SummaryAn economy’s openness must be measured considering multiple variables. For instance, all countries are considered open economies to some degree, but not all allow free movement of capitals across borders. Others might have governments that control information flows and Internet service. In this LP, we learn to analyse an open economy from a purely economic point of view, looking at their net exports and their Balance of Payments.
Net capital outflows (NCOs, also called net foreign investment) make reference to the difference between the acquisition of foreign assets by domestic residents and the acquisition of domestic assets by non-residents. Therefore, it has to do with savings and investment (loanable funds) and foreign currency exchange.
The relationship between net capital outflows and foreign currency exchange can be easily seen using a model, which analyses the market for loanable funds and the market for foreign currency exchange, in the context of an open economy. The link between these two markets will be net capital outflows. Let’s start by defining each market.
The market for loanable funds
In a few words, this market is a simplified view of the financial system. All savers come to the market for loanable funds to deposit their savings. Also, everyone looking for a loan (either to spend it or to invest it) comes to this market. In order to see how the supply and demand of loanable funds work, we use the following identity:
S = I + NCO
S = savings
I = domestic investment
NCO = net capital outflows
Savings corresponds to everything an economy saves from its income, both from the private sector and government accounts. Therefore, it represents national savings. On the other side of the identity we have national investment and net capital outflows. In other words, on one side we have savings being supplied to the market, while on the other side we have money demanded for national investment and net foreign investment (net capital outflows). As seen in the adjacent figure, equilibrium is reached when the quantity of savings (which correspond to supply of loanable funds) equals investment and net capital outflows (demand for loanable funds).
The supply for loanable funds (SLF) curve slopes upward because the higher the real interest rate, the higher the return someone gets from loaning his or her money. The demand for loanable funds (DLF) curve slopes downward because the higher the real interest rate, the higher the price someone has to pay for a loan.
The market for foreign currency exchange
In order to understand this market, which is the market in which domestic currency (let’s say euros) is exchanged for foreign currencies, we must use another identity:
NX = NCO
NX = net exports
NCO = net capital outflows
Again, if the economy is running a trade deficit (NX<0), it must be financing the net purchase of goods and services by selling assets abroad, so foreign capital is entering the economy (NCO<0). In order to buy domestic assets, foreign economies must exchange their currencies into euros, which increases the demand for euros. If the economy is running a trade surplus (NX>0), the excess in foreign currency it receives is being used to buy assets from abroad, which means domestic capital is flowing out of the economy (NCO>0). In this case, residents must exchange their euros for foreign currency, which increases the supply of euros, as seen in the adjacent figure.
The equilibrium is determined by the real exchange rate, since it corresponds to the relative price of domestic and foreign goods, thus affecting net exports. The supply of euros (S€, derived from net capital outflows) curve is vertical because it does not depend on the real exchange rate (as seen before, it depends on real interest rate, which is considered as given in this market). The demand for euros (D€, derived from net exports) curve slopes downwards because the higher the real exchange rate, the more expensive European goods are for foreign economies, thus reducing the quantity of euros demanded to buy those goods (since less people wants to buy European goods).
Net capital outflow
Net capital outflow links both markets. It does so because it depends on real interest rates, and because it determines the supply of euros. As we can see in the figure below, the net capital outflow curve slopes downwards. This is because the higher domestic real interest rates, the more attractive our assets are. This will attract foreign investment, which will in turn reduce net capital outflow (since more capital is entering the economy).
As seen in the figure below, the equilibrium is guaranteed by net capital outflows. The supply and demand for loanable funds determines a total quantity of loanable funds, but also a real interest rate, which in turn affects net capital outflows. Supply and demand of euros determine the real exchange rate, which also affects net capital outflows.
As we can see, these two markets and the net capital outflows linking them are tightly interconnected. In order to understand how this model can become a really useful tool, let’s review a few scenarios to see how the model responds.
Effects of budget deficits, trade policies and political instability
–Government budget deficit: when a government runs a budget deficit, it reduces the quantity of available loanable funds, thus shifting SLF to the left. This happens because the government’s expenses surpass its revenues. Therefore, it has negative savings, which reduces total savings. Shifting the supply of loanable funds reduces the total quantity at equilibrium, but also increases the real interest rate (to i1). This increase of the real interest rate reduces net capital outflow. The reduction of net capital outflow decreases the quantity of euros being supplied to be exchanged for foreign currency, which ultimately causes the real exchange rate to appreciate.
-Trade policy: let’s see how import quotas affect the market for loanable funds. Since an import quota reduces imports at any real exchange rate, net exports rise. Therefore, foreigners will need to buy more euros to buy EU net exports, which will shift the demand for euros (D€) to the right. This will appreciate the real exchange rate, but will have no effect on the market for loanable funds, and therefore the real interest rate will remain the same. Since the real interest rate does not change, neither do net capital outflows. However, the appreciation of the euro will increase imports and decrease exports (domestic goods are more expensive relative to foreign goods). This will gradually return the demand for euros (D€) to its initial state. Therefore, we can conclude that trade policies do not affect the trade balance.
-Political instability: this can easily turn into capital flights, such as the ones lived in Mexico in 1994, in some Asian countries in the late nineties, or the one that ultimately caused the Argentinian crisis of 2001. Capital flights basically mean that large quantities of assets or money are leaving an economy, which will shift the net capital outflow curve upwards, to show increasing net capital outflows. This will affect both the market for loanable funds and the market for foreign currency exchange. First, it will increase the demand for loanable funds (in order to increase the purchase of assets overseas), shifting the demand curve (DLF) to the right, increasing the real interest rate. Secondly, since people wants to convert their euros into a more “secure” currency, supply of euros rapidly increases, shifting the supply curve to the right.