International Linkages and Mundell-Fleming Model

International Linkages : Flows of Trade and Capital in an Open Economy

• World economies are interconnected through two major channels: international trade in goods and services and cross-border movement of finance/capital; these linkages cause economic developments in one country to significantly influence others.

• Due to these trade and financial connections, both economic growth and recession in countries such as the USA affect income and output in countries like India, Mexico and Japan, and vice versa.

• For example, a recession in the USA reduces American incomes, lowers demand for imports, and consequently reduces India’s exports to the USA.

• Similarly, if the US Central Bank lowers interest rates below those prevailing in India, capital tends to flow from the USA to India in search of higher returns, as observed during 2002–03 and 2003–04. Such capital inflows affect the rupee exchange rate and increase India’s foreign exchange reserves held by the Reserve Bank of India (RBI).

• Since foreign exchange reserves with RBI influence the money supply in India, international capital movements can directly affect domestic monetary conditions.

• In the era of globalisation, economies have become increasingly integrated through trade and capital flows; therefore, growth or recession in one economy can have worldwide repercussions.

• Among international linkages, financial and capital movements have acquired particular importance. Households, banks and corporate firms can hold financial assets such as government bonds, corporate bonds and equity shares not only in their own countries but also in foreign countries.

• In most countries, including India, there are generally no restrictions on holding financial assets or physical assets abroad, enabling investors to diversify internationally.

• Portfolio managers of banks and large corporations continuously search across countries for assets offering the highest and most attractive yields, leading to international allocation and reallocation of funds.

• Through this shifting of assets by wealthy households, banks and corporate firms, financial markets across the world become interconnected, creating strong global financial linkages.

• The mobility of capital in search of better returns influences income, employment, exchange rates and interest rates both domestically and internationally.

• Since households, institutional investors, banks and corporations seek the highest risk-adjusted returns, capital market returns across open economies become linked with one another.

• For instance, if interest rates or returns on equity in India rise relative to those in the USA, US investors will tend to lend or invest in India to earn higher returns, resulting in capital inflows into India.

• Conversely, when borrowing costs are lower in the USA, borrowers may seek funds from US financial markets to take advantage of lower interest rates, thereby reinforcing the integration of global capital markets.

National Income and Trade Balance in the Open Economy

• A key distinction between an open economy and a closed economy is that in an open economy, aggregate expenditure need not equal domestic output of goods and services.

• An open economy can spend more than its income/output by borrowing from abroad, whereas it can also spend less than its output by lending the surplus to foreigners.

• According to national income accounting, Gross Domestic Product (GDP) is given by:
  Y = C + I + G + NX
  where C = consumption expenditure, I = investment expenditure, G = government purchases of goods and services, and NX = net exports.

• Net exports (NX) represent the difference between exports (EX) and imports (IM) and are also known as the balance of trade.
  NX = EX – IM

• Rearranging the national income identity establishes the relationship between net exports, GDP, and aggregate domestic expenditure:
  NX = Y – (C + I + G)
  where (C + I + G) denotes aggregate domestic expenditure and Y denotes GDP.

• If GDP exceeds aggregate domestic expenditure \((Y > C + I + G)\), then net exports are positive, implying that the country exports more than it imports.

• If GDP is less than aggregate domestic expenditure \((Y < C + I + G)\), then net exports are negative, implying that the country imports more than it exports.

• Thus, the difference between domestic output (GDP) and aggregate domestic expenditure determines whether a country has a trade surplus (positive NX) or a trade deficit (negative NX).