Inflation, Saving and Growth in the Open Economy

Abstract

Policies of deficit spending financed by inflationary means can be expected to affect adversely a country’s balance of payments, especially the balance of payments of developing economies which are typically very open economies with a high income elasticity of demand for imports. There are only two ways in which excess aggregate demand in any economy can be dissipated at full employment; one is by inflation, the other is through a rise in the volume of imports. If the income elasticity of demand for imports is very high, and developing countries are able to finance an import surplus, the balance of payments may take the major part of the strain of excess demand with the internal price level rising very little. In short, there are two ways in which plans to invest exceeding plans to save can result in a greater volume of total saving and investment. One is forced saving brought about by rising prices; the other is by running an import surplus. The relationship between domestic saving and investment and the foreign balance is easily seen using the national income identity

$$Y = C + I + X - M$$

((8.1))

where Y is income C is consumption I is investment X is exports and M is imports.