What is a net foreign investment

Macroeconomic models of the open economy. The theories of N.G. Mankiw, R.A. Mundell and J.M. Fleming


Section 1: Introduction to the topic

Section 2: Mankiw model of the open economy
2.1 The credit market
2.2 The foreign exchange market
2.3 Overall economic equilibrium in the open economy
2.4 Example: State budget deficit

Section 3: The Mundell-Fleming Model
3.1 Characterization of the macroeconomic equilibrium of the small open economy
3.1.1 The goods market
3.1.2 The money market
3.1.3 The balance of payments
3.2 Investigation of fiscal policy measures
3.2.1 Flexible exchange rates
3.2.2 Fixed exchange rates
3.2.3 Comparison of the two currency systems
3.3 Analysis of monetary policy measures
3.3.1 Flexible exchange rates
3.3.2 Fixed exchange rates
3.3.3 Comparison of the two currency systems

Section 4: Extension of the Mundell-Fleming model by
international repercussions
4.1 Investigation of fiscal policy measures
4.1.1 Flexible exchange rates
4.1.2 Fixed exchange rates
4.1.3 Comparison of the two currency systems
4.2 Analysis of monetary policy measures
4.2.1 Flexible exchange rates
4.2.2 Fixed exchange rates
4.2.3 Comparison of the two exchange rate systems

Section 5: Extension of the Mundell-Fleming model by allowing flexible goods prices
5.1 The macroeconomic balance of goods
5.1.1 The aggregate demand for goods
5.1.2 The macroeconomic supply of goods
5.2 Investigation of fiscal policy measures
5.2.1 Flexible exchange rates
5.2.2 Fixed exchange rates
5.2.3 Comparison of the two currency systems
5.3 Analysis of monetary policy measures
5.3.1 Flexible exchange rates
5.3.2 Fixed exchange rates
5.3.3 Comparison of the two currency systems

Section 6: Concluding consideration of economic policy



Section 1: Introduction to the topic

The overall economic situation in the European Union is currently characterized by only very subdued growth, which is insufficient to combat the pronounced underemployment in some EU countries. Not least because of this, the German Chancellor Gerhard Schröder recently called for more growth in order to increase the level of employment in Germany and Europe[1].

Schröder and French President Jacques Chirac made a similar demand when they called for the European Stability Pact to be interpreted in a growth-oriented manner[2].

In contrast, the President of the European Central Bank, Jean-Claude Trichet, showed himself[3], concerned about the risks to the price stability of the euro that arise from the recent high growth in the money supply M3[4].

So the question arises of examining the effects of monetary and fiscal policy measures on price stability and national income, and thus on the growth of an economy. In doing so, it is important to take into account various premises and framework conditions, in particular the fact that today, realistically, it must be assumed that economies are open; Economies that are connected to other economies through the flow of goods and capital.

N. Gregory Mankiw with his model of the open economy as well as Robert A. Mundell and J. Marcus Fleming with their so-called Mundell-Fleming model provide valuable thought constructs that can help analyze and assess the effectiveness of economic policy measures, assuming certain premises .

Both models are presented and explained below.

Section 2: Mankiw model of the open economy

Nicholas Gregory Mankiw[5] gives with its model of an open economy[6] the ability to present, view and analyze various economic policy measures or events.

The starting point is the expansion of the closed economy models[7] to a model of the open economy, i.e. to allow and analyze the relationships and contacts of an economy with other economies. These relationships and contacts basically take place in two markets:

(1) On the goods market: there are exports and imports of goods and services. The difference (exports - imports) represents the external balance or the current account, the so-called net exports (X). In detail, the power balance can be divided into:

- Trade balance (flow of goods)
- Service balance (exchange of services)
- Transfer balance (transfer payments without direct economic consideration)

(2) On the capital market: this is either a question of investments by residents in foreign assets, or investments by foreigners in domestic assets. The difference is the net foreign investment (net foreign investment NFI) represent.

Both variables, net exports as well as net foreign investment, represent essential determinants of the macroeconomic equilibrium.

The following applies:

- Savings = domestic investment + net foreign investment[8]
- S = I + NFI
- Net foreign investment = net exports[9]
- NFI = X

Mankiw's model assumes that these variables are mapped on the credit markets and currency markets:

2.1 The credit market

The credit market is the market for creditworthy funds. The first decisive intellectual step in the Mankiw model is based on the assumption that the supply of credit funds can only come from domestic savings (S). In contrast, the demand for loan funds results from the domestic investment wishes (I) as well as the wishes for foreign investment, more precisely, the net foreign investment (NFI).

Both parameters depend on the real interest rate: a higher interest rate makes investments more attractive and therefore encourages saving, and the supply of credit increases accordingly. However, a higher interest rate also makes investments more expensive and thus reduces the willingness to invest. This leads to a lower demand for loan funds.

Depending on whether the domestic or foreign interest rate is relatively higher, investments fall either domestically or abroad, i.e. net foreign investments rise or fall.

This relationship can be graphically shown in the real interest rate / credit volume diagram (ir-CV-

Diagram, see Fig.1). [Figure not included in this excerpt]

- The demand for credit (Credit Demand = domestic investment wishes plus net foreign investment) is a falling curve (CD curve, see Fig. 1).
- The loan offer (Credit Supply = domestic savings) represents a rising curve (CS curve, see Fig. 1).
- In the equilibrium, the equilibrium credit amount (CV0, see Fig.1) and the equilibrium real interest rate (ir0, see Fig.1) are set.

2.2 The foreign exchange market:

The foreign exchange market is the market in which domestic currency is traded in exchange for foreign currency. As with the credit market, Mankiw assumes an analogy of supply and demand to the key variables of the open economy: the net foreign investment (NFI) represents the amount of domestic currency that is offered for the acquisition of foreign currency for the purpose of acquiring assets abroad from the foreign currency . In the model, this represents the supply of domestic currency.

The net exports, on the other hand, represent the amount of domestic currency that is demanded in order to be able to convert foreign currency obtained from export transactions (goods and services) back into domestic currency. Accordingly, they correspond to the demand for domestic currency.

This relationship is shown graphically in the real exchange rate-domestic currency diagram (er-LC diagram, see Fig. 2).

- [Figure not included in this excerpt] The demand for domestic currency (Local Currency Demand = Net exports) is a rising curve (LCD curve, see Fig. 2).
- The supply of domestic currency (Local Currency Supply = Net foreign investments) has a vertical course, since the amount of domestic currency offered for the purpose of foreign investments is not determined by the real exchange rate (LCS curve, see Fig. 2).
- In the equilibrium, the equilibrium amount of domestic currency that is traded (LC0, see Fig. 2), as well as the equilibrium real exchange rate (er0, see Fig. 2), at which the domestic currency is exchanged for foreign currency.

A special case of this model is the theory of purchasing power parity: "This theory says that one unit of any currency should be able to purchase the same amount of goods and services in every country"[10]. The real exchange rate is therefore a fixed amount, changes in the price levels of the two countries are expressed in changes in the nominal exchange rate, while the real exchange rate remains fixed (er = en x p * / p). This assumes a marginally short period of time until net exports react to the smallest changes in the real exchange rate and the previous real exchange rate is practically immediately restored. In the graphic representation, this special case of fixed real exchange rates would be a horizontal line.

2.3 Overall economic equilibrium in the open economy

The net foreign investment represents the variable that conceptually connects the credit market and the foreign exchange market, since it is a significant manipulating variable in both markets.

The net foreign investments are determined by the real interest rate, more precisely by the relation of the domestic real interest rate to the foreign real interest rate: a relatively higher domestic interest rate makes domestic investments more attractive, i.e. it displaces net foreign investments. Conversely, a relatively lower real domestic interest rate leads to reduced domestic capital investment and instead to increased net foreign investment.

This implies a falling course of the NFI curve in the ir-NFI diagram (see Fig. 3), with the curve starting in the negative area (more foreign investments in Germany than domestic investments abroad) and in the positive area (more inland Investments abroad as foreign investments in Germany) runs into it.

Figure not included in this excerpt

To illustrate the overall economic equilibrium of the open economy, all three elements discussed can now be summarized: credit market, net foreign investment and foreign exchange market (see Fig. 4)

Figure not included in this excerpt

- The supply (domestic savings, CS curve, see Figure 4) and demand (domestic investment wishes and net foreign investments, CD curve, see Figure 4) on the credit market determine the real interest rate (ir0, see Figure 4 ).
- The real interest rate determines the extent of net foreign investment (NFI curve, see Figure 4).
- The net foreign investments correspond to the supply of domestic currency on the foreign exchange market (LCS curve, see Fig. 4), together with the demand of the foreign exchange market for domestic currency (= net exports, LCD curve, see Fig. 4) they determine this real exchange rate (er0, see Figure 4).

The modes of action behave accordingly if a manipulated variable (domestic savings, domestic investments, net foreign investments, net exports) is changed due to economic policy measures or events: The other manipulated variables are adjusted until a new macroeconomic equilibrium is reached in the open economy.

2.4 Example: State budget deficit

This will now be explained using an example: A government budget deficit actually corresponds to negative public savings. With the help of the Mankiw model, the mode of action and the influence of this fiscal policy contraction on the remaining variables of the overall economic equilibrium of the open economy is to be analyzed (see Fig. 5).

- The negative public saving leads to a reduction of the total economic saving (corresponds to the sum of private and public saving). This reduces the supply of credit and leads to the crowding out of investments. In the graphic representation, the CS curve is shifted to the left towards the CS1 curve (see Fig. 5).
- There is a corresponding increase in the real interest rate from ir0 to ir1 (see Fig. 5).
- Due to the increased real interest rate, the net foreign investment is reduced. This corresponds to a movement on the NFI curve from point A to point B (see Fig. 5).
- This induces a reduction in the supply of domestic currency on the foreign exchange market, which corresponds to net foreign investment. In the graphic representation, the LCS curve is shifted to the left towards the LCS1 curve (see Fig. 5).
- The result is a fall in the exchange rate from er0 to er1 (see Fig. 5), which equates to an appreciation of the domestic currency.
- A new macroeconomic equilibrium is established in the open economy with a new level of domestic saving, domestic investment, net foreign investment and net exports, as well as real interest rates and real exchange rates.

In conclusion, it can be said that, according to the Mankiw model of the open economy, a government budget deficit causes real interest rates to rise, domestic investment is crowded out, the current account balance deteriorates and the domestic currency appreciates.


[1] Government declaration by the German Chancellor before the Bundestag of the Federal Republic of Germany on March 17, 2005

[2] Informal meeting of Gerhard Schröder and Jacques Chirac in Blomberg, Germany on 22./23. March 2005

[3] Monthly press conference of the European Central Bank in Frankfurt / Main on April 7, 2005

[4] Growth of the money stock M3 in the euro area by 6.5% from March 2004 to March 2005, data also from the ECB press conference on April 7, 2005

[5] born February 3, 1958 in Trenton, New Jersey; Professor of Economics at Harvard University; until February 2005 Chairman of the Council of Economic Advisors of the President of the USA.

[6] see Mankiw pp 689-737

[7] see Mankiw pp. 515 - 688, but also other common models of the closed economy, based on J.M. Keynes The General Theory of Employment, Interest and Money

[8] Mankiw p.698

[9] Mankiw p.696

[10] Mankiw p.719

End of the excerpt from 44 pages