In a small open economy, goods market equilibrium occurs when desired

In a small open economy, goods market equilibrium occurs when desired saving minus desired investment equals net exports. Explain.

What will be an ideal response?

ANSWER

The domestic interest rate equals the world interest rate, regardless of the quantities of saving and investment. If saving is greater than investment at this interest rate, the excess of saving is used to purchase foreign assets. Then, the money paid to acquire foreign assets returns to purchase domestic goods, increasing net exports. If saving is lower than investment, domestic assets are being sold to foreigners, a capital inflow that enables the purchase of imports, reducing net exports.