Let us make in-depth study of the trade and financial relations between different countries of the world.
Different economies of the world are linked together through two channels.
(1) Through trade in goods and services;
(2) Movement of finance or capital across countries.
It is because of these international linkages that both the higher economic growth and recession in the U.S.A. make a substantial difference to income and output in other countries such as India, Mexico, Japan and vice versa as the latter have both the trade and financial relations with the former.
For example, recession in the United States that reduces the incomes of the American people affects their demand for imported goods and would affect India’s exports to the United States. Besides, if the Central Bank of America lowers interest rate below that prevailing in India, this will increase capital outflows from the United States to India as was witnessed during in 2002-03 and 2003-04.
Dollar inflows into India will affect the foreign exchange rate of rupee and also the reserves of foreign exchange with Reserve Bank of India. It will be recalled that reserves of foreign exchange with RBI determine the money supply in India.
It is quite evident from above that in this age of globalisation when the economies of the world have been integrated through flows of trade and capital, growth and recession in one economy have world-wide repercussions. International linkages in the area of financial and capital movements have acquired crucial importance in modern times.
The households, banks or corporate firms, say of the USA, can hold assets such as government bonds, corporate bonds, equity (i.e. share capital) of companies not only of their own country but also those of foreign countries. In most countries of the world today (India included) there are no restrictions on holding of financial assets such as corporate bonds, equity capital (i.e. corporate shares) and physical assets abroad.
As a matter of fact, portfolio managers of the banks or large corporations shop around the world for parking their funds in the assets of the countries which offer them most attractive yields. It is through shifting of their assets by rich households, banks or corporate firms that link financial markets around the world. This mobility of capital or finance to search for better yield around the world affects income and employment, exchange rates and interest rates at home and abroad.
As mentioned above, households, institutional investors, banks and corporate firms search around the world for the highest return (of course, adjusted for risk). As a result, returns or yields in capital markets in various open economies get linked together.
For example, if rates of interest or return on equity capital in India rise relatively to those in the USA, the US investors would try to lend or invest their capital in India to take advantage of higher returns. On the other hand, the borrowers would turn to the USA to borrow funds from the US financial markets to take advantage of lower rates of interest.
National Income and Trade Balance in the Open Economy:
An important difference between the open economy and the closed economy is that in an open economy, the aggregate expenditure in any year need not be equal to its output of goods and services. This is because a country can spend more than the income it earns from production of goods and services. It can do so by borrowing from abroad.
On the contrary, a country can spend less than the value of goods and services it produces because it can lend the difference to foreigners. To understand it fully recall the national income accounting explained in an earlier chapter.
It will be recalled that the economy’s gross domestic output (GDP) can be divided into the four components:
Y = C + I + G + NX …(1)
where C stands for consumption expenditure, I for investment, G for government purchases of domestic goods and services and NX for net exports. NX is the difference between expenditure on exports (EX) and expenditure on imports (IM). Thus, net exports (NX) = EX – IM. The net exports is also known as balance of trade.
From the national income accounts identity given in equation (1) above we can know the relationship between net exports, gross national product and aggregate domestic expenditure.
To do so we rearrange the equation (1) above as under:
NX = Y – (C + I + G) …(2)
where (C + I + G) represents aggregate domestic expenditure and Y represents Gross Domestic Product (GDP). The equation (2) shows that if Gross Domestic Product (Y) exceeds aggregate domestic expenditure (C + I + G), net exports (NX) are positive, that is, we are exporting more than we are importing.
On the other hand, if a country’s Gross Domestic Product is less than aggregate domestic expenditure, it will be importing more than it is exporting and therefore its net exports will be negative.
Saving, Investment and International Flows of Goods and Capital:
We have seen that saving and investment play an important role in determining the level of national income and employment in an economy in the short run. Besides, saving and investment are crucial to the long-run economic growth of a country.
It is therefore important to know how saving and investment are related to the international flows of goods and capital. This can be shown by rearranging the national income accounts identity. Let us first rewrite the national income identity.
Y = C + I + G + NX … (1)
Rearranging we have
Y – C – G = I + NX …(2)
Since saving is the part of national income (Y) that is left after expenditure on consumption by households and Government purchases of goods and services, Y – C – G in (2) above represents saving (S) of the economy. Note that national saving Y- C- G is the sum of private saving which is equal to Y – T – C (where T represents taxes) and public saving which is equal to T – G. Thus National Saving = Private Saving + Public Saving
or S = (Y – T – C) + (T – G)
= Y – C – G
writing S for Y- C – G in national income identity in (2) above we have
S = I + NX …(3)
Subtracting / from both sides of equation (3) we have
S – I = NX …(4)
The national income accounts identity of the open economy presented in (4) above shows that economy’s net exports (NX) must always be equal to the difference between saving and domestic investment (S – I). This difference between saving and domestic investment represents net capital outflow. The equation (4) above shows that net capital outflow equals net exports.
Net capital outflow is also called net foreign investment by some economists. Thus the equation (4) indicates that if saving (S) exceeds domestic investment (I), that is, if net capital outflow is positive, the economy will be lending or investing the excess saving abroad.
If, on the other hand, domestic investment in the economy is greater than its saving that is, if capital outflow is negative it means it will be receiving net investment funds from abroad. Thus net capital outflow, that is, the difference between saving and investment of the economy (S -I) equals the difference between the amounts the residents of country will be lending or investing abroad and the amount that the foreigners will be lending or investing in that country.
Thus the net capital outflow represents the international flow of funds to finance investment in a country. It follows from above that the difference between national saving and domestic investment, that is, net capital outflows always equals the net exports.
It may be noted that net exports is also called trade balance because it represents what extent trade in goods and resource of a country departs from the equality of imports and exports. Thus
Net Capital Outflow (S – I) = Trade Balance
From our above analysis we arrive at the following conclusions:
(1) If saving exceeds domestic investment (S > I) for an economy it follows from above that net exports (NX) or trade balance will be positive. In other words, in this case the country will be running a trade surplus. This case implies that the residents of the country would be lending or investing abroad.
(2) If saving is less than domestic investment (S < I or S -I < 0) of a country, its net exports will be negative, that is, the country will be running a trade deficit. In this case there will be capital inflows to finance the extra imports.
(3) Thirdly, if saving equals investment (S = I or S – I = 0), the net exports (NX) will be zero, that is, the country will have a balanced trade.
It follows from the above the identity of national income accounts of an open economy (S – I = NX) that the international flows of capital and international flow of goods and services are the two sides of the same coin.
It may however be noted that international flows of capital can take many forms. First, foreigners can lend to a country when it has excess of imports over exports. Secondly, the foreign can buy domestic assets such as the American firms buying shares in the Indian Stock Exchange or buying physical assets in India. By buying assets of another country, the foreigners are making investment and providing financial funds to the country.