Fiscal policy and the substitution between national and foreign savings

Abstract

This paper addresses the relationship between fiscal policy, the real exchange rate, national and foreign savings, and investment. It shows how the mechanism of the finance–investment–saving–funding Keynesian circuit (FISF) works in open economies. This is undertaken in an attempt to demonstrate that real exchange rate changes affect the FISF circuit in that they trigger the substitution between national and foreign savings. Thus, domestic investment causes savings, but the distribution of aggregate savings between its national and foreign components depends on the level of the real exchange rate. Finally, we show that if government budget deficits change relative prices in an economy, this worsens the current account balance by triggering substitution between national and foreign savings. Thus, the constraint on investment (and on growth) that can emanate from this process is one that emerges from external forces.

Key words:

• Fiscal policy
• national savings
• foreign savings
• exchange rate

JEL classifications:

• E22
• F41

Notes

¹Schmidt-Hebbel et al. (1992) find that foreign capital inflows tend to reduce household saving in the short run. The long-run effect of foreign saving on household saving is positive, however, because the income growth from the investment that is financed by foreign lending is realized. In Loayza et al. (2000), the resulting estimates show that an increase in external saving is partly offset by a decline of private and national saving in both the short and long run. These results conform with the standard view that external saving acts as a substitute rather than as a complement to domestic saving. Other empirical studies, Aizenman et al. (2007) for example, find that neither significant substitution nor complementarity between domestic and foreign savings is in evidence.

²Following the Keynesian literature, finance represents the short-term credit required during the interregnum between the intention to invest and its achievement. Finance requires no saving and depends on the short-term bank financing arrangements. Funding corresponds to the substitution of the short-term obligations by a long-term issue and requires the public to give up an amount of liquidity equal to real savings (see, for example, Davidson [1986], for further details).

³The appreciation of the real exchange rate corresponds to a shift in the relative price of tradable and nontradable goods, which increases real wages and reduces profits.

⁴See, for example, Kandir (1989) and Pereira (1999) for further analysis of the markup model.

⁵It must be borne in mind that the exports whose receipts are exchanged for the imports of consumption goods does not represent national savings.

⁶To simplify the argument, suppose that before currency appreciation CA = 0, and X − M = 0. After appreciation, a trade deficit arises—that is, exports become smaller than imports. The excess of imports over exports does not correspond to national savings, but rather to the absorption of foreign savings.

⁷Keynes also suggests that “the finance required during the interregnum between the intention to invest and its achievement is mainly supplied by specialists, in particular by banks … . It (finance) employs no saving … [but] on the other hand, there will always be exactly enough ex-post saving to take up ex-post investment” (Keynes, 1937a, pp. 666–669). Davidson argues that “Entrepreneurs most hold some cash balances between periods to assure themselves that when they enter into forward contracts for the hiring of inputs for production of capital goods they will be able to meet these obligations. The quantity of cash balances needed each period to meet these forward contracts for producing investment goods will be unchanged as long as planned investment is unchanged … . Keynes argued ‘if, for example, profit expectations exogenously increase, then at the initial flow of output and rate of interest, entrepreneurs will demand additional investment goods … the demand for money to pay for the production of these additional investments at any given interest rate will increase even before any additional employment and income are generated.’ … It is evident from The Treatise on Money and Keynes’s finance motive notes in the 1937 issues of The Economic Journal that specifying the demand for money as a direct function of current income is a gross and somewhat misleading simplification of his liquidity analysis” (Davidson, 1994, pp. 122–123). Minsky’s position on this theme is that, “Investment is a process in time, and investment typically involves a large number of firms that produce inputs into the finished capital assets. Investment thus involves a complex of payments, which need to be financed … investment in our economy is a money-now-in-exchange-for-money-later transaction” (Minsky, 1986, pp. 213–214).

⁸This simplification makes the argument easier to understand and the results are not misleading. The overvaluation of the real exchange rate in Z with its exports falling should mitigate investment. However, an expansionary fiscal policy can be applied in order to maintain investment at the same level—that is, fiscal policy can offset the worsening of the entrepreneurs expectations about the uncertain future caused by the currency overvaluation. Similar arguments can be presented for the W economy.

⁹In our model, before changes in the real exchange rate level take place, all income related to KG exports by W is used to import CG from Z. However, the income related to CG exports by Z induces lower consumption the marginal propensity to consume is less than 1 in Z.

¹⁰In general, authors who deal with the twin-deficits hypothesis present the savings–investment identity in order to show the link from fiscal policy to the current account: S − I = Y − E = X − M; or, Sp + Sg − I = X − M, where, S and I are national savings and investment, Y and E are national income and expenditure, X and M are national exports and imports of goods and services, and Sp and Sg are private and government savings, respectively.

¹¹Again, in Krugman (1999), this proposition cannot be supported insofar as in the argument as advanced, there are real exchange rate changes.

¹²In Krugman’s (1999) view, the following sequence occurs: budget deficit → decline in national savings → rise in the real interest rate → real exchange rate appreciation → CA deficit. In the Keynesian view, the sequence is different: budget deficit → possibility of real exchange rate appreciation → decline in net exports and as a consequence reduction in national savings and CA deficit → increase in (absorption of) foreign saving.

Additional information

Notes on contributors

Philip Arestis

Philip Arestis is professor in the Department of Land Economy at the University of Cambridge. Marco Flávio Cunha Resende is associate professor in the Department of Economics at the Federal University of Minas Gerais.

Marco Flávio Cunha Resende

Marco Flávio Cunha Resende wishes to thank the Ministry of Education-Brazilian Government, for financial support from CAPES, which enabled him to visit the University of Cambridge (Centre for Economic and Public Policy, Department of Land Economy).