So far, we have been discussing how residents of an open economy participate in world markets for goods and services. In addition, residents of an open economy participate in world financial markets. A U.S. resident with $20,000 could use that money to buy a car from Toyota, or he could instead use that money to buy stock in the Toyota corporation. The first transaction would represent a flow of goods,  whereas the second would represent a flow of capital.

The term net capital outflow refers to the difference between the purchase of foreign assets by domestic residents and the purchase of domestic assets by foreigners.

Net capital outflow = Purchase of foreign assets by domestic residents
– Purchase of domestic assets by foreigners.

When a US. resident buys stock in Telmex, the Mexican phone company, the purchase increases the first term on the right side of this equation and, therefore, increases US. net capital outflow. When a Japanese resident buys a bond issued by the US. government, the purchase increases the second term on the right side of this equation and, therefore, decreases US. net capital outflow.

The flow of capital abroad takes two forms. If McDonald’s opens up a fast-food outlet in Russia, that is an example of foreign direct investment. Alternatively, if an American buys stock in a Russian corporation, that is an example of foreign portfolio investment. In the first case, the American owner is actively managing the investment, whereas in the second case, the American owner has a.more passive role. In both cases, U.S. residents are buying assets located in another country, so both purchases increase US. net capital outflow.

The net capital outflow (sometimes called net foreign investment) can be either positive or negative. When it is positive, domestic residents are buying more foreign assets than foreigners are buying domestic assets. Capital is said to be flowing out of the country. When the net capital outflow is negative, domestic residents are buying less foreign assets than foreigners are buying domestic assets. Capital is said to be flowing into the country. That is, when net capital outflow is negative. a country is experiencing a capital inflow.

We develop a theory to explain net capital outflow in the next chapter. Here let’s consider briefly some of the more important variables that influence net capital outflow:

• The real interest rates paid on foreign assets

• The real interest rates paid on domestic assets

• The perceived economic and political risks of holding assets abroad

• The government policies that affect foreign ownership of domestic assets

For example, consider US. investors deciding whether to buy Mexican government bonds or US. government bonds. (Recall that a bond is, in effect, an IOU of the issuer.) To make this decision, US. investors compare the real interest rates offered on the two bond. The higher a bond’s real interest rate, the more attractive it is. While making this comparison, however, US. investors must also take into account the risk that one of these governments might default on its debt (that is, not pay interest or principal when it is due), as well as any restrictions that the Mexican government has imposed, or might impose in the future, on foreign investors in Mexico.

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