MacroeconomicsI_working_version (1)

International Linkages 133
The determinants of net exports include domestic and foreign incomes and the real
exchange rate. Domestic income, Y, influences expenditures for imports, foreign income,
Y f , affects foreign demand for our exports and the real exchange rate, R, sets
competitiveness of the domestic goods abroad.
NX = X(Y f ,R) – Q(Y,R) = NX(Y,Y f ,R)
We can summarise the relations influencing the trade balance as follows (under the ceteris
paribus assumption):
• An increase in domestic income increases expenditures on imports and therefore
worsens the trade balance.
• A rise in foreign income raises the expenditures on exports and thus raises
domestic aggregate demand and improves the home country’s trade balance.
• A real appreciation by the domestic country worsens the trade balance and
therefore decreases aggregate demand.
14.7. Capital Mobility, the Balance of Payments and
Capital Flows
Some of the well-known and influential economic models (e.g. Mundell-Fleming Model)
work under assumption that capital is perfectly mobile. We consider capital perfectly
mobile internationally when investors can buy assets freely in any country they want
to, without obstructions, in whatever amounts, and with low transaction costs. In case
of perfect capital mobility, asset holders are willing and able to shift large funds in order to
seek for highest profit and lowest cost.
However, such high degree of capital market integration implies, that the interest rates
(interest yields of similar kind of assets) tend to similar level. With no barriers for capital
mobility every deviation from a world’s interest rate will bring large (infinite) capital
movements towards the highest yield. In terms of balance of payments perspective, a
decline in domestic interest rate relative to that in foreign economies will cause a capital
outflow. The domestic residents will be lending abroad the foreign investors will prefer
buying financial assets abroad and this will accordingly lead to worsening the balance of
payment.
Looking again from the balance of payments perspective, the overall balance of payment
surplus is equal to sum of the trade surplus, NX and the capital account surplus, CF:
BP = NX (Y, Y f , R) + CF (i – i f )
To conclude we can summarise domestic and foreign income and the real exchange rate as
the determinants of the trade balance and the interest differential as the determinant of a
balance on capital account. Under the perfect capital mobility assumption, we can state that
a rise in domestic income worsening the trade balance could be offset by an increase in
domestic interest rates in order to ensure an overall balance-of-payment equilibrium.