by many authors over the years.
Although the correlation between saving and investment rates varies with particulars such as which
countries are included and which time periods are considered, the basic finding remains the same:
Countries that have high saving rates are also countries with high investment rates, and countries with low
saving rates are also countries with low investment rates.
135
influences on saving and investment could yield a positive correlation even if capital is completely mobile
across national boundaries.
Concern about common influences is the main reason why Feldstein and Horioka averaged saving and
investment rates across long periods of time and studied the cross–country relationship. This technique
allowed them to separate the effect from short–run business cycle fluctuations that may induce a
correlation between saving and investment within a country from year to year. But even over long periods
of time, saving and investment continue to be endogenously determined, and common influences may still
be important.
One way that a correlation might occur is in response to sustained shifts in a country’s productivity or
demographics that lead to an increase in its long–run investment rate and its long–run saving rate.44 For
instance, a technological advance in one country may increase investment at the world interest rate and,
136
LECTURE SUPPLEMENT
6-3 The Open Economy in the Very Long Run
The small open economy model of Chapter 6 explains that the trade balance is determined in the long run
by the levels of domestic saving and investment. For example, if domestic saving is less than domestic
investment at the world interest rate, then net exports are negative, and there is a trade deficit. The
counterpart to this trade deficit is an increase in indebtedness to foreigners.
The model of Chapter 6 evidently cannot describe the economy in the very long run because a country
cannot run large trade deficits forever.1 At some point, the foreign debt must be repaid. Something is,
therefore, missing from the Chapter 6 model if we wish to talk about the very long run.
ADDITIONAL CASE STUDY
6-4 Tourism and the Exchange Rate
Expenditures on international tourism are likely to be sensitive to changes in exchange rates because a
significant amount of tourism probably represents discretionary purchases that are sensitive to relative
prices. Vacations taken abroad by Americans contribute to U.S. imports, while expenditures by foreigners
on visits to the United States add to U.S. exports. Table 1 (see next page) presents the percentage change
138
Table 1 Tourism Trade and the Real Exchange Rate
Year
Real Tourism
Exports (%
change)
Real Tourism
Imports (%
change)
Real Exchange
Rate (Index,
March 1973 =
100)
1973
14.9
–5.7
99.0
1975
8.1
–3.5
94.5
1976
13.9
6.4
94.5
1977
0.2
3.0
92.9
1978
7.4
3.3
87.3
1979
7.2
–2.4
88.4
1980
11.7
–0.1
89.8
1981
33.1
9.0
96.6
1982
–7.7
18.6
106.1
1983
–11.2
13.3
110.6
1984
Break in series
Break in series
117.9
1985
0.1
10.3
122.7
1986
10.3
–6.9
107.4
1987
8.5
18.4
98.7
1988
16.6
2.9
92.1
1989
18.1
3.1
93.8
1990
12.3
6.8
91.2
1991
4.7
–9.2
89.7
1992
10.1
3.1
87.8
1993
4.6
5.0
89.1
1994
1.2
3.6
89.0
1995
6.3
1.1
86.5
1996
6.5
4.0
88.5
1997
2.9
8.7
93.2
1998
–2.7
13.2
101.2
1999
5.6
0.1
100.3
2000
3.7
12.8
104.1
2001
–14.4
–7.0
110.1
2002
–5.8
–4.8
110.3
2003
–4.6
–4.8
103.6
2004
10.4
13.0
99.0
2005
–4.4
2.0
97.3
2006
–1.0
0.2
96.2
2007
9.0
–2.1
91.7
2008
7.2
–2.7
87.8
2009
–8.0
–9.0
91.4
2010
10.8
4.1
87.2
2011
4.8
0.8
82.7
2012
3.9
11.7
84.4
2013
6.4
2.7
84.5
2014
4.2
6.9
86.3
Source: U.S. Department of Commerce, Bureau of Economic Analysis and Federal Reserve Board.
Note: Real tourism exports and imports are exports and imports of travel as reported in the National Income and
Product Accounts. The real exchange rate is a weighted average of the foreign exchange values of the U.S. dollar
1974
8.8
–10.2
95.6
139
CASE STUDY EXTENSION
6-5 The Exchange Rate and the Inflation Rate
The relationship between the nominal exchange rate and the inflation rate is particularly evident for
countries experiencing hyperinflation. If the price level in one country is increasing rapidly, then
movements in foreign prices and in the real exchange rate will be relatively insignificant. We therefore
expect to see depreciation of the domestic currency at a rate approximately equal to the inflation rate.
Figures 1 and 2 illustrate this for the Israeli and Mexican hyperinflations of the 1980s.1
1 Figures 1 and 2 present changes in the logarithms of the two variables. The change in the logarithm is a measure of the growth rate of a variable.
The close negative relationship between the inflation rate and the change in the exchange rate thus illustrates that price level increases were indeed
matched by currency depreciation. See Supplement 8–5, “Growth Rates, Logarithms, and Elasticities,” for more information on growth rates and
logarithms.
ADVANCED TOPIC
6-6 Covered Interest Parity
Suppose that a U.S. company wishes to purchase goods from a producer in the United Kingdom. The U.S.
firm agrees to take delivery of the goods three months hence and to pay an agreed–upon price in U.K.
pounds at that time. The U.S. company, however, might be concerned about exactly what was going to
happen to the dollar–pound exchange rate over the next three months.1 It can avoid this uncertainty by
buying U.K. pounds at the forward rate. International financial institutions not only buy and sell currencies
at the current (spot) rate, they are also willing to write an agreement to exchange currencies at a future date
and at a prespecified rate. Thus, if the U.S. company needs 10,000 pounds in three months’ time, it knows
1 + i = (e/f)(1 + i*).
If we define the forward premium to be (f – e)/e, then we have a good approximation3:
Premium ≅ i* – i.
The premium will be positive (i.e., the forward rate will be above the spot rate) if the U.K. interest rate
exceeds the U.S. interest rate. The premium will be negative if the opposite is true.
The forward rate should be a good predictor of the future spot rate. To see this, note that if investors
1 This is a particular concern since exchange rates can be quite volatile in the short run. See Chapter 13 of the textbook and Supplement 13–11,
141
ADDITIONAL CASE STUDY
6-7 Purchasing–Power Parity and Real Exchange Rates
If the principle of purchasing–power parity provided an accurate theory of real exchange rate
determination, then we would expect real exchange rates to be relatively stable. Major short–run
fluctuations in the real exchange rate would not occur because of arbitrage in goods markets. Such
stability is, quite simply, not observed in the data. As an example, Figure 1 shows the real exchange rates
for Canada, the United Kingdom, and Japan. Economists, therefore, look to behavior in financial markets
rather than goods markets for explanations of short–run fluctuations in exchange rates.
142
CASE STUDY EXTENSION
6-8 More on the Big Mac and PPP
The following graphs use the series of Big Mac prices and exchange rates collected by The Economist to
illustrate the failure of PPP.11 For each of the four countries (Canada, Germany, Hong Kong, and South
Korea), the graph shows the actual exchange rate (foreign currency per U.S. dollar) and the exchange rate
implied by PPP. The latter is simply the ratio of the price of a Big Mac in each country to the price of a
Big Mac in the United States, both prices measured in local currency terms. If PPP held, the actual
exchange rate and the PPP implied exchange rate would be the same. If the actual exchange rate is above
the PPP implied exchange rate, then the dollar is said to be undervalued. If the actual exchange rate is
below the PPP implied exchange rate, then the dollar is said to be overvalued.
