26_raga_ch26_topic_01.

qxd 23/2/10 4:31 pm Page 1

I N V E S T M E N T A N D S AV I N G I N G L O B A L I Z E D F I N A N C I A L M A R K E T S 1

Investment and Saving in Globalized

Financial Markets
In Chapter 15 in Microeconomics and Chapter 26 in Macroeconomics we examine
how the real interest rate is determined in the market for financial capital by the inter-
action of the supply of saving and the demand for investment. In both chapters we are
examining a closed economy—that is, an economy that trades neither goods nor finan-
cial assets with the rest of the world. Our closed-economy model predicts that a change
in Canada’s investment demand or Canada’s supply of national saving leads to a
change in Canada’s equilibrium interest rate, even if the interest rates in other countries
are held constant.
In reality, however, there is a great deal of international trade in financial assets.
Every day, households, firms, and governments in one country purchase assets from
(and sell assets to) households, firms, and governments in other countries. Billions of
dollars worth of financial assets cross international borders all the time. One result of
these massive financial flows is that interest rates on similar assets in different countries
tend to move together. For example, when interest rates on ten-year Canadian govern-
ment bonds rise by one percentage point, similar changes usually occur to the interest
rates on ten-year U.S. government bonds, and also on ten-year German, Japanese, and
Australian government bonds.
With globalized financial markets, in other words, our closed-economy model
presented in Chapters 15 and 26 does not provide a complete description of what is
happening. Here we develop a version of the model better suited to an economy in
which financial assets flow easily across international boundaries.

The Law of One Price in a Globalized Financial Market

We begin with the closed-economy model from Chapters 15 and 26, which can be
summarized with the following three key assumptions:

1. The quantity of financial capital demanded is negatively related to the real interest
rate.
2. The quantity of saving supplied (“national saving”) is positively related to the real
interest rate.
3. There is a single type of financial capital in the country, and hence we can think of
a single interest rate as its price.

The third assumption is necessary in order to speak of a single market for financial
capital, and thus a single price for that product—the interest rate. If there were many
types of financial assets, varying in their riskiness or in their term to maturity, then we
would have to think separately about the market for each asset, and there would be
several interest rates to determine. In reality, there are many types of financial asset.
This third assumption is therefore a simplifying one that allows us to focus on the
determination of interest rates in general, while ignoring movements between the dif-
ferent interest rates that apply to different types of assets.
With these three central assumptions, our model predicts that the equilibrium real
interest rate in Canada will be determined at the intersection of the downward-sloping

Ragan, Economics, 14th Canadian Edition

Copyright © 2014 Pearson Canada Inc.
26_raga_ch26_topic_01.qxd 23/2/10 4:31 pm Page 2

2 I N V E S T M E N T A N D S AV I N G I N G L O B A L I Z E D F I N A N C I A L M A R K E T S

investment demand curve and the upward-sloping supply curve for national saving. Like
other demand-and-supply models, we assume that the interest rate will adjust upward
or downward until this equilibrium interest rate is reached. In addition, any shifts in
the two curves will lead to changes in the equilibrium interest rate and to changes in
the equilibrium flow of investment and saving.
We now modify this closed-economy model with two further assumptions:

4. Financial capital is highly mobile and can be freely traded internationally.

5. There is a single type of financial capital in the world.

Assumption 4 makes this an open-economy rather than a closed-economy model;

assumption 5 extends assumption 3 to the whole world, whereby we assume that all
financial assets, both inside and outside of Canada, are the same.
Assumptions 4 and 5, taken together, lead to the prediction that there will be a
single interest rate in the world market for financial capital. Since all financial assets
are the same, and since they can be freely traded across international boundaries, it is
not possible to have different interest rates in different countries. If there were different
interest rates in different countries, lenders would quickly shift their supply of financial
capital to the countries with higher interest rates, and this increase in supply would
tend to push down the interest rate in these countries. At the same time, borrowers
would quickly shift their demand to countries with lower interest rates, and this
increase in demand would tend to raise the interest rate in these countries. If financial
capital is very mobile across borders, the immediate result of these shifts would be to
bring interest rates in different countries to the same level. This result is an application
of the law of one price.
Figure 1 illustrates saving, investment, and interest rates in this model of a globalized
financial market. Part (i) of the figure shows the world market for financial capital,
with the world investment demand curve (ID) and the world supply of saving curve (S).
Each of these curves is the horizontal summation of the demand (or supply) curves
from the many individual countries. The world equilibrium interest rate (iW) is deter-
mined at the intersection of the world investment demand and world saving supply
curves.

FIGURE 1 The World and Canadian Markets for Financial Capital

S SCan
Real Interest Rate

Real Interest Rate

Excess supply
}

i*W i*W

ID IDCan

QW Quantity of qI qS Quantity of
Financial Capital Financial Capital
(i) World (ii) Canada

Ragan, Economics, 14th Canadian Edition

Copyright © 2014 Pearson Canada Inc.
26_raga_ch26_topic_01.qxd 3/25/10 5:50 PM Page 3

I N V E S T M E N T A N D S AV I N G I N G L O B A L I Z E D F I N A N C I A L M A R K E T S 3

Part (ii) of the figure shows the Canadian market for financial capital with the
Canadian investment demand curve and the Canadian saving supply curve. Given the
law of one price applied to the world market for financial assets, the interest rate in
Canada must be the same as the world equilibrium interest rate determined in part (i),
for any amounts of investment demanded or saving supplied in Canada. Thus, it is not
necessarily true that the quantity of investment demanded will equal the quantity of
saving supplied in Canada. Part (ii) is drawn in such a way that at the world equilib-
rium interest rate, the quantity of saving supplied in Canada, qS, exceeds the quantity
of investment demanded, qI.The idea that saving and investment need not be equated
within an individual country raises the obvious question: What happens if there is a
gap between the two?

Investment–Saving Imbalances Within a Country

Figure 2 shows the market for financial capital in Canada for a given level of the equi-
librium world interest rate. We consider alternative positions of the investment demand
and saving supply curves in Canada. In part (i), there is an excess supply of financial
capital in Canada at the equilibrium world interest rate. In part (ii), there is an excess
demand for financial capital in Canada at the equilibrium world interest rate. In both
cases, note that the imbalance between the quantity of investment demanded and the
quantity of saving supplied in Canada creates no pressure for the world interest rate to
change. The world interest rate is determined in the equilibrium of the world financial
market, in a situation like part (i) of Figure 1, where the total quantity of investment
demanded equals the total quantity of saving supplied. But even when the world finan-
cial market is in equilibrium, many individual countries will have situations like part (i)
in Figure 2, and many others will have situations like part (ii). In fact, when the world
financial market is clearing, the sum of all the excess supplies, as in part (i), will exactly
equal the sum of all the excess demands, as in part (ii).
Now consider parts (i) and (ii) of Figure 2 separately. If Canada has an excess
supply of financial capital at the equilibrium world interest rate, as in part (i), where
does Canada’s “extra” saving go? Canada’s national saving is more than sufficient to

FIGURE 2 Investment–Saving Imbalances

S1 S2
Real Interest Rate

Real Interest Rate

Capital outflow
}

iW iW
}

Capital inflow

I2D
I1D

Quantity of Quantity of
Financial Capital Financial Capital

(i) Capital outflow = current account surplus (ii) Capital inflow = current account deficit

Ragan, Economics, 14th Canadian Edition

Copyright © 2014 Pearson Canada Inc.
26_raga_ch26_topic_01.qxd 23/2/10 4:31 pm Page 4

4 I N V E S T M E N T A N D S AV I N G I N G L O B A L I Z E D F I N A N C I A L M A R K E T S

finance all of the investment desired by Canadian firms. The extra saving can then be used
to acquire foreign assets.1 Canada as a whole has a capital outflow because Canadian
financial capital is flowing abroad to purchase those assets. In terms of the balance-of-
payments accounting that is discussed in Chapter 35, Canada in this case has a current
account surplus.
Now consider part (ii) of Figure 2. If Canada has an excess demand for financial
capital at the equilibrium world interest rate, how does Canada finance all of its desired
investment? Canada’s national saving is insufficient to finance all of the investment
desired by Canadian firms, and so some additional financing must be provided by for-
eigners. This is accomplished by Canadians selling assets to foreigners. Canada has a
capital inflow because foreign financial capital flows into Canada in order to purchase
Canadian assets. In terms of the balance-of-payments accounting discussed in Chapter 35,
Canada in this case has a current account deficit.

Domestic Shocks
We can now imagine what would happen in Canada’s financial market if there were a
shift either in Canada’s investment demand curve or in Canada’s saving supply curve. If
there is no change in the world investment demand and saving supply curves, there will
be no change in the equilibrium world interest rate. Thus, any shift in the demand or
supply curves in Canada will simply change the amount of excess supply or excess
demand of financial capital. Canada’s current account deficit or surplus will change,
but there will be no change in the equilibrium interest rate. An increase in the supply of
saving (with investment demand held constant) will lead to a greater flow of Canadian
saving and thus to an increase in Canada’s current account surplus (or a reduction in
the current account deficit). Conversely, an increase in investment demand (with the
supply of saving held constant) will lead to a greater flow of Canadian investment and
thus to an increase in Canada’s current account deficit (or a reduction in the current
account surplus).

1 In this simple model, Canadians would purchase from foreigners the one type of asset that exists. In reality,
an excess of saving over investment in Canada would lead to the accumulation of many kinds of foreign
assets—stocks, bonds, physical capital, and land.

Ragan, Economics, 14th Canadian Edition

Copyright © 2014 Pearson Canada Inc.