Week 11

Lectures 21 & 22

Open Economy Macroeconomics: Net Exports and International Capital Flows Reference: Bernanke, Olekalns and Frank Chapter 15 Key Issues Balance of payments Relationship between the capital and the current accounts Determinants of international capital flows Saving, investment and capital inflows

Balance of Payments Record of transactions between residents of a country and non-residents Current Account Transactions leading to a change of ownership of commodities or a direct flow of income Capital Account Transactions involving the purchase or sale of assets

Current Account Balance on merchandise trade (exports less imports of goods) (plus) Net services (plus) Net income (includes labour and property income; interest, dividend and royalty payments) (plus) Current transfers (migrant funds, foreign aid) (equals) Balance on Current Account
3

Share of GDP

0.02

0.04

0.06

-0.08 0
Sep-59 Sep-62 Sep-65 Sep-68 Sep-71 Sep-74 Sep-77 Sep-80

-0.06

-0.04

-0.02

Current Account and its Components

$CA/$Y $TB/$Y $NFI/$Y

Sep-83 Sep-86 Sep-89 Sep-92 Sep-95 Sep-98 Sep-01 Sep-04

Capital Account Transactions between domestic and foreign residents that involve the acquisition of an asset or a liability New liabilities are recorded as credits (as they bring in foreign exchange) like exports of goods and services Acquisition of assets are recorded as debits (as they require foreign exchange to be given up by domestic residents) like imports of goods and services

Official and Non-Official Accounts The capital account is divided between two sectors. The official sector records the transactions of the government sector and the Reserve Bank. The non-official sector records the transactions of private sector firms, financial institutions and households.

Balance on Financial Account The important part of the capital account is the balance on the financial account, which records: direct and portfolio investment balances of net foreign investment in Australia and Australian investment abroad plus changes in the RBAs holdings of foreign exchange and gold

Balance on Capital Account A smaller part of the capital account is the balance on the capital account, which records: the cancellation of debts of poor countries and funds taken in and out by migrants, plus The net acquisition/disposal of non-produced, nonfinancial assets, e.g. records sales of embassy land or patents and copyrights

International Capital Flows Purchases and sales of real and financial assets across international borders are called international capital flows. From the perspective of a particular country: purchases of domestic assets by foreigners are called capital inflows, purchases of foreign assets by domestic households and firms are called capital outflows. Difference = net capital inflow/outflow
9

Capital Flows, Saving and Investment International capital flows allow countries to invest in more productive investment opportunities than would be possible relying only on national savings. In a closed economy, we have seen that national saving and investment are equal. In an open economy, where capital flows are possible, savings from other countries can finance investments.

10

Current and Capital Accounts The balance on the capital (and financial) account will be the same value as the balance on the current account, though have the opposite sign. This implies that (subject to recording errors) CAB + KAB = 0 CAB = -KAB Why?
11

Why Does CAB=-KAB? Suppose an Australian purchases a $40,000 Japanese car, and writes a cheque for $40,000. The Japanese company has three options with the money: They could use the $40,000 to buy Australian goods. Australian import = exports so CAB = 0

12

 Could buy a real or financial Australian asset or simply leave the money in the bank (an asset acquired by foreigners). The import would not be offset by an export so CAB = -$40,000, and there is a capital inflow of $40,000, so KAB = +$40,000. They could swap the $40,000 with a third party for another currency (e.g. yen), but the third party would only have the preceding two choices

13

Determinants of Capital Flows Why would foreigners want to acquire Australian assets, and conversely, Australians want to acquire assets abroad? The factors that determine attractiveness of any asset are: Return and Risk Other things equal (i.e. foreign real returns and the degree of risk) a higher domestic real interest rate will tend to increase capital inflows, as Foreigners buy more domestic assets Domestic residents buy less foreign assets
14

Capital Flows and the Real Interest Rate

Domestic r

KI<0 KI>0

Capital Flows KI

15

Capital Flows and Risk Risk has the opposite effect on capital flows. For a given real interest rate, an increase in the riskiness of the domestic assets reduces the net capital inflows, as domestic assets become less attractive to domestic and foreign purchasers. This shifts the capital inflow curve to the left for any given real interest rate.

16

An Increase in Riskiness of Domestic Assets KI KI Domestic r

Capital Flows KI
17

Small Open Economies In small open economies (SOE) like Australia, large capital flows would tend to eliminate any sustained differences in the interest rates between the domestic and foreign interest rates: r=r*

r=r*

KI

KI
18

Saving, Investment and Capital Flows In a closed economy, we have seen that national saving (NS = private + public saving) and investment (I) are equal. NS = I In an open economy, where capital flows (KI) are possible, savings from other countries can finance domestic investments. NS + KI = I

19

Saving and Investment in a SOE NS r

r=r* I NS I

KI

S,I,KI

I NS = KI = Net capital inflows

20

Saving, Investment and Net Exports We can use national accounting identity to show the relationship between these variables. Y=C+I+G+NX Y-C-G = NS NS-I=NX If NS < I, NX will be negative i.e. a trade deficit.

21