With virtually no exceptions, modern economies are open economies, which means that they engage in international trade of goods and services and in international borrowing and lending.

Economic openness is of tremendous ben­efit to the average person. Because the United States is an open economy, U.S. consumers can enjoy products from around the world (Japanese MP3 players, Italian shoes, Irish woolens) and U.S.

Beyond the economic diversity and opportunity it creates, economic open­ness carries another important implication: In an open economy, a country's spending need not equal its production in every period, as would be required in a closed economy with no foreign trade and no international borrowing and lending. In particular, by importing more than they export and borrowing from abroad to pay for the difference, the residents of an open economy can tempo­rarily spend more than they produce.

The ability of an open economy to spend more than it produces is both an opportunity and a potential problem. For example, by borrowing abroad (and by selling off U.S.-owned assets to foreign investors), the United States was able to finance a large excess of imports over exports beginning in the 1980s. As a result, U.S. citizens enjoyed higher levels of consumption, invest­ment, and government purchases than they could have otherwise. At the same time, however, they incurred foreign debts that may be a future burden to the U.S. economy.

Why do countries sometimes borrow abroad to pay for an excess of imports over exports but at other times export more than they import and lend the difference to other countries? Why doesn't each country just balance its books and import as much as it exports each year? As we explain in this chapter, the fundamental determinants of a country's trade position are the country's saving and investment decisions. Thus although the issues of trade balances and international lending introduced here may seem at first to be unrelated to the topics covered in Chapter 4, the two sets of questions actually are closely related.

To explore how desired national saving and desired investment help deter­mine patterns of international trade and lending, we extend the idea of goods market equilibrium, described by the saving-investment diagram, to include

Learning Objectives

5.1 Explain how the balance of payments is calculated.

5.2 Discuss goods market equilibrium in an open economy.

5.3 Discuss the factors that affect saving and investment and determine the current account balance in a small open economy.

5.4 Discuss the factors that affect saving and investment and determine the current account balance in a large open economy.

5.5 Analyze the relationship between the government budget deficit and the current account deficit.

a foreign sector. We show that, unlike the situation in a closed economy, in an open economy desired national saving and desired investment don't have to be equal. Instead, we show that, when a country's desired national saving exceeds its desired investment, the country will be a lender in the international capital market and will have a current account surplus. Similarly, when a country's desired national saving is less than its desired investment, the country will be an interna­tional borrower and will have a current account deficit.

By emphasizing saving and investment, we develop an important theme of this part of the book. However, to focus on the role of saving and investment, we ignore some other factors that also influence international trade and lending. The most important of these factors is the exchange rate, or the rate at which domestic currency can be exchanged for foreign currency. We fully discuss exchange rates and their role in the open economy in Chapter 13.

5.1