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 assetsby domestic residents and the acquisition of domestic assets by non-residents. Net capital outflows takes two forms: foreign direct investment, and portfolio investment. Foreign direct investment implies actively managing the asset or the interest bought, while portfolio investment requires no role at all in management.
An open economy can therefore buy and sell assets in the financial markets, generating flows of capital.
NCO = Acquisition of foreign assets by residents – Acquisition of domestic assets by nonresidents
When the net capital outflow is positive, domestic residents are buying more foreign assets than foreigners are purchasing domestic assets. When it’s negative, foreigners are purchasing more domestic assets than residents are purchasing foreign assets.
Imbalances in the net capital outflow (NCO) are associated with imbalances in the trade balance (or net exports, NX), following the identity NCO = NX. Each exchange that affects the net capital outflow, also affects net exports in the same amount. For instance, if an economy is running a trade deficit, it must be financing the net purchase of goods and services by selling assets abroad. If it’s running a trade surplus, the excess in foreign currency it receives is being used to buy assets from abroad.
Since net capital outflows are related to net exports, they are therefore related to gross domestic production. From the equation showing the relationship between the current account, savings and investment, we have:
S = I + NX = I + NCO
S = savings
I = domestic investment
NX = net exports
NCO = net capital outflows
From these equations, we can derive an easy-to-use cheat sheet about international flows of goods, services and investment: