Hey, welcome back, Unit 5, Lesson 3, we'll discuss growth in an open economy.  We're going to continue with Juan as our example. Juan does not trade with the  rest of the world. 

His only way to save for the future is by building up his capital stock. In this  case, national savings equal investment. An economy that does not trade with  other countries is called a closed economy. 

An economy that trades with other countries is called an open economy. Pretty  simple. In the modern world, no economy is completely closed, although some  economies, such as Belgium, are much more open than others, such as North  Korea. 

The world as a whole is a closed economy. Of course, if Solovenia is an open  economy, Juan has other options. He might decide that he can get a better  return on his savings by investing in foreign assets, such as Italian real estate,  shares of an Australian firm, or Korean government bonds. 

Domestic investment would then be less than national savings. Juan is lending  to the rest of the world, so domestic investment would be less than national  savings because Juan is taking his capital, his cash, his assets, and investing it  domestically. He is not investing as much in the national savings. 

Juan, therefore, is lending to the rest of the world. Alternatively, Juan might think that the benefits of investment in his home economy are sufficiently high that he  borrows from the rest of the world to finance investment and beyond the amount of his savings. He wants to borrow as the benefits of investing in his home  

economy. 

He wants to borrow more so that he can make a greater investment, and this will help him grow his operations faster. Domestic investment is then greater than  the national savings. So if Juan then lends to the rest of the world, then he will  have extra resources in the future when those loans are repaid. 

So if he borrows from the rest of the world, he will need to pay off that loan at  some point in the future. There may be very good opportunities in an economy  that justify a lot of investment. In this case, it is worthwhile for an economy to  borrow from other countries to supplement its own savings and build up the  capital stock faster. 

So if we don't have to worry about manufacturing as much goods to sell so that  we have capital stock, so we have cash reserves and more materials, let's 

reserve our materials and then borrow the cash so we don't have to touch the  cash that we already have. We already have a surplus of materials. So to  continue to fund the growth of our operations, let's borrow the cash like Juan  has done here to invest into our operation so that we can grow our operation at  a much faster pace and then be able to repay that loan in the future but keep  our capital stocks high because we have to pay that loan back over time, not in  one lump sum. 

So as we produce these goods, we'll be able to sell them for a profit and then  just have to pay back segmented a little bit at a time to repay that loan and in  the meantime as we're paying that loan off, making payment by payment by  payment, we're in the meantime building up our capital reserves, our materials,  our inputs and outputs to create more capital and more effective final product,  we're able to do that much more effectively and efficiently since we had the loan  to make greater investment into our company instead of having to use all of our  cash that we already had on hand to grow operations. That loan helped us to be  able to grow faster. So the circular flow of income shows us how these flows  show up in the national accounts. 

If we are borrowing on net from other countries, there is another source of funds in addition to national savings that can be used for domestic investment. If we  are lending on net to other countries, domestic investment is reduced. So if we  are intaking more cash from other companies as investment, let's say we are  bringing in debt to fund and fuel our operations, we'll have funds in addition to  national savings despite having to pay that back because we'll have more cash  on hand. 

Okay, so we'll see that as funds addition to the savings. If we are lending to  other nations, domestic investment is reduced because we are taking the capital that we can invest into our own domestic economy and then we are loaning that  out to other nations so therefore we have less money to invest into our own  domestic economy. So investment equals national savings plus borrowing from  other countries. 

That is the first example. Second, investment equals national savings minus  lending to other countries. So we are either going to borrow from other countries or we are going to lend to other countries. 

So again, if we borrow from other countries, we are going to have a surplus in  funds additional to the national savings but if we lend to other countries, that will  show a decrease in the availability of funds for us to invest domestically. So  savings and investment in the country are linked but they are not the same 

thing. The savings rate tells us how much an economy is setting aside for the  future but when studying this accumulation of capital in an economy, we look at  the investment rate rather than the savings rate. 

The total investment as a fraction of GDP is called the investment rate. So  whatever we have as a total of GDP, so we have the total gross domestic  product, the entire output of a nation, the investment rate, the savings rate is a  fraction of the total investment from GDP. So we have the total investment that  we made into the economy versus the entire aggregate of the production inside  a nation that is known as a savings rate. 

So the total investment divided by the total GDP of a nation will give you the  savings rate. So low investment rates may be due to low savings rates. Let's  think about this for a minute. 

They may also reflect relatively low returns to increases in the capital stock in a  country. The low investment rate that prevailed for many years in Niger not only  reflected a low savings rate but also indicates that something is limiting  investment from external sources. So for the United States in contrast, a  significant part of the high investment rate is due not to domestic savings but the inflows from other countries. 

So the United States borrows a significant amount of cash from other countries  by selling bonds to China, to the EU, to Japan. So they are taking all of these  inflows in due to the sale of debt instruments. So they are showing a high  domestic savings rate because we have all of this cash coming in in debt  obligations when it necessarily doesn't provide a long-term surplus due to it  being debt brought in. 

So from a short-term snapshot, one year or one quarter, it will show the  domestic savings up from when they bring in the cash they borrowed but over  time it will be a liability due to it being a debt obligation. So now we know that  output per person is a useful indicator of living standards. Increases in output  per person generally translate into increases in material standards of living. 

But to the extent that an economy trades with other countries, the two are not  equivalent. If an economy borrows to finance its investment opportunity, output  per person will exaggerate living standards in the country because it does not  take into account outstanding obligations to other countries. If an economy  places some of its savings elsewhere, then measures of output per person will  understate living standards.

The national accounts deal with this issue by distinguishing between GDP, which measures the production that takes place within a country's borders, and gross  national product, which corrects for income received or paid to other countries. 



Last modified: Monday, September 28, 2026, 8:35 AM